Embrace Small-Cap Volatility

Of all the horror movies in which a person is given some awesome, uncontrollable power, I think The Invisible Man with Claude Rains is one of the most poignant. If you were invisible, you'd have the power to stroll into forbidden, secret places. But you'd also become subject to the buffeting of forces in an obliviously insensitive world. You'd begin to doubt your own existence ... and then your sanity.

When volatility sends the price of small-cap stocks south, investors in such companies may tend to feel a little bit like the Invisible Man. We hear it from people subscribing to our Motley Fool Hidden Gems small-cap service: They see that their holdings have so much potential, and yet individual stock prices often get savaged downward, defying what rational analysis tells them ought to happen. Are the compelling fundamentals of these companies invisible to the market?

Volatility is unavoidable in small-cap investing. It can be a gut-wrenching, stress-inducing part of the small-cap investing experience, or it can be the grease that runs the profit machine. Where a 3% move in Procter & Gamble (NYSE: PG  ) or McDonald's (NYSE: MCD  ) would be out of the ordinary, good or bad news can routinely move small caps' share prices more than 10%. It can be tough for an investor to handle, but the determining factor is self-discipline. Think of the following as a stress-management checklist for living with volatility.

Determine your small-cap investment criteria
Small-cap investing has high -- yet manageable -- risk, at least when compared to value or income investing. Significant returns probably will not materialize early on in any individual investment. A conscious decision on one's small cap risk limit is essential. Those relying on investments for regular income should be extremely cautious with small-cap investing.

Small-cap investors should also understand the metrics used for predicting volatility. While beta is perhaps the most common metric for predicting a stock's volatility, it actually describes a stock's volatility relative to the market as a whole. So, under "normal" circumstances, a low beta could indicate a relatively safe, if somewhat lethargic, investment. United Utilities (NYSE: UU  ) , for example, has a beta of 0.08. A low beta in a wild market won't guarantee smooth sailing. Also, low volatility has little relation to a stock's growth potential. Bad corporate news can trounce share prices of low-beta equities as much as they might high-beta equities.

Perform due diligence before pulling the trigger
Investors sometimes open their stakes without understanding the company's business. Then, at the first sign of negative volatility, they finally scramble to look at the firm's financial statements. That's being reactive, not proactive. You need to understand a company before investing in it. If the stock happens to rally to unattractive levels while you're doing your research, you'll nonetheless be in a great position to buy when the stock inevitably dips. If the stock falls, you'll know more about the company and therefore be less prone to panic. Cognitive scientists have determined that uncertainty is one of the most stressful and painful emotional states. Prior due diligence reduces the element of surprise and is the most effective way of minimizing investment uncertainty.

Due diligence does not only include checking the criteria for buying a stock. With rare exception, it should also include formulating the conditions for selling based on the stock's valuation. Because small-cap companies often have greater growth prospects than blue-chip companies, your reasons for selling a small-cap company are more apt to change.

All Motley Fool newsletters, including the small-capHidden Gems service, incorporate a great deal of diligent qualitative and quantitative analysis into every recommendation. Foolish analysts review companies with a critical eye toward understanding a business rather than just evaluating a stock. However, subscribers do both themselves and the Motley Fool an injustice if they blindly follow a Foolish recommendation without performing their own due diligence.

Manage the diversity of your small caps
Because investing in smaller businesses is inherently riskier than other approaches, you should diversify your small caps by buying into a number of companies in different sectors. But small-cap companies are acutely subject to changes in industry dynamics, so you shouldn't own too many stocks that you can't adequately follow them all. Investors should buy stocks only to the extent that they can either monitor, or effectively rely on others to monitor, those positions. Heed the wisdom in Mark Twain's Pudd'nheadWilson:

"Behold, the fool saith, 'Put not all thine eggs in the one basket' -- which is but a manner of saying, 'Scatter your money and your attention'; but the wise man saith, 'Put all your eggs in the one basket and watch that basket!'"

Balance strong hands with vigilance
Roller coasters have well-designed restraints that prevent riders from falling or otherwise injuring themselves as the cars climb steep inclines and plummet into troughs. Investors, however, have only their own self-confidence preventing them from leaping out of an investment when it slumps to a low price. Hence the need for "strong hands" to hang on to the investment during worrisome, sometimes inexplicable turbulence. In fact, I would argue that investors should expect dips early on in any individual Hidden Gems investment. One of the best performing Hidden Gems picks, FormFactor (Nasdaq: FORM  ) , dropped 23% beneath its recommended buy-below price within the first two months after its recommendation last July. Strong hands were rewarded, however, since the stock is now almost 30% above the recommendation price.

Let's be fair. If slews of investors knew what we knew about our Hidden Gems, the stocks would never be cheap enough for us to buy. Given the risks associated with smaller companies, it is reasonable that temporary paper losses will sometimes be in the double digits before recovering. Sell-offs of small-cap shares often have little to do with fundamental changes in the company's situation or prospects. Sometimes, investors are simply spooked, driving prices down.

The Hidden Gems strategy of buying in thirds, described recently by Fool writer Rich Duprey, is one way that savvy small-cap investors use stock price dips as buying opportunities. Temper that buying strategy with careful analysis, however. Recently, two Hidden Gems stocks tumbled by 40%, but the newsletter's analysts dissuaded investors from doubling down their investment in one. Why? Because it had suffered two potentially significant setbacks.

In the face of small-cap volatility, how has Hidden Gems done? Better than 30% returns. So, while Hidden Gems stock prices meander like Monty-Pythonesque twits in a stair-climbing competition, we can take heart that volatility travels in both directions, true small-cap winners seldom stay invisible for long, and most twits eventually reach the finish line.

Motley Fool co-founder Tom Gardner runs Hidden Gems, and you can try the newsletter on him for 30 days at no cost. Or, even better, you can join Tom risk-free at Hidden Gems for one year and download the Motley Fool's first-of-its-kind Blue-Chip Report 2005: 10 Monster Stocks for the Next Decade right now -- for free. This way, you get the best of both worlds. Click here to find out more while this offer lasts.

Fool contributor Michael Jaffe owns shares in FormFactor, but has no financial position in the other companies mentioned. The Motley Fool has a strict disclosure policy.


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