The Small Cap Microscope: Your small cap investment checklist

The Small Cap Microscope is your weekly analysis of how best to navigate the small cap market.

The ASX 200 is just off its ten year high, making it all the more difficult for investors to identify any bargains. There’s been plenty of talk of the limited value opportunities out there due to stretched valuations right across the ASX. For that reason attention is turning to the smaller end of the market.

This focus on small caps has picked up in 2018 and looks set to continue for the time being. That is, at least until the market sees a correction, or company earnings catch up to share prices.

So while inherently more volatile, now may be the time to allocate more of your portfolio to small caps and micro-caps.

Of course, that shouldn’t be taken as a blanket statement. With little-to-no analyst coverage or media attention, which small caps to buy and which to avoid is often taking a stab in the dark.

In fact, most small caps make for poor investments so it is imperative to be selective. It’s true that big gains can be up for grabs, but this is far from a given. What is really needed is a strategy — a game plan for how to pick small caps.

Here’s a checklist to help keep you on track.

Understand the business

It’s important to know how a business makes its money. Or at least, how it plans to. Many smaller companies are yet to turn a profit, although that’s not necessarily a reason to write them off.

What’s important is to understand the business, the sector and industry it operates in, and genuinely believe the company's story. If you don’t understand the ins and outs of ‘the cloud’, for example, a company with a more tangible business might be more suitable.

Management

The quality of the management team is crucial for success, especially for smaller companies. Make sure to check up in the background of the company directors. Do they have a solid track record of running a successful company? Or do they come with a questionable past?

Also check that management has skin in the game — are they betting on the success of the business? You can do this by checking the director’s interest ...and it can be very telling. Every time a director buys or sells shares, it must be reported to the ASX within three days. Review the latest Appendix 3Y to make sure that management isn’t bailing and selling up.

Major shareholders

Just like checking the directors’ interest, it’s worth checking who the major shareholders are.

Reviewing the substantial shareholder notices, which are available on the ASX website, will highlight who owns the largest parcels of stock.

If management owns a large chunk that's a good sign, as is the case if well-known investors such BRW Rich Listers, foreign billionaires, and large fund managers are onboard.

Adequate cash

Particularly for early stage businesses, the cash flow statement can be very telling. It gives a clear picture of revenues, expenses and cash backing and provides a clearer picture of the true cash profitability of a business, and if or when it might need to raise capital.

Check that the business has adequate cash in the bank to fund its growth plans and cover operating expenses. If not, it may need to raise capital, which would dilute the value of your shareholding. Although, if it will be used for a promising growth initiate it may be worth it.

Buy at a fair price

Firstly, understand that a ‘low’ share price doesn’t necessarily make a stock ‘cheap’. The share price alone does nothing to reflect the value of the investment. It all depends on how many shares are on offer, which combined provide the market capitalisation — which is what the market thinks the company is worth.

However without comparing this to the company’s assets, its earnings or potential for future earnings, and its peers, this provides little information and you could still be paying too much.

Share price­­­­ movements

It’s generally not a good idea to buy stocks that have fallen to a record low, or are in a steady downtrend. Don’t try to catch a falling knife — a stock in a downtrend is likely to remain in a downtrend.

The exception here is if there’s good reason for it to turnaround, say a material change to a business, a promising acquisition a new management team, or an overall improvement in the sector.

Try to determine if the drop is due to a fundamental reason that will negatively impact the company over the longer term, or whether it’s just due to market volatility, which could even be a buying opportunity.

Also note the stock’s liquidity. A lack of volume can mean orders may be filled at a price much higher than you are prepared to pay, so set limit orders at a price no higher than what you’re willing to pay when placing a trade.

Questionable information

It’s often a struggle to find adequate information on small caps, and micro caps in particular, especially those that have only recently listed. It pays to do your own research. Read company announcements, watch videos of the directors speaking, and look at their presentations. But keeping in mind that only the positives are being highlighted.

For those companies that do have analyst coverage, these reports can be a good source of information, but bear in mind that brokers recommendations are often quite optimistic due to conflicts of interest.

I’d generally avoid paying much attention to social media especially Twitter, or stock forums and blogs that are there to pump stocks.

Over the coming weeks I’ll be exploring this checklist in more detail, exploring how you should go about investing in small cap stocks that will deliver a significant positive overall return over time – primarily targeting capital growth when it comes to small caps.

Meagan Evans is an experienced financial writer and analyst with extensive investment market knowledge, having worked across a range of asset classes both locally and abroad. Meagan is adept at breaking down complex financial concepts and investment ideas to create compelling, research-backed articles.

This article is General Information and contains only some information about some elements of one or more financial products. It may contain; (1) broker projections and price targets that are only estimates and may not be met, (2) historical data in terms of earnings performance and/or share trading patterns that should not be used as the basis for an investment as they may or may not be replicated. Those considering engaging with any financial product mentioned in this article should always seek independent financial advice from a licensed financial advisor before making any financial decisions.