How to Profitably Invest In Small Cap Stocks
Part I: Valuing the Undervalued

Smallcaps.us - Educational SeriesOver the years I’ve learned many (often costly) lessons that have made me a better small cap investor. Because some might be useful for you as well, I thought I’d share them. Hopefully they help you to avoid some of the mistakes I’ve made. To start, this is the first article of a 4-part series on how to profitably invest in small cap stocks.

When investing in small cap stocks, there are many different approaches you can take. There are two types of small cap stocks that have a special appeal for my tastes as an investor, and those are:

  • Fundamentally undervalued more mature companies with real revenues and earnings.
  • Younger companies with a high potential, innovative product or service.

The small cap stocks that fall into each of these categories have different pros and cons and there are different ways to evaluate each for addition to my portfolio. Today, we’re going to look at those companies with real revenues and earnings that are fundamentally undervalued.

Determining a Small Cap Stock’s Value

It’s not hard to figure out whether or not a company with real revenues and earnings is undervalued when compared to its peers. The quickest way is to use Yahoo Finance. After typing in the symbol of the company you’re researching, click the “Industry” link in the left column. When you do, you get an overview of the P/E ratio, earnings, PEG ratio, etc. of the company you are researching next to its peers.

Why is it undervalued?

Recognizing that a small cap stock is undervalued is one thing, but understanding why is an even more important part of the process because undervalued stocks can either be worthy buys that will gain value over time, or stocks that are priced this low for a good reason and as a result should be avoided.

Some reasons that a small cap stock might be undervalued include the fact that it might have old-fashioned products and be unable to keep up with demands of evolving consumers, it might have a management team that is not performing as it should, or it could have a terrible balance sheet. Sometimes, it might simply be the fact that it is a Chinese company listed in the U.S. -something that many investors these days flee from due to the prior fraudulent activity associated with some of these companies, like Rino International which overstated its revenues by more than 17 times.

Evaluating the Data

Once you’ve narrowed down your undervalued small cap stock choices by using the steps above, it’s time to evaluate the stocks you’re considering buying as you would any other. To do so, I do several things including taking a hard look at the balance sheet, the income statement and the number of shares outstanding.

The Bowser Rating System

My friend Max Bowser, publisher of the popular investment newsletter The Bowser Report, has developed an extraordinary rating system that is based on fundamental analysis. By giving these small cap stocks a rating, Max aims to separate the financially strong issues from the weak ones.

With this system he rates 12 factors, one of which is double-weighted. The factors are:

1. Book value
2. Principal business
3. Sales (historical?)
4. Highest price per share in last two years
5. Average daily volume
6. Dividend
7. Current ratio
8. Long-term debt
9. Shares outstanding
10. Earnings during last 5 years
11. Current sales
12. Current earnings (double weighted)

The highest “Bowser Rating” any stock can receive is 13. If a stock gets an 8 or higher, he considers it a buy. The 8 is purely subjective, but experience has taught Max that it illustrates a good entry point.

The Bowser system is an in-depth rating strategy. If you would like me to go deeper into these factors in a follow-up post, let me know in the comments.

Another consideration you must make is to read the company’s SEC filings (their 10-K and latest 10-Qs). These reports can also be found on Yahoo Finance in the left column after you enter the ticker symbol. While reviewing the filings, I take a look to see if the compensation going toward management seems reasonable, if the number of outstanding warrants and options isn’t too high and whether the company is involved in any lawsuits. It’s also a good place to find the management team members’ bios.

Then, take a look around the company website. Get familiar with the products they offer and what companies/ retailers use or sell those products. Read the press releases the company has issued and do a Google search to see if you can get a feel for what the company and industry is about, as well as consumer sentiment about the company and its products. Once I’ve gathered all this information, I put it together and evaluate it as a whole.

Further Advantages of Small Cap Investing

The next and final step in my small cap research process is to contact the CEO or CFO of the company. This, to me, is the most important advantage involved in dealing with small cap stocks-their management teams are generally accessible. Since these are the people who hold the future success of the company in their hands, it’s very valuable.

When I can’t reach a CEO or CFO (taking into consideration their schedule and after making multiple attempts to reach them), or if I hear from them and don’t like what they say, I move on to the next stock.

Example: Acme United Corporation

I first learned about Acme United Corporation via a newsletter called The Quiet Investor, published by my friend John Gay. It is one of the best small cap focused investment newsletters available.

During late 2008, Acme United’s stock dipped below $10 dollars for the first time in several years. That triggered my attention and made me wonder what had happened to cause such a drop. My initial research indicated the stock was undervalued compared with its peers. That was my cue to start digging deeper and when I did, I found that:

  • Acme United Corporation was a leading worldwide supplier of innovative branded cutting, measuring and safety products in the school, home, office, hardware & industrial markets.
  • Its products were organized under three global brands: Clauss, PhysiciansCare and Westcott. The latter was the leading scissors brand in the USA and the number one ruler brand worldwide.
  • In late 2008, the company’s board of directors approved a new stock repurchase program of up to 150,000 common shares, almost 4.5% of Acme’s shares outstanding at the time.
  • Next to a healthy balance sheet with almost $5.5 million in the bank, a strong current ratio of 5.2 and a price to book of 1.02, Acme also paid a quarterly dividend of 5 cents.
  • During the 5 preceding years, Acme’s net sales averaged a 16% annual growth while earnings per share had an average annual increase of 34%.

These were all positive factors that didn’t justify the declining stock price. In early 2009, as the stock was now trading below $8 dollars due to the financial crisis, I was convinced Acme was an excellent investment candidate.

I picked up the phone and talked with Walter Johnsen, the company’s CEO, on several occasions. I found out that Mr. Johnsen knew the business and the industry inside out and that he had a clear and realistic vision where he wanted the take the company.

As a result, I bought my first shares of Acme United.

Final Thoughts

As you go through the entire process of evaluating a small cap stock, you’ll find that there are always negative attributes peppered in with the positive. Don’t let the presence of a negative factor discourage you from buying some shares if you are comfortable with all other aspects of the company. Don’t waste your time searching for the perfect combination, it’s not out there.

Next week: Part 2: Investing in Young Companies with High Potential

What do you think, is this helpful? what other educational themes or subjects would you like me to cover in the future? And which lessons have you learned along the small cap investment road?

2 comments… add one
  • marius johnsrud February 19, 2011, 7:36 pm

    thanks.

    this was in fact very helpful! there are very few of the newsletters out there that actually give advices you can use. Learning what you and other successful investor do for making money in the market is saving guys like me a lot of money as we learn how to profit.

    I would like to learn more of the fundamental as well of the technicals of the small cap market.

    One thing that could be interesting to learn about is how the small cap market is dependent of the larger macro economical trends as well as how the bigger market (big cap stocks) are affecting them.

    Are there any typical correlations between changes in commodity prices and small cap stocks?

    Are there any cyclical patterns within different segments of the small cap stocks or in particular stocks that can be profitable?

    What is most important to avoid doing in the small cap market in order to prevent substantial losses?

    which strategy has worked best for you when it comes to long and short term profits?

    Are there any typical signs of “bubbles” in a small cap stock? By that i mean if it is possible to foresee a big drop in the price and when a big increase in price are only temporary. I have also been subscribing to a lot of newsletters with stock picks, typical one stock pick a day. I know these often are scams, but when all the subscribers buy the stock, the law of supply and demand creates the self fulfilling prophesy of significant increase in price. I have made some profit on this, but knowing when to get out of your position seems to be the hardest part. Do you have any thoughts on this? do you have any suggestions for signals for good entry and exit points?

    Is there a big risk of not being able to sell the stock, if there is little volume?

    This was a lot of questions but i still hope you will take some time to answer.
    Thanks for the useful education and in advance thanks a lot for your time.

    regards
    Marius Johnsrud

  • admin February 21, 2011, 6:47 pm

    Hi Marius,

    Many thanks for your kind words and insightful questions.

    During the next three weeks we’ll be covering more of the buying process, patience and selling. So those articles should answer some of your questions.

    After that we’ll start a series on the reasons why to buy small cap stocks. As we’re still working on those articles I’ll make sure to answer as much of your questions as possible.

    One question I will already answer though. I never worry about volume. I take my time to buy the shares I want at the price I want and I do the same when I want to sell. This is immediately the big advantage us retail investors have compared with Wall Street. Their assets under management are simply too large to invest in a company with a $10 million market cap. They don’t have the time to patiently build a position in a company, and even if they do, they might end up owning 10% or more of the company which usually isn’t their intention either.

    Many thanks again and keep your question coming, they’re a great inspiration for new articles.

Leave a Comment