In "These Stocks Will Burn You," I cautioned against getting too excited about the potential for making millions in small-cap stocks. Not because the chance for huge gains isn't there with small companies; I could give you any number of examples similar to E*Trade Financial's (Nasdaq: ETFC) 391% gain in 10 years, or Valero Energy's (NYSE: VLO) 2,443% run-up after adjusting for dividends. A modest $5,000 investment in each of those two would have returned you more than $150,000 in all.
No, my warning was simply to let you know that with such high potential reward comes high risk. It's one of the laws of investing, and one we teach about constantly in our Motley Fool Hidden Gems small-cap investing service. You need to do all you can to avoid having a stock or two inflict years' worth of damage on your portfolio.
So how can we Fools reduce the risk involved while still keeping the potential reward high enough? Two things. First, pay attention to the balance sheet and stay away from companies that are overleveraged with debt and burning through lots of cash. In my original article, I recommended sticking with profitable companies with cash-to-debt ratios of at least 1.5. Second, buy two, three, or even more of these small fries with the same amount of cash you'd normally allocate to one position. If $6,000 is all you're comfortable allocating to a "normal" stock purchase, try buying three small caps you like at $2,000 apiece. That way, if one crashes to earth and loses half its value, your portfolio won't be overly harmed by it.
For example
A good example comes from the small caps I've bought in the past several months from Tom Gardner's recommendations in Hidden Gems. I now own Buffalo Wild Wings (Nasdaq: BWLD), Cutter & Buck, and Ctrip.com (Nasdaq: CTRP). Cutter & Buck, a Tiny Gems micro-cap recommendation, was down 25% for me before being bought out by a Swedish firm. However, I'm also sitting on current gains of 150% in Buffalo Wild Wings and 170% in Ctrip. If we assume for simplicity's sake a $2,000 investment in each, my $6,000 would have turned into $11,900: a nice 98% gain despite Cutter & Buck's "quarter haircut."
Of course, larger companies can be volatile and burn you as well: Supposed "sure things" such as JDSU (Nasdaq: JDSU), Gateway (NYSE: GTW), and RF Micro Devices (Nasdaq: RFMD) all lost more than 90% in the great Tech Wreck of 2000. Each of these still has recovered but a fraction of their value. But you must be especially on your guard with small caps.
How to get small
Despite the risks, the promise is there -- and we actively encourage you to make small caps a part of your portfolio, especially if you have a few years to go before retirement. If you need help separating the wheat from the chaff and want to find out which five small companies Tom Gardner and Bill Mann suggest you buy now, consider a trial run with Hidden Gems. After more than three years, their recommendations are beating the S&P 500 by an average of 62% to 26%. If you're interested, here's more information on a no-risk, free trial.
This article was originally published on Dec. 5, 2006. It has been updated.
Rex Moore is allowed to operate heavy machinery. He owns shares of Buffalo Wild Wings and Ctrip.com. This information is brought to you by the Fool's disclosure policy.
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