4 tips to avoid catastrophic small-cap losses

Small-cap shares have been known to generate life-changing returns for many investors. Where a FTSE 100 company may return 10% in a year, it’s not uncommon for a smaller company to return 10 times this amount over the same period. However there’s one fundamental downside to small-caps – higher risk. 

Preservation of capital is one of the keys to being a successful investor, and for this reason caution is warranted with small-caps, because the losses can be devastating. Here are four questions I always ask myself before buying a smaller company.

1. Is the company profitable?

It’s easy to get caught up in the hype of an exciting story when investing in smaller companies. Indeed, many investors buy a stock on the back of a tip from a friend or colleague without doing their research. This is a huge mistake in my opinion.

I’ve found over the years that companies that are already generating profits tend to continue generating profits and conversely, companies that are not making a profit now, may never make a profit. And without a tangible earnings figure, it’s harder for investors to place an estimated valuation on the company.

While it’s no doubt possible to make money from companies that aren’t yet profitable, I’ve learnt that eventually, if no profits materialise, it’s likely the share price rise will go into reverse. Shares are often said to “take the escalator up and the elevator down”, and trust me, you don’t want to be the investor stuck in the elevator heading downwards.

So the first thing I look for now is profitability, and eliminate pie-in-the-sky-type stocks that aren’t yet profitable. 

2. Is cash flow positive?

Next up I check the company’s cash flow. This can be found on the cash flow statement under ‘cash from operations’ or ‘operating cash flow’. Cash flow is the life-blood for any company, large or small. Without adequate cash flow, a business will eventually struggle to operate, unable to pay suppliers, buy raw materials or pay its employees. The cash flow statement will give an indication about a company’s true health, so it’s definitely worth checking to make sure cash flow is positive.

3. Is the valuation reasonable?

So the company is making a profit and generating cash. Great. But what about the valuation? In my opinion, investors need to be cautious when a company is trading at an eye-wateringly high valuation. 

How high is high? Well for a company that is growing earnings by 30% per year, a P/E ratio of 25 to 30 is not that unreasonable. However, a ratio of say, 150 is more dangerous. A valuation of this level suggests that investors have got carried away and have bid the stock up to exuberant levels. And if the company misses expectations, the downside can be brutal.

4 Is it all hype? 

Lastly, I’m wary of over-hyped bulletin boards. I’ve found over the years that the stocks that are hyped the most on bulletin boards, are often the most dangerous. Contributors on these boards will urge you to buy the ‘hot’ stock before the price “takes-off“, however while you’re buying, the chances are they’re selling, a process known as a ‘pump and dump.’

The best opportunities to my mind are stocks that are truly under the radar, and are yet to be discovered by the bulletin board rampers.