How to Profitably Invest In Small Cap Stocks
Part 2: Investing in Young Companies with High Potential - How to Profitably Invest In Small Cap StocksBuying stocks in a company that is relatively young and has potential for future growth even though it is currently generating no revenues or earnings is a great way to give your portfolio the tools it needs to grow substantially. But it’s also a risky activity that requires a lot of research to create a sufficient foundation for success.

Reviewing Young Companies

Not every young company is a good fit for the hopeful investor’s portfolio. The first step in reviewing potential companies is to compare them with their peers on Yahoo Finance. While the company you are considering buying might not have any earnings, its peers may. When you see this, then you know that the company you want to buy may not be able to compete adequately within the sector since it’s still in its developmental phase and it’s already been beaten to the consumers by its better established peers.

Next, review the company’s balance sheet and make sure it has a low amount of debt and enough cash and available credit to draw on. I also prefer that it have a low number of outstanding shares.

Getting a Feel for the Sector and Management Team

Going along the same vein, I also check the company’s SEC filings and take a look at its website. As we discussed last week, my goal is to get a feel for both the good and bad aspects working for the company. Are there any holes in its product, service or marketing attempts? Does it have a product or service that has a future, or one which will be outdated quickly? What other companies might partner with it to expand their own service offerings? It is also a good idea at this point to do a Google search for the company. Check what the public says about the company and its industry and try to consider the results in terms of both positive and negative potential trends.

If I still think the stock has potential at this point, I then evaluate the management team by looking at their history, their prior successes and failures and evaluate their capability to carry the company into the future. After this I contact management to get a better feel for their future plans and their ability to execute them successfully. A good management team is vital to a young company because the fate of the company hangs on the team’s ability to get the company off the ground.

Money Losing Example and Lesson Learned: Fonar Corp.

This story takes me back to the 1990s, a time when I discovered Fonar Corp., a manufacturer of magnetic resonance imaging (MRI) scanners. As I researched the company I found that its President and CEO, Raymond Damadian, made a discovery in 1970 that would eventually be the basis for magnetic resonance (MR) scanning. This gave Fonar and edge, resulting in the company being at the forefront of MRI research and development since its inception and having installed hundreds of MRI scanners worldwide.

Although Fonar already had sales, I placed the company in the young potentials category for two reasons:

  • It had recently brought the Open MRI to the market. This revolutionary scanner allowed patients to be scanned in a weight-bearing condition, such as standing, sitting or bending in any position that caused symptoms. This was a gigantic leap forward from the noisy, claustrophobic tunnel scanners that had been in use up until this point. I was convinced this was going to be the MRI-to-own for every hospital and diagnostic center;
  • Because Fonar was an early innovator, it owned many patents. In order to be able to compete, its competitors used Fonar’s patented technology but didn’t pay royalties. In 1992, Fonar filed suit against nearly every one of its competitors in the MRI industry. I believed the patents were valid and that the money received from the lawsuits would enable Fonar to manufacture even better scanners.

This was before I made it a policy to contact the management of a company before buying their stock. So without making that important phone call, I decided to buy my first shares of Fonar.

Fonar settled most lawsuits at favorable terms. So I continued adding shares as I was convinced that the company was going to conquer the scanner market with its technology that was years ahead of its competitors’. In 1997, it even received a $128 million settlement.

There was one thing, however, that I did not take into account: the type of competition Fonar faced. These were all giant multi-nationals like GE, Hitachi, Philips, Siemens and Toshiba. They had enormous networks and influence in hospitals and diagnostic centers. As a result, Fonar continued to develop state-of-the-art products but it didn’t cause a sales increase.

Investors were disappointed and started selling shares. I ended up doing the same at a big loss. Lesson learned: when it’s David against Goliath, Goliath often wins.

Profitable Example: Global Green Solutions Inc.

Another young company I’ve purchased shares of was Global Green Solutions Inc. I found out about this greentech company in 2008 when green technology was a hot emerging industry with a lot of potential for growth. At the time, Global Green Solutions was developing a system that would produce industrial steam and electrical power from waste biomass. This system was called Greensteam.

When I evaluated the potential of the company, I found that Greensteam had the following advantages over other biomass technologies:

  • The combustion process was specifically designed to meet the world’s strictest biomass combustion air emission regulations and could be permitted in virtually any air quality jurisdiction. Tests showed that undesirable combustion byproducts such as NOx, VOCs, CO and particulates were extremely low;
  • It’s capable of generating steam up to 30% less cost than oil and gas fuels;
  • Its technology is specifically designed to use waste biomass as fuel;
  • It has a high waste biomass to steam energy conversion efficiency.

What also impressed me was the fact that this young company, still in its developmental phase, had already signed a contract with Aera Energy LLC, a Shell/ Exxon Mobile joint venture and one of the largest oil and gas producers in California. The contract was to install 10 full scale Greenstream units.

The purpose of these units is to generate steam for Aera Energy’s advanced oil recovery process. At that moment, Aera was operating hundreds of natural gas-fired steam generators throughout its oilfields and aimed to reduce its fossil fuel operating costs and emissions by replacing them with waste biomass fired steam generators. To me, this not only showed how valuable the system was, but also that it would definitely be in demand.

Additionally, Global Green had a low amount of outstanding shares, one of my primary stipulations. They also had a management team that was very experienced and balanced between disciplines.

All of this worked to convince me that this might be a good investment opportunity, in spite of the fact that their cash position was tenuous. So I got on the phone and spoke with the Company’s CEO, Doug Frater. Mr. Frater and I talked multiple times and his willingness to talk along with his confidence and answers swayed me into buying.

Final Thoughts

Investing in small cap stocks is exciting because you can reap huge rewards if you thoroughly do your homework and it’s lots of fun knowing you unearthed a company’s true potential before other investors and Wall Street has.

Try to buy undervalued shares of a young company with strong growth potential and watch them on their way up once the rest of the investing world catches on.

And remember, you don’t have to buy all the shares at once. You can invest gradually, buying more shares each time the company shows forward momentum. I usually buy 25% worth of the position I want to take initially, and add more when (and if) appropriate.

Next week: How to Profitably Invest In Small Cap Stocks – Part 3: Patience

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