For today's article, I'd like to share with you the thoughts of Erik Eason, a member of our Motley Fool community who has spent a lot of time researching the Foolish 8 strategies for use in his own investing. We asked Erik to write a short article describing what he's learned in his small-cap investing experiences. I shared this writing recently with the participants in our Succeeding With Small Caps online seminar, and wanted to share it with a wider audience of investors who may just be starting out in small-cap stocks. -- Zeke Ashton
Small caps are fickle beasts and not for the faint of heart; but for those with fortitude and who prefer to laugh than worry, they are very rewarding and a lot of fun. You should also have a fair bit of investing experience before you tackle them, because you've got to dig into them and watch them carefully. Zeke tracked me down (I'm on a one year sabbatical) to ask me to share some lessons learned from my own experiences with small caps. I've got a bunch (lessons, that is) so I'll try not to ramble too much!
Selling is much harder than buying. Sell, you say?! Yes, sell. Unlike The Motley Fool's Rule Maker and Rule Breaker portfolios, small caps are NOT long-term buy-and-hold. Most of these little guys never make the big league, and we are not looking for the next Microsoft (Nasdaq: MSFT). I'll repeat that: small-cap investing has nothing to do with Rule Breaker investing. We are not looking for companies that will appreciate 1000% in the next five years; we are looking for companies which will appreciate on average maybe 50%-100% in the next year or two. So don't go falling in love with them.
With that said, however, small caps are the only place to find and profit from the next Microsoft. Maybe you'll get lucky, but that's not the goal. Figuring out when to sell is the hardest part of small-cap investing.
Finding good companies is harder than buying. There is a lot to be learned about what constitutes a good small cap; but once you've learned it, found your favorite resources, defined your own strategies, and made your spreadsheets, it becomes a production line that doesn't take too much time. With experience you can look at your spreadsheets and know immediately which companies warrant a deeper look.
Buying is waaaaay too easy! So keep your durn finger off the buy-trigger!! Found what looks like a great little company? Don't pull that trigger! Dug into it and are even more excited? Don't pull that trigger! Maybe did a little valuation and are impatient because its stock price is rising? Definitely do not pull that trigger. Go take a walk, go play with your dog, take a holiday, think about what other fun things you could do with that money. You've got more homework to do, as well as comparisons with other opportunities, before you buy.
Small caps are an enormous amount of fun, but definitely more stressful because their stock prices wander all over the charts, even when they are doing very well. You cannot ignore them for months at a time like you can a blue chip. They are, however, so much more diverse and intriguing. Every time you go fishing for new companies to investigate, who knows what you will catch? They are involved in every imaginable niche of every imaginable industry. They and their stocks can suddenly hit the spotlight and fly to the sky, or get whapped by a flyswatter and plummet to earth. It's a whole lot more fun than a roller coaster! One of my favorite moments was when one of my small caps got selected for the S&P mid-cap index (mid-cap, small-cap, what's in a word anyway?). I felt so smart! 'Course it got beaten up later, but like a good boxer it came back.
Small-cap investing is about pragmatism and patience. Optimism and impatience are extremely hazardous to your investing. I am an impatient optimist by nature, so I know the challenge of holding back; and I also know the consequences of failing to do so (been burned by this -- ouch!). If I can be pragmatic and patient, then you can do it, too! Just constantly keep in mind that it pays very, very well to approach investing that way; and that it's far more fun to win than to lose.
Small caps rise and fade in industries. They are, therefore, valued as much for their industry as anything. Watch your screens carefully for signs of an emerging or fading industry. Find a rising industry? Then get into the best of its small caps. One of your invested industries fading? Then get out of all of its small-caps.
Watch the main leaders in those industries in which you hold small caps. Is the news still enthusiastic about them or do you see dark clouds approaching? Watch for relentless, industry-wide changes in the analyst ratings of the leaders, and industry-wide swings in stock prices contrary to the market, then go check the news. When the telecom companies faltered from too much debt and insufficient growth in their markets, Cisco (Nasdaq: CSCO) and Lucent (NYSE: LU) got hammered. So did every company in their supply chains. Having trouble valuing a small cap? Then evaluate the leaders and see where they stand. Their small-cap suppliers are probably being given the same level of enthusiasm or pessimism.
Industries can rise in a bear market. As the tech industry nose-dived over the last year with the coming bear, the energy industry rose (remember those rising gas prices?). Bear markets do not apply to all industries!
Do not tolerate crooked or inept management. When you see a company's stock price plummet because they got caught with their pants down, sell and never look back. Be utterly intolerant of them in the future. Fool me once, shame on you; fool me twice, shame on me.
Take an occasional sabbatical. Unless you are rockin' and rollin', pull your money out of small caps every so often and take a breather. Once your head and heart are thoroughly clear and refreshed, then ask yourself: Are you having more fun in life while out of small caps? Are you eager to get back in? Did you really make money? What would you do differently next time?
With skill, experience, and attentiveness, small caps can be the most rewarding type of investing. So have fun, learn a lot, and prosper.
Cheers, and Good Luck!
- Erik Eason (FoolishErik on the Motley Fool discussion boards)
Eric Eason doesn't own any of the stocks mentioned in this article. The Motley Fool has a disclosure policy.