The shares of many small-cap and microcap companies may be inefficiently priced as a result of a narrow investor audience, a scarcity of research coverage and immature investor relations programs. This translates into opportunity for astute investors willing to do some homework. Our Web site is designed to be an important tool in helping investors identify and track interesting small-cap companies in an efficient fashion.

Focus on a Company's Long-Term Earnings Growth Potential

The objective of most investors with portfolio holdings in the small-cap sector appears to be long-term capital gains far in excess of those of broad-based market indices. P/E expansion alone is usually too weak an influence to generate that magnitude of performance differential. Investors should, therefore, focus their small-cap purchases on stocks that are expected to show well-above-average rates of earnings growth. The mathematics of compounding can result in powerful price performance for those stocks that register rapid earnings growth over a sustained period.

Many of the companies that have shown rapid earnings growth over sustained periods have had common characteristics. These have included one or more of the following:

Many of the companies that have shown rapid earnings growth over sustained periods have had common characteristics. These have included one or more of the following:

Competitive advantage. Most rapidly growing small companies will attract scrutiny by larger, better-capitalized firms. A competitive edge in the form of a strong research and development effort, manufacturing know-how, marketing savvy or some other advantage allows the company to continue making rapid earnings progress even in the face of this potential competition.

Financial strength. This is usually gauged by working capital adequacy, capitalization and interest coverage ratios, the degree of off-balance-sheet financing and other factors. A high return on equity is a plus, since it helps enable growth to be financed internally.

Conservative accounting policies. Be wary of unusual revenue recognition policies, capitalization of expenses, significant off-balance-sheet financing, audits by unrecognized accounting firms and qualifications included in auditors' statements.

An absence of significant exogenous risks. Such risks can include an unfavorable political landscape or regulatory environment, and exposure to the vagaries of dealing in foreign markets.

Cautionary Notes

The two major risks in investing in small-cap stocks appear to be fundamental risk and market risk. Fundamental risk relates to the chance that earnings expectations for a company will not meet expectations. This can result from any number of internal or external circumstances. Internal difficulties can stem from inexperienced management, production problems, inadequate controls, unwise diversification or difficulties in obtaining financing. External problems can result from shifts in government regulations, consumer preferences, competition, technology and other factors.

Market risks for small-cap stocks are abundant. The shares often have narrow shareholder bases, little support from traditional research analysts and limited shareholder relations efforts. Insiders and early-stage investors sometimes use the liquidity provided by public markets to lighten their positions. Public shareholders may be in a minority position. Transactions costs can be quite high, particularly in thinly traded, Nasdaq-listed issues. In addition, institutional interest is usually spotty at best, especially for shares whose market capitalization is below $50 million. Below that threshold, liquidity is usually insufficient to support a flow of institutional transactions.

The market risks for individual companies are magnified by the fact that the popularity of small-cap investing seems to run in deep, multi-year cycles. At cycle tops, the P/E of small-cap companies has often been double or more the P/E accorded the S&P 500, while at bottoms the relative P/E has dipped below that of the 500. The turning points for these cycles are difficult to forecast.

Valuation Parameters

Setting target valuations for small-cap stocks is usually a challenge. Many of the companies are relatively young and may not have even experienced a full business cycle. Some of the key valuation barometers are listed below:

Revenue growth. The rate of internally generated revenue growth is probably the single most important measure of a small-cap company's potential.

Cash flow. Watch both the rate at which the company is using cash resources and the availability of external funding sources. Operating margin trends. Economies of scale should begin to take hold as revenues expand.

Earnings per share. A young company's achievement of positive EPS is viewed as a major milestone. Results thereafter should continue to trend higher.

A recognized large shareholder or strategic partner. Investors should take comfort in the fact that these shareholders or partners usually perform a high level of due diligence and may add fundamental value to the company.

Investors generally recognize the importance of earnings growth rates in the valuation process but are unsure how to quantify the relationship. It is important to recognize that the relationship between growth rate and P/E should be based on the mathematics of compounding and is therefore exponential rather than arithmetic. There are sophisticated models available that can quantify the relationship. For the purposes of this discussion, however, it is sufficient for an investor to recognize that rapid growth rates compound very quickly, and stocks exhibiting such growth should be accorded premium valuations.

The Research Works, LLC

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