Why These Stocks Didn't Burn Me

In "These Stocks Will Burn You," I cautioned against getting too excited about the potential for making millions in small-cap stocks. Not because small companies fail to present the chance for huge gains; I could give you any number of examples that did, like Research In Motion (Nasdaq: RIMM) and Activision (Nasdaq: ATVI). Up 3,906% and 644%, respectively, over the past five years, a modest $5,000 investment in each of those companies would have returned you more than $230,000.

No, my warning simply aimed to let you know that with such high potential reward comes high risk. It's one of the laws of investing, 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 and still keep the potential reward high enough? First, we can 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, we can buy two, three, or even more of these small fries with the same amount of cash we'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 bought Buffalo Wild Wings, Cutter & Buck, and Ctrip.com. Cutter & Buck, a Tiny Gems micro-cap recommendation, was down 25% for me before it was bought out by a Swedish firm. However, I'm also sitting on current gains of 35% in Buffalo Wild Wings and 258% in Ctrip. If we assume (for simplicity's sake) a $2,000 investment in each, my $6,000 would have turned into $11,360: a nice 89% gain, despite Cutter & Buck's "quarter haircut."

Of course, large companies can be volatile and burn you as well. Consider that Sun Microsystems (Nasdaq: JAVA), Time Warner (NYSE: TWX), Broadcom (Nasdaq: BRCM), and CA (NYSE: CA) all lost 50% or more in the great Tech Wreck of 2000. 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 right now, consider a trial run with Hidden Gems. After more than four years, their recommendations are beating the S&P 500 by an average of 33% to 14%. 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 a Fool analyst and looks great in flannel. He owns shares of Buffalo Wild Wings and Ctrip.com. The Motley Fool also owns shares of Buffalo Wild Wings. Buffalo Wild Wings and Ctrip are Hidden Gems selections. Time Warner and Activision are Stock Advisor picks. This information is brought to you by the Fool's disclosure policy.