Building a Small-Cap Portfolio

In this week's column, I'd like to talk about the subject of small-company investing within the context of how much time and money one should expect to devote to the pursuit of first-class investment results. But before I jump into the meat of today's topic, I'd like to first thank Brian Graney, who has decided to move on to other challenges, for his dedicated and often brilliant navigation of the world of small-cap investing in this column over the past six months. In addition to his wonderful qualities as a writer, Brian has been an absolute pleasure to work with, and we will miss his wit and humor as well as his investing insights here at Fool HQ.

In reading over Brian's past columns this week, it's completely obvious to me that Brian's shoes can't be adequately filled. Nevertheless, I am very happy to have received the small-cap investing baton here at the Fool, and hope that, wherever our journeys in investing take us, we will benefit not only from our investments but also from enjoying the opportunities to learn whatever we can along the way.

Also, I'd like to share with you why it is that I find small-company investing so rewarding. It has always been my view that trawling the waters of small companies, looking for a gem here and there, is the most Foolish of all investing styles. Because small companies are often of little or no interest to Wall Street analysts, a dedicated Fool can often gain a huge edge by virtue of learning more about a given company than the rest of the market.

This makes small-cap investing, to my mind, the most even playing field for the individual investor. On the other hand, it's also true that the small-cap investing waters are where individual investors are most often eaten by sharks. Considering that my investments have been occasionally known to provide a nice, juicy shark snack, I can assure you that refining the art of small-company investing is a never-ending process -- and therein lies the challenge.

The other element about small-cap investing that I find delightful is the endless variety of businesses that one comes across. Many of the companies that pop up on the Small-Cap Foolish 8 spreadsheet each month are new to me, and these companies don't have the media or analyst coverage that often serve as a crutch or shortcut to research. Without a multitude of Wise opinions to lean on, an individual investor has no choice but to come to his or her own conclusions about the investment merits of the business. There is perhaps no better way to learn about business than to look at a different one every couple of days. When asked by author Adam Smith for his advice for someone entering the investing field, Warren Buffett explained:

"Well, if he were coming in with small sums of capital, I'd tell him to do exactly what I did forty-odd years ago, which is to learn about every company in the United States that has publicly traded securities, and that bank of knowledge will do him or her terrific good over time."

Smith responded skeptically with the observation that there are over 27,000 publicly traded companies, to which Buffett replied: "Well, start with the A's."

While few individual investors will have the time or the interest to examine even one hundredth of those companies in his or her lifetime, even looking at one company a week can be insightful and profitable. Eventually narrowing down your odyssey to one or two industries in which you are especially interested means that you can become quite an expert in those areas within a relatively short time period. By developing and then sticking to a circle of competence, you will likely improve your investing batting average substantially over time.

That long introduction to small-cap investing aside, let's get to the questions of how much individual investors should allocate to investing in small-cap companies, and secondly, how often an investor should reassess the prospects of the companies already purchased.

Let's answer the latter question first, since it has some bearing on the first question. Investors in small companies must be aware that a diehard commitment to long-term buying and holding can be decidedly hazardous to one's wealth. Investing in small companies differs quite dramatically from our Rule Breaker and Rule Maker philosophies in this respect. On the other hand, one should consider holding as long as 1) business fundamentals look intact, and 2) the stock remains in a price range in which it is undervalued to fully valued -- but not excessively valued.

Small-cap investors should commit to re-evaluating the business on a quarterly basis, at a minimum. That means reading not only the earnings press releases published by the company, but also the 10-Q or 10-K regulatory filings. Of course, if there are identifiable events you are expecting that will impact the company's business, you need to be watching for those developments between quarters as well. With a small company, you need to be on top of all three financial statements, and any important business developments, because the picture can change in a hurry. Day-to-day monitoring is usually not necessary, but the burden of following the companies is much harder than, say, what we do over in the Rule Maker Portfolio.

Now let's get back to the first question: How much of my portfolio should I dedicate to small-cap stocks, and how many stocks are ideal? In terms of number, it depends upon two factors: how much time you can devote to following the stocks, and how many great opportunities you come across. I like to follow the Peter Lynch principle that for every 20 rocks you dig up, you'll find one that you think may be a diamond. For every five keepers, one will disappoint, three will be OK, and one will be a tremendous performer, with the returns of the great performer usually sufficient to carry your entire portfolio to market-beating gains.

That being the case, a portfolio of five to ten small-cap stocks, if carefully selected, is usually more than sufficient. Because the volatility of small-cap stocks tends to be quite high, waiting until the market serves up a perfect pitch by offering a great price on a company you want to own will increase your odds of generating exceptional returns. (I am also pleased to note that we will be dedicating a monthly feature to some of our favorite small-cap stocks in our new investing publication, The Motley Fool Select.)

As far as allocation goes, if you decide to concentrate on small-cap stocks, I recommend putting 75% of your equity money in an index fund and using the rest to find small-company gems. If you are investing in other investing strategies, such as Rule Maker or Rule Breaker, rather than a diversified vehicle like an index fund, you'll eventually want to allocate your money on the basis of where the opportunities are rather than going by a fixed percentage allocation.

Next week, I'll be back with some case studies of what NOT to do from my own small-cap investing experience. It's always amazing to me how much one can learn from the dumb investing decisions of others, and I hope you'll swing back by next week and take the opportunity to learn from some of mine!