Investors cannot reliably align themselves with the multi-bagger potential of small-cap stocks (C$250 million to C$3 billion market cap) without a thorough research process that separates high-probability winners from also-rans.
In this article, we will delineate such a process, step by step, with eyes on capitalizing on the favourable macroeconomic conditions for the asset class’ long-term returns, including expected rate cuts, higher earnings and widespread cheap valuations.
How to conduct your own small-cap stock research
- Use a screener to delineate a universe of prospective small-cap stocks.
- Identify markets in a tailwind.
- Identify a company’s value proposition.
- Analyze financial statements.
- Evaluate the management team.
- Build a position according to your know-your-customer (KYC) profile.
1. Use a screener to delineate a universe of prospective small-cap stocks
The first step to successful small-cap stock research is to screen the market for companies with attractive financial performance, as captured by metrics such as revenue, income and shareholder value. We’ll be using a tool from The Globe and Mail, but Yahoo! Finance and Investing.com have equally insightful offerings.
We can model our screening parameters after two broad and comparably effective investment styles, and they are growth and value:
- Growth investing means you’re willing to pay a richer price for a stock than its financial ratios suggest you should, with the anticipation that future growth will reward you handsomely.
- Value investing, on the other hand, means you’re looking for stocks that seem to be trading for cheaper than they should because of excessive market cluelessness or pessimism.
If you identify more as a growth investor, your screener should focus on revenue growth, which measures how much a company has collected in sales, while taking a look at cost of goods sold and current and long-term debt to make sure the company is growing as sustainably as possible. This set-up grants it the best chance at growing net income, aka profits, and generating share-price appreciation for investors.
Open The Globe and Mail’s screener tool, and select “market cap” under the Fundamentals tab. Click “add filter” and set it to between C$75 million and C$4 billion. Repeat this process with:
- “Five-year revenue growth” under the Growth tab, and choose all categories over 10 per cent.
- “Debt-to-equity” – a measure of how much debt a company holds versus how much stock it has issued – under the Ratios tab, and set it to a maximum of 0.5 to tilt away from heavily indebted companies.
- “Net income,” and set it to over C$1 to ensure profitability, or remove it altogether if you feel comfortable evaluating companies that have yet to turn a profit.
If you identify more as a value investor, your screen should emphasize stocks that have performed poorly despite their profitability or otherwise value-added operational history, which we can tease out by sorting for:
- Earnings-per-share growth, which tracks how much profit a company has taken in divided by the number of shares on the market. Select “earnings per share growth vs. the previous year” from the Per Share Info tab and set it to over 20 per cent.
- One-year return, a measure of how a company’s stock has performed going back 12 months. Select “one-year return” from the Growth tab and set it to -95 per cent, revealing companies whose stocks have suffered precipitous falls despite a substantial improvement in profitability, making them strong candidates for a value investment.
Now that you have a prospective list of small-cap stocks to consider, how should you begin to sort through them to make sure their financial ratios aren’t just smoke and mirrors, but are in fact indicative of robust long-term returns?
2. Identify markets in a tailwind
To make sure a small-cap stock is worth your research, start from the top of your list and, one by one, determine if the industries they compete in are expected to grow into the future, affording the companies the ability to depend on demand from a rich and diverse marketplace.
While this may sound like a gargantuan task, it need not be. A simple Google News search with the name of the industry followed by the word “market” will suffice, i.e. “copper market,” “cancer drug market,” or “environmental services market.”
After reading three to five articles from reputable news sources, such as Bloomberg, the Financial Times, Morningstar, Barron’s or The Wall Street Journal, note their overall tone. Is it optimistic or pessimistic? Over how long? Would market expectations moving forward allow your potential stock pick a long-enough runway to thrive and reward you for investing? Business plans will differ widely, but if we take the S&P 500 as our guide, you’d want your stocks to be in industries with at least 20 years of expected growth.
3. Identify a company’s value proposition
Now that you have one or a handful of small-cap stocks active in industries with encouraging long-term prospects, you can determine what kind of problems they’re trying to solve for their customers, and whether they’re any better at solving them than their competitors.
For this, you need to visit a company’s website and read its latest investor deck or presentation, where you’ll learn about its business plan and how it differentiates itself in the marketplace. Here are some hypothetical questions to get you in the right frame of mind to suss out companies with competitive advantages:
- Does a bladder cancer drug work significantly faster or more efficiently than legacy treatments?
- Can a copper mine be operated at industry-low costs thanks to clean energy and its strategic location near key infrastructure?
- Is a new health drink being picked up by an exponentially growing number of retail stores thanks to its nutritional value and dairy-free formula?
You should also consult reports from banks, investment companies, online forums or research houses for independent analysis on what a stock has to offer, making sure to read them with a critical eye that demands all claims be backed up with facts.
The more durable a company’s competitive advantage, the more likely you should be to hold the stock in your portfolio, contingent on your financial goals and situation, which we’ll discuss later on.
4. Analyze financial statements
Having narrowed down your research to small-cap stocks adding value in growing markets, we can now check how that value is transferring onto financial statements. In this step, you are double-checking results from step 1, as well as expanding your understanding of how healthy your prospective investments are at an operational level.
On the income statement, you will find revenue, gross profit and net income. You’ll want to see growing totals from all three, and should investigate the root causes behind any losses or deceleration, and whether they may persist, by perusing a company’s Stockhouse news feed.
On the balance sheet, you will see how your investment candidate matches up in terms of assets and liabilities:
- Make sure current and long-term debt is completely covered by net income or operating income.
- Look for evidence that a company is turning over inventory more efficiently, keeping less of it around while making more money. Similarly, receivables should be kept under control or decreasing, indicating management’s ability to collect on services rendered.
- If intangible assets, like brands, copyrights or intellectual property, are high or growing, delve into the investment deck or recent news releases to figure out whether any of it is monetizable.
On the cash flow statement, you can learn if a company comes out ahead in terms of the cash it produces from its operations, investment activities and financings. If the net change in cash at the bottom of a quarterly or yearly statement is positive, the company generated more cash than it spent over the period. The bigger the stack of cash you see, the higher your conviction should be that some of it will end up in your pocket as a dividend or through a growth initiative, supposing management is skilled enough to generate shareholder value.
5. Evaluate the management team
With operations making money or trending in that direction, and target markets brimming with long-term demand, the only box left to check before buying shares is management’s ability to not mess up a good thing and to deliver for investors.
Visit the management page of your small-cap stock pick’s official website and read the biographies of the leadership team and board of directors. In an ideal world, each team member will be an industry stalwart with a long track record of increasing responsibility for recognizable brands. In the real world, investors will often have to draw a line between moving onto the next stock pick and holding onto a great business under unproven leadership.
Where you draw that line will largely depend on how the company does in steps 1-4, your current financial situation, and the risk you’re willing to take to accumulate money and spend it throughout your life.
6. Buy and manage your small-cap stocks according to your KYC profile
Every new investment decision should be made according to your know your customer (KYC) profile, which determines how risky your investments need to be to fulfill your financial goals. You can form a working idea of your profile by answering these questions:
- Are you investing for the long term, or over 10 years, for retirement or a child’s education, or for the short term, or five years or less, for a major purchase such as a car or house?
- Do you feel comfortable with it being normal for the stock market to drop by 20 per cent or more into bear market territory every five years or so?
- Do you have insurance and an emergency fund set aside with a few months’ worth of basic expenses to cover injury or loss of employment?
- Do you pay off your credit card bill in full, every month, well aware that the interest on it, often higher than 20 per cent, far outweighs the high single-digit returns you can expect from stocks over the long term?
- Do you invest in a diversified portfolio of index funds or individual stocks, in which small-cap stocks will play a meaningful role alongside large-cap, mid-cap, international, growth and value stocks?
If you answered yes to all questions and are investing for longer than a decade, you should feel comfortable actioning your research and allocating at or above the current market cap of small-cap stocks in the global market. Based on Vanguard’s all-equity index ETF, VEQT, that figure stands at 8.18 per cent.
When you decide on an appropriate allocation to small-cap stocks, follow these steps to buy your shares:
- Choose an investment account to hold them in: Canadians enjoy a diverse set of options:
- A registered retirement savings plan, or RRSP, allows you to knock off every dollar you contribute from your income taxes and grow your investments tax-deferred until the time of withdrawal.
- A tax-free savings account, or TFSA, allows you to invest and pay no taxes on any of your gains.
- A registered education savings plan, or RESP, allows account holders to take advantage of special grants and invest tax-deferred towards a child’s education.
- A registered disability savings plan, or RDSP, allows a person living with a disability to invest up to C$200,000 towards the future.
- Canadians can also open a taxable or non-registered account, in which you must pay taxes on all gains, but can also lower your taxable investment income by deducting amounts lost on positions you sell.
- Pick an account provider: There’s nothing wrong with paying full price for a robust set of features at one of Canada’s Big Six banks, but if low fees and functional, bare-bones interfaces are more your speed, Wealthsimple and Questrade are your best options.
- Enter your order: Look up your chosen small-cap stock’s ticker code on Stockhouse and type it into the “buy” page on your provider’s investing platform. Then enter the number of shares to buy, a limit price a penny or two above the ask price, and set the order to be good until end of day. Hit the “buy” button and wait for a confirmation message. If the share price fluctuates during this process and the order doesn’t go through, leave it until the market closes at 4 pm ET and try again the next day if necessary.
- Rebalance: Should your allocation to small-cap stocks fall below or overshoot the threshold chosen above, make sure to direct new portfolio money away or towards the asset class, as needed, to move in the threshold’s direction.
Which small-cap stocks should investors have on their radars? How would you complement our research process to optimize portfolio results?
Join the discussion: Find out what everybody’s saying about how to research small-cap stocks on Stockhouse’s stock forums and message boards.
The material provided in this article is for information only and should not be treated as investment advice. For full disclaimer information, please click here.
(Top photo, generated by AI: Adobe Stock)