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Five rules to a successful return on small-cap stocks

Those willing to do a little homework can dramatically reduce the risks when it comes to purchasing small-cap stocks.

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Small-cap stocks generally provide the best returns, but few investors buy them because they deem them too risky.

But those willing to do a little homework can dramatically reduce the risks.

Small companies will always be less safe than bigger ones. They share all of the risks of bigger stocks – economic, competitive, regulatory – and layer on a few more for good measure.

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But if you start by following a few guidelines, you can improve your odds of success a lot, and therefore the returns you make overall.

I've learned over the years that there are five basic pillars to investing in small-cap stocks. If you can learn how to implement them, you'll do well.

1) Look for solid management.

That may sound obvious, but it just can't be emphasized enough. Bank CEOs might make one big decision a year and it's often a bad one. In the small-cap world, management can matter even more, because they make many decisions, and often on the fly, since their businesses are small and typically new and growing.

So they have to be trustworthy, hard-working, aligned with shareholders (i.e. own stock) and, most of all, confident.

A CEO who lacks confidence will either make a bad decision or they'll look out for their own hide at your expense.

2) The business should be simple and easy to understand.

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If you can't convince your skeptical neighbour to buy the stock by explaining what the company does and how it will succeed, don't bother. I've lost lots of money on the tech stocks of businesses I really never understood. But I've made far more on stocks like duct-tape maker Intertape Polymer Group Inc., which I recommended in this space a few years ago.

3) The idea should be promotable in the context of the market.

This means, for instance, you don't buy junior mining stocks when the Venture Exchange is in freefall, as it was last year.

It's also important that the company can tell its story convincingly. We had good success with Patient Home Monitoring Corp. and a lot of that had to do with the fact that former CEO Michael Dalsin is exceptionally good at telling his story. Promotion is not a dirty word; it's vital to a small company, particularly in Canada where most financial people are experts in energy or mining and nothing else.

Small companies typically have to raise money and if they don't do it at higher prices than last time they will fail, so promotion is critical.

4) The story needs "blue sky," meaning the company must have a large addressable market for its product or service.

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The real key to making a lot of money in small- or micro-caps is to sell your shares to institutional investors eventually. They don't touch small companies, but once the market value gets to $100-million, they start to notice. If it gets to $200,000 and it makes sense, they will buy.

To get a market cap of that size, the company has to not only grow but also convince investors that it can get even bigger.

A second and related point is economies of scale. As revenues expand, the company has to demonstrate that not only will its profits grow, but so will its profit margins – the percentage of revenue that's net income.

I touted Nordex Explosives Ltd. in this column a couple of years back but that didn't work out at all, because although revenues expanded as I expected, profits did not. Until that changes, the stock will remain a micro-cap.

5) Finally, and this is especially critical in micro-caps, make sure the capital structure is tight.

Many entrepreneurs go public by teaming up with a shell corporation that's listed on an exchange with a few bucks in the bank but no operating business. The shell acquires the private operating company by issuing its owners shares in the shell and they then take over the listed company.

There are lots of people who make a living selling shells to unwitting entrepreneurs for far more than they're worth. They then promote the stock to produce enough volume to sell all their shares, usually in a short period of time.

So always find out how many shares are outstanding, who owns them and what they paid. I recently saw a small-cap with 80 million shares outstanding and half were owned by the shell originators. That will not end well.

Follow these basic rules and you'll see an improvement in your portfolio.

Fabrice Taylor, CFA, publishes the President's Club investment letter, for which he and The Globe and Mail have a distribution agreement.

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