Investing in small cap stocks can be risky business. But it can also be very rewarding both financially and mentally – particularly when that stock you’ve so staunchly supported for years finally gets a breakthrough and the share price sky rockets.
However, it’s not for everyone. Investing in small cap stocks requires dedication, research, a strong stomach and a cool head.
So, what are the key things you to remember to be a successful small cap investor?
In-depth research and an eye for detail
There are more than 2,200 stocks on the ASX, the majority of which are small cap stocks.
It can be a daunting list when each stock you invest in needs to be considered in detail before you buy it.
To be a good small cap investor you need to fully understand the business that you’re investing in, including its business model, its products and services, competitors and the potential market opportunity.
You also need to know who the management team are that are running the business and have confidence and trust in their abilities.
It’s necessary to consider whether the product or service is able to sell or to scale and you will want to be comfortable in the timeframe that this will take.
Most importantly, you need to get behind the numbers and understand where the revenue comes from, what the business is spending its cash on, and what the runway is for the company given its current cash balance and income.
A healthy appetite for risk
Let’s face it, losses happen. They happen in large cap investing and small cap investing. They are perhaps more prevalent in small cap investing due to the sheer number of small cap companies out there.
However, when there is a colossal loss in a large cap stock – it is much more widely publicised.
Even if you have done your research and thoroughly understand the business and its potential, a mistake can happen, an outside factor can impact the business and the sector may take a nose dive.
Therefore, you need to be prepared to lose and be in a position to swallow your losses.
Discipline and knowing when to cut a loss
Trading small caps isn’t done with a half-hearted approach. You’re either in or you’re out.
While losses will happen, having a rigid stop on your losses and knowing when to pull the plug is an important part of any investment strategy. And sticking to them is key.
Being disciplined in this respect is key to any good small cap investment strategy – it controls your behaviour and can help take the emotion out of it.
It’s all too easy to tell yourself ‘if I just hold on a little longer it might go back up and I will be able to recover my loss’ only to see the stock take a further nose dive and increase your loss.
Therefore, remember to keep in mind what your goal is in terms of returns, the position you are willing to hold in any one stock, what your stop-loss rule is and also when you take a profit.
A long-term view and focus on the fundamentals
While there are a number of over-night success stories, such as a mining company making a bonanza gold discovery or a biotech company releasing stellar clinical trial results that leads to a rapid increase in share price, it is more likely that success builds over time.
Investing in small cap stocks requires a longer-term investment view. It takes time for a small company to grow.
For example, the highly successful WAAAX stocks were once smaller stocks that may have flown under the radar.
Three years ago the Wisetech (ASX:WTC) share price was sitting around $4 and today it is hovering above $20. Similarly, with Appen (ASX:APX) – it was just under $4 three years ago and today it is around the $25 mark.
As a company builds and meets various milestones along the way the value for investors will be created. If you’ve been in the stock from early on you will be set to benefit from this value creation over time.
Once again, if you are confident that you’ve done your research and believe in the fundamentals of the business, you should be comfortable holding your position and putting aside the smaller everyday movements and chitter-chatter in the market.
A good broker
While it is possible to use an online broker and make your trades online, these trades do not always go through immediately and there is a delay before the transaction is carried out that can make it difficult to get into or out of the stock at the price you want.
Therefore, having a physical broker that can put an order through for you immediately can be beneficial – particularly if it is in the instance that the stock is taking a nose dive and you want to cut your losses.
However, a physical broker does tend to charge higher fees than the online brokers and you will need to weigh up the pros and cons of both and determine whether you are comfortable with these.
Patience is a virtue
When you’re invested in small cap stocks one of the hardest things to do is to maintain your position and not to act on every price move.
If you have done your research and are confident in the business, its management team and strategy then you need to hold your ground.
Being driven by small price movements and making a snap decision to sell based on a small amount of volume causing a five percent drop in the share price is not only ineffective, but it will drive you insane – particularly as these moves are fairly common in small caps on a daily basis.
If you have the confidence in a stock and truly believe in the business, it may be wise to build your position in the stock over a matter of weeks versus putting in a large order all at once.
This can be more palatable but, in many cases, will also be necessary as it may not be possible to get a large order filled right away due to the liquidity in the stock.
This content does not constitute financial product advice. You should consider obtaining independent advice before making any financial decisions.
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