"How do you decide which stocks to buy?" This is probably the most frequently asked question among those just getting started in the world of investing. Or heck, among investors at any level. We're always interested in what works for other people.
There's nothing wrong with that question, but those just getting interested in small-cap stocks should realize that what works for one person may not work for another. Yes, just as there's more than one way to size a fish, to skim a batch of pond scum, to give back to Meredith, or to skin a cat... there's also more than one way to evaluate small-cap stocks.
Consider your abilities
If you're new to the game, there's little chance that you'll be able to conduct an effective discounted cash flow analysis of a particular company. If you're a slow learner like me, there's little chance of running an effective DCF even after several years. Does this mean we shouldn't invest at all? No! (If I answered "yes," I'd have to end the column here.)
Some will take to such methods easily, while others will never be able to achieve good results with them. Similarly, some folks do very well by constructing elaborate mathematical formulas, weighting each factor separately and coming up with buy and sell criteria. Others are better at learning business models inside and out, and gauging a company's potential for success or failure based on that. Some are adept at picking out bottom-scraping turnaround companies, while others know a 500-pound gorilla when they see one.
The point is to figure out your strengths, and play to them. Despite the tendency to think there is one correct way to do everything, the world simply does not fit into neat little boxes. There isn't a "holy grail" of investing methodology; if there were, everyone would do it and then it wouldn't work anymore.
Know thyself
Knowing your temperament and personality can help you get a handle on your strengths. The Keirsey Character and Temperament website is a fascinating place to begin studying yourself. Similar to the well-known Myers-Briggs Personality Type Indicator, Keirsey has a couple of tests you can take online after free registration.
I found that I was an "ENFP," and it was comforting to know that there are others out there who are hopelessly disorganized, learn from intuition, and prefer to live their lives spontaneously. (There's a good summary of the different character types here.)
I certainly don't think every person can be characterized by four simple letters, but Keirsey's tests can tell you a lot about yourself, even things you may have been vaguely aware of but never crystallized in your mind. And, if you're similar to me, you'll need to force yourself to write down your investing framework instead of just letting it float around inside your head.
Small-cap specifics
Zeke Ashton wrote an excellent column several months ago detailing the four variables under your control when buying a stock:
1. Which companies to buy
2. What price to pay
3. How large a position to take, and
4. Buy, hold, or sell at the current price
Regardless of which small-cap investing framework you employ, it should address these four issues. Zeke also adds a very important point that can improve your methodology: "Accordingly, I encourage you to do a postmortem analysis of some of your recent investment decisions." In other words, learn from your mistakes and your successes.
Small-cap investors have a wonderful resource located here at Fool.com in the form of the Foolish 8 discussion board. There, you'll find ongoing discussion about promising small-cap companies as well as different investing philosophies. You'll want to start with the board's FAQ, compiled by board veteran mathetes. The FAQ will explain what the Foolish 8 is, and what it is not. It also has a section devoted to the topic of this column.
You can learn about investing the "Ed May way," for example. Community member edmay developed a six-step method that will take you through screening, research, financial sheet analysis, buying, and selling.
Erik Eason, known as FoolishErik on the boards, has contributed in this space before, and has conducted extensive research on small-cap investing. He also refined a small-cap method first introduced by Tom Gardner and came up with a way of grading stocks. He later introduced a new method that emphasizes operating profit and invested capital called OPIC.
This is just a small sampling of the different ways to go about the small-cap investing process. Feel free to look through the boards for more help. In addition, the four columns in the "Related Links" box in the upper-right part of this page will help you immensely as you begin to develop your own framework.
My final piece of advice is to make sure you are intimately familiar with any company you are considering for investment. Know how the company makes money, how it plans on growing, and what factors might disrupt its plans. Know the company's entire industry, including which competitors are most likely to throw it off course.
Remember: You can never be too rich, too thin, or too knowledgeable about your investments.
Rex Moore is so disorganized he once missed a final exam in college, and his to-do list is nothing more than a wish list. He does know which stocks he currently owns, and is able to follow the Fool's disclosure policy.
