Streetwise for Friday, October 5, 2018

Having just undergone a shoulder replacement in the past week, and with my activities severely restricted, I spent time thinking about questions from readers that I have not answered recently.

One question of note is why I rarely write about companies with a lesser market capitalization i.e., small cap companies. Keep in mind that small cap is often defined as a company with a market capitalization (the number of shares outstanding multiplied by the share price) of less than $1 billion dollars. Market capitalization represents one estimate of the a company’s value.

Investors are often interested in small caps because they add bit of spice to a portfolio, meaning higher volatility and risk along with the possibility faster price appreciation than you might find in a stodgier corporation, such a Clorox.

There is another advantage to small-cap stocks and that is the ability to steer clear of institutional investors and the potential volatility they can create. For example, mutual funds have restrictions that limit them from buying unduly large amounts of any one issuer’s outstanding shares. Thus, many mutual funds are unable to invest in small-cap companies.

There is no denying the increased risk inherent in small caps, in part due to less analyst coverage and often a reduced amount of in-depth financial data. However, do not be dissuaded by a company’s size before you look under the hood. Companies of this ilk can have excellent growth potential and the small-cap label can be misleading.

One reason is that the world of small-cap has changed. What was once considered a large-cap stock in 1980’s could very well be a small-cap stock today. As a result, there are some large small-cap companies that offer up excellent investment opportunities.

Investing in small-cap companies is like driving a sports car, fast and capable of quick turns. The downside of the small cap world is that if you make a mistake, the punishment can be severe given a potential lack of liquidity and a larger spread between the bid and ask price than you may be used to.

Some small-caps are new ventures, while others might be former large-cap companies whose stock price has fallen to the point where their market capitalization has sent them back into the small-cap arena. While a decline back into the small-cap arena could be external and outside of a company’s control, be careful. Do your research before you invest.

A key question for all companies, regardless of size, is how well they weathered the difficult times of the Great Recession. A small-cap that has a strategic patented core technology is usually capable of withstanding most any economic environment. Doing so suggests more than just competitive strength, it also implies that there is focus and efficiency, qualities critical to any investment.

A common problem among smaller technology companies is the ability to finance a continual transition to the next generation of product offering. This means having in place enough access to capital. Along the same vein, a company’s relationship with its suppliers is significant and concerns may again revolve around the need for capital to fund raw materials, capital equipment and additional personnel.

Any hint of insufficient capital can lead to an overly harsh discount of a company’s shares.  While problems of this nature are most often found in the lower end of the size spectrum, they should never be over looked.

Watch for signs of weak or inexperienced management. Scrutinize dismissal announcements and any inconsistencies that may signal confusion in the realm of corporate direction. A perceived difficulty in hiring and retaining qualified people should be a red flag.

Has the company experienced production or administration inefficiencies evidenced by a decline in financial accounting measures, such as profit margins? Anytime margins change, up or down, share prices generally follow along.

Always remember that even a beautiful new Ferrari with two flat tires goes nowhere.

Lauren Rudd is a financial writer and columnist. You can write to him at LVERudd@aol.com. Phone calls accepted between 9 AM and 3 PM at (941) 706-3449. For back columns please go to www.RuddInternational.com.