If you’re a young investor looking to build a nest egg, you should strongly consider adding small caps to your growth portfolio. The TSX is chalk-full of hot up-and-coming companies that have the potential to become multi-baggers throughout the next decade and beyond.
Unfortunately, many promising small-cap stocks don’t have much coverage (if any at all) from the sell-side analyst community, because of a lack of interest from the general public. Smaller companies haven’t had the chance to establish themselves partially due to a lack of financing compared to the behemoths.
As such, many unheard-of names may not be discovered until much later, when the company’s market cap reaches the mid-cap threshold, earning the trust of investors, as the business’s brand begins to make a name for itself.
Of course, there are exceptions — most notably, “shady” micro-cap venture mining companies that use their limited capital resources on televised ads to promote their stocks on networks such as BNN. Such commercials can serve as to pump up a stock that can be quickly dumped by manipulators. That’s a major reason why there’s now a disclaimer when such ads are broadcast during commercial breaks. It’s a warning label that new small-cap investors shouldn’t take lightly.
Finding hidden gems isn’t easy
Small-cap stocks have a stigma attached to them, and for good reason. There’s a lot of poor-quality merchandise out there, but if you know where to look and what to look for, digging up hidden gems can be a heck of a lot easier, and you can avoid potential pitfalls by knowing what you should be avoiding.
Still, small caps are notoriously unfriendly to newer retail investors who may struggle to find any commentary or analyst coverage of a stock in question on the web. That’s the thing about small caps — you’ll need to do your homework and ensure proper due diligence, because it’s likely that nobody else will be able to help you react accordingly to a material event.
Where to start
First, avoid overleveraged companies and try to avoid “sexy” plays, like marijuana or anything crypto or blockchain related, because the name in itself is just a magnet for gamblers. Case in point: Long Blockchain Corp.
Second, find businesses within industries that you understand, and make sure that management has allowed for a high degree of transparency into their operations and their business models. Look at the company’s Management Discussions and Analysis (MD&A) section of the annual report for overviews, future goals, and management’s strategy.
Third, think about the target market and ask yourself if the company’s product or service could have the potential to grab a chunk of the pie away from the incumbents in the space.
Fourth, analyze liquidity and solvency ratios to get a better gauge of how a firm will fare in the event of tough times.
Fifth, have a look at how the company’s rate of growth over the last five years and look for positive trends like accelerating revenue and operating cash flow (or net income if the firm is capable of generating a profit in the early stages).
Sixth, don’t forget about valuation!
Boyd Group Income Fund (TSX:BYD.UN) is a security that fits the bill. It’s a smart-beta stock that is firing on all cylinders while maintaining excellent financial health. Shares broke the $2 billion mark this year, so while it’s no longer technically considered a small cap, it’s still got ample upside for those who are willing to buy and hold.
While it’s true that there are a tonne of dangerously risky low-market-cap stocks on the TSX and TSX Venture exchanges, there are gems buried out there, and if you’re willing to do some digging, you could find a stock (or income fund) that’ll give your long-term returns a considerable jolt.
Stay hungry. Stay Foolish.
This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.
Fool contributor Joey Frenette has no position in any of the stocks mentioned.