Where should you look for small caps with potential to deliver above-average results? In chapter two of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks,” author Ian Wyatt had several suggestions. But, first, he described his targets, with two specifics in mind:
- Growing revenues, at least 20% per year.
- Earnings growth of at least 20% per year.
He added that companies hitting these benchmarks are exceptionally competitive and able to overtake their larger peers. As an example, he cited Walmart (WMT, Financial), which caught up to and passed Sears (SHLD, Financial), posting better results while still a small and regional company.
Where do you find companies such as the young Walmart? Well, you won’t find them in the mainstream financial media, according to Wyatt. Any company that gets the attention of these media outlets will be well known already and their valuations will be too high.
To start, finding big ideas means digesting “vast amount of information” and formulating a working investment thesis. This reference to vast quantities of information reminds us of Warren Buffett (Trades, Portfolio), who spends countless hours reading annual reports, financial statements, industry reports and more.
One area where opportunities may present themselves, on a cyclical basis, are the natural resource and commodity sectors. For example, gold, other precious metals and oil and gas. If oil prices are on the rise, an investor would look for a “small, obscure company getting into a regionally focused refining or production program, oil sand extraction, or even exploration.”
Wyatt offered these tips for finding the next big idea:
- Visionary leadership: Not every small cap within an emerging or present trend will succeed, so look for leaders with a particular vision about the trend they are within. Think of leaders such as Jeff Bezos, Steve Jobs and Bill Gates (Trades, Portfolio).
- An idea for the time: A true investment opportunity will be well suited to emerging consumer trends. Wyatt cited the case of Lexar Media (since sold to former competitor Micron Technology (MU, Financial)); management understood what consumers wanted and delivered it to them by maximizing technology effectiveness. Beginning in 2002, it delivered a stable of products, including flash drives, digital music players and digital cameras.
- Strong growth potential: Wyatt looked for companies that found niches they can dominate, saying broad markets are already going to be occupied by bigger players. He added that niche-focused small caps can realize significant growth and sizable profits. And while niches may be small, profit margins can be large.
- Growing exposure: Investors can optimize results by buying a generally-unknown small cap, which then becomes more widely known. True Religion Apparel (TRLG, Financial) found its niche by producing domestically made denim garments. It raised its profile, and ultimately its share price, by giving its high-end jeans to celebrities; the celebrities were then seen wearing True Religion jeans in magazines.
- Very small capitalization: Watch for micro-caps with ambition. Wyatt reported most of the best-performing stocks have had market caps of less than $100 million (micro-caps may be defined as being below $500 million, while small caps range from $500 million to $2 billion).
- Competitive edge, or moat: A distinct advantage over competing companies, whether through product design/capability, distribution or sales approaches. Sonic Solutions (now owned by TiVo (TIVO, Financial)) caught the DVD wave in 2002 and found its edge by bundling its software into computers sold by Dell, Gateway and Compaq.
- Managed growth trend: Beware of companies that grow too fast because that growth may outpace the resources they need. Wyatt advised investors to watch for consistency in the debt and working capital ratios to identify good cash flow policies.
In searching for new ideas, it may help to look at sectors and companies that are becoming obsolete. Polaroid, which invented the instant camera, is one example, one that failed because it could not keep up with other developments from more aggressive companies. Another is Polaroid’s biggest competitor, for a while. Eastman Kodak (KODK, Financial) dominated film photography for about a century, but failed to catch the digital wave and lost its leadership position.
Ironically, digital camera makers were soon made partially obsolescent themselves as smartphones became the tool of choice for those trying to capture the magic of a moment.
Getting back to the competitive edge issue, a small-cap needs one to grow. To illustrate the point, Wyatt provided the case of Calavo Growers (CVGW, Financial), which began as an avocado growers’ cooperative in the 1920s. It went public in 2002, and three years later became the first company to sell avocados in China. He said the company had several advantages arising out of the demographics of its customers, including a demand to eat more healthily, as well as distribution edges. Over the five years up to mid-2008, it had an annualized return of almost 18%, compared with a 7% gain for the S&P Packaged Foods and Meats Index.
Above, we noted the tremendous upside available when a small cap is “discovered” by the financial media. The same holds for discovery by institutional investors. Calavo enjoyed that process, and by 2009 some 22% of its stock was owned by pension funds, mutual funds, hedge funds and other big market players. Since the institutional investors usually buy very big blocks of shares, they can make the stock price soar.
While timing the entry of institutional investors is not easy to see, it may happen at certain price intervals. For example, many funds will not buy stocks priced at less than $5 or $10. Wyatt advised keeping an eye on volume; start with a three-month average volume reading, then watch for significant increases accompanied by share price appreciation.
A dramatic example of a small cap exploding was International Assets Holding Corp., with its share price more than doubling in less than three months, in 2006. In that period, the number of institutional investors jumped from seven to 17 and, to top it off, 12 of them also added to their positions. That was enough to push the price of $15 at the end of June up to more than $40 in early December.
Another aspect of institutional buying also merits attention: A company that is widely owned by institutional investors is unlikely to post huge gains, unless it is an exceptional one (such as the FAANG stocks).
In summary, in chapter two of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks,” Wyatt explained how he found small-cap stocks with exceptional potential. He started by setting a threshold of 20% for both revenue and earnings growth, then explained how he watches trends as well as the interests of the financial media and institutional investors.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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