Companies with smaller market capitalizations are typically considered to be inherently more risky investments than larger companies due to the fact they are more prone to volatile price movement and tend to be less insulated from shocks.
However, smaller companies also tend to be underfollowed and underanalyzed by the market. Therefore, they can present good opportunities for investors who are willing to do their homework. Obviously, all companies, as well as the industries they operate in, are different. Nonetheless, there are some factors that are common to most successful small caps.
A strong balance sheet
As mentioned previously, smaller companies are more prone to exogenous shocks that can make the entire enterprise fold. This is because they typically have less cash and, therefore, a smaller margin for error. Now, while being cash-poor is certainly a problem, a far bigger problem can materialize when a small company attempts to raise more money with a heavy reliance on debt.
Yes, the extra cash will probably help accelerate growth, but it makes the company far more vulnerable to setbacks, both internal (for example, a delay in the release of a new product) and external (for instance, an interest rate hike that sharply increases the cost of borrowing). Companies with solid balance sheets and low levels of debt tend to do better on average than highly leveraged ones.
A growing moat
Unless the sector they are operating in is completely new (a rare occurrence), small companies are usually competing against industry giants. In order to survive against a competitor with more cash, more brand recognition and benefits from economies of scale, a smaller company is going to need something that differentiates it from the established players.
Self-funded growth and cash flow
In a similar vein to a strong balance sheet, it is a good sign when a smaller company is able to fuel its growth with its own profits. Of course, raising capital is a natural part of any business strategy, and most small caps will occasionally resort to borrowing to boost growth. But at a time when private equity funds are pouring billions of dollars into cash flow-negative businesses just because they are compelling growth stories, a small company that can sustain itself and possibly even return some of its profits to shareholders is usually doing something right.
Summary
Small-cap investing has more than its fair share of risks. But by looking out for companies with strong balance sheets, a low reliance on debt, an ability to self-fund growth and an expanding economic moat, investors can minimize those risks and increase the odds of finding a winner.
Disclosure: The author owns no stocks mentioned.
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