Last week's column on Small-Cap Risks illustrated the inherent risks in small-cap investing, even when using a helpful selection screening tool like the Foolish 8. Given the risks involved and the poor subsequent performance of many of the stocks that have appeared on the monthly Foolish 8 lists since 1998, why would anyone want to invest in this area?
The answer is that despite the risks, some of the greatest investing opportunities in the stock market are in small companies that have the potential to become much bigger companies over time. Granted, not every small company out there will turn out to be a growth firecracker. Most, in fact, will be duds. But as expressed last week, one big winner can make up for a half-dozen losers over time.
How do you find those big winners? That is the $64,000 question on every small-cap investor's mind. Unfortunately, there is no single magic method for consistently picking great stocks. If there were, everyone would be using it. In reality, instead of methods for guaranteed winnings, there are only systems for keeping the risks of a big loss to a bare minimum.
Many investors think about their stocks only from the point of view of their upside potential and busy themselves by counting their potential stock gains in their head. "If XYZ Corp.'s stock can just go from $10 to $20 per share, which is where it was last May, then I can buy that new SUV that seats 15 and has the built-in microwave oven in the back seat!" This may be a fun way to think about the long-term wealth creation power of stock investing, but it is also dangerous. Really, it's no different than dropping a quarter in a one-armed bandit and hoping you'll catch the mathematical probabilities at just the right instant so that you'll end up with a screen full of cherries.
The better way to think about stock picking is to start out not by calculating how many cars your garage might potentially gain from buying a company's shares, but by estimating how much you might end up losing. Adopting this mindset may not be as much fun in the short term, but it will pay off over time. As the historical returns of some of the stocks on the July 1998 Foolish 8 list showed last week, you can lose quite a bit. And remember, every company that passes the Foolish 8 screens has a number of things going for it. Perhaps most fundamentally, all Foolish 8 companies have profits and positive cash flow from operations. So, these companies are not exactly the dreck of the stock market when they hit the list, although several may end up in that category over time.
When I think about potential losses from owning an individual stock, my mind always comes back to four main questions. By asking these questions over and over while researching a company, a small-cap investor can add discipline to the stock selection process and avoid the one-armed bandit syndrome:
- Is this a good business area?
- Is this a good company?
- Is there good management?
- Is the stock selling at a good price?
These are the four "goods" that a small-cap investor should always look for in a potential investment. Of course, trying to quantify different levels of "goodness" can be a challenge. As legendary investor Phil Fisher commented in a recent issue of Outstanding Investor Digest, "There's no real standard of measurement of what's good." It's up to the individual investor to figure these things out. And that's exactly what our columns over the next few weeks will attempt to do.
These four "goods," though simple, cover a lot of investing ground. The first "good" deals with the specific business opportunity of a company and incorporates such notions as identifying large business trends, thinking about future growth opportunities, and judging competitive threats. Identifying good companies and good managements go hand in hand, as both deal with such things as how a company handles its internal operations and costs, how it funds itself, and how it allocates its cash.
Finally, looking for good prices opens up questions relating to valuation and setting expectations for the future, topics that have been introduced in previous columns. The last thing a small-cap investor should want to buy is a good company in a good business area with a good management team, but which needs a miracle in terms of future earnings growth in order to just provide a humdrum investment rate of return down the road.
Thinking about investing opportunities using a mindset based on the four "goods" is not a guarantee of outstanding long-term investing success. Investors should always expect the unexpected, especially when dealing with small caps. However, a mindset geared toward preventing bad swings rather than looking only for home runs is an effective way to deal with the high risks involved in picking individual small-cap investments.
