The ABCs of Small-Cap Investing

04/10/2013 9:00 am EST

Focus: STRATEGIES

Small-cap stocks have great potential, but here are a few tips to avoid the pitfalls and enhance your profits, says Thomas Garrity of Cabot Small-Cap Confidential.

Over time, small caps have been the best place to invest your money as an investor in individual stocks. They are exceptional builders of wealth. As more investors become aware of this high-potential asset class, there's a good chance they will invest in small-cap stocks, further enhancing their returns.

Valuation is just one reason why small-cap stocks are so attractive—as institutions largely ignore small-cap stocks, smaller investors can often buy them for reasonable prices.

The other major reason is growth potential. Small companies breed innovation, which is at the heart of product differentiation. As companies decide how best to maximize what little capital resources they have, their products represent their potential for rapid payback, increasing market share and entry into fresh markets.

Here are some tips for getting the most from your small-cap investments:

  1. Take partial profits. I've found that a key to better performance is to take partial profits on some winners. In the past, some of my stocks have gone around the world—a 100% gain turned into a 25% gain—which is something we want to avoid, so I advocate paying yourself periodically.
  1. Allocate more funds to your strongest stocks. In cases when you're comfortable with a company and knowledgeable about its business, build large positions in the stock. Generally, I recommend allocating more funds to stocks that are showing strength (consistency in their price movement).
  1. Sell some of your top stocks and laggards. When a stock goes up, say, 50% or more, take some profits and redistribute them in your other strong stocks. As for underperforming stocks, there too you should make partial sells and reallocate your funds to stronger candidates.
  1. Write options against your positions when available to generate income and improve overall yield.

A habit you should get into is buying stocks off the bid versus the ask side of the spread. Second, consider building your position in a stock on days when the share price is under pressure. Third, use multiple buy orders rather than a lump sum. Finally, enter your stock orders with bid limits. Run your trading like your business—on your terms—and be diligent.

One of my investment hallmarks has always been to give Wall Street's unknown stocks a chance. I'm partial to companies that have dominant positions in thriving industries, or what I like to call pure plays (a company with a product that has created its own category in a large addressable market).

Second, I seek companies with dedicated research teams to develop the products, and sales staffs that will bring the products to market.

I stick with a position in a stock until either profit objectives are met, the market deteriorates, or the management of a company gets stupid or greedy.

Here's how I deal with a stock that has appreciated more than historical market returns: If the stock is up 50%, I sell one-third to one-half of my original core position to bank profits and hold the rest until A, B,or C above.

If a stock exhibits a loss beyond a normal threshold, I'll tolerate the loss (on paper) if nothing has changed fundamentally with the company or the markets they address. If the company's balance sheet is strong, and it has key products and good management, the stock will eventually come back into favor. And I always remain aware that every stock eventually disappoints.

In certain instances, I recommend stop-losses—usually to protect a large profit—but it's important to remember that stop-losses can work both ways. You can be stopped out only to have share prices go higher.

We expect to own a number of stocks that will go up significantly in price, and we expect there will be stocks that will show losses (although we also expect our gains to more than cover our losses).

To increase our chance of overall success, we take small profits on leading stocks and reallocate those dollars in stocks just beginning to show price strength and stocks which have fallen deeper into undervalued situations.

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