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Tips on Finding Good Small Cap Stocks to Invest In

February 25, 2012 | Comments: 0 | Views: 162

Small capitalization stocks have outperformed most asset classes over long stretches of time. According to an Ibbotson Associates study, small cap value stocks are the best asset class for risk-adjusted returns. On the flip side, small cap growth stocks are one of the worst asset class.

Many investors, when looking for small stocks, try to find the next Google or next Facebook, which is a mistake. The problem with the glamor stocks is often the business model is unproven. While it is true that perhaps one out of 100 such stocks may end up delivering block buster returns, the rest of the portfolio may not do well. It is quite likely that a vast majority of the small growth companies turn out duds and may go out of business eventually. No one has a crystal ball, and it is not possible to predict which of these stocks will be the next Google.

Investing in small cap value stocks is a different matter altogether. This companies can be undervalued for any number of reasons. Perhaps there is not enough investor attention to them. Typically these stocks lack wall street coverage so they tend to fly under most investors' radar. Another reason they may be undervalued is a temporary stress in their business, which can happen from time to time. The trick is to determine if these business conditions are permanent or are they something that the company can eventually work out of. What is important here is that most of these stocks once had a thriving business, so their business model is more or less proven to work. Any improvement in business conditions, or with some changes to the business strategy, it is very likely that these companies can bounce back. When this happens, the stock price will follow.

Since we are looking for proven businesses with temporary distress, it is important to pay attention to their balance sheet. We only want the companies that have the ability or the financial strength to survive the current conditions and make the necessary changes to come out stronger.

How do we do that?

For starters, we should look at the book value of the company, and more specifically the Price to Book ratio. If it is less than 1, this tells us that the company has enough assets to support the current stock price. More conservative investors may also want to consider the Tangible Book Value, which is the book value minus intangibles such as goodwill.

Once this is done, we should next look at the working capital needs and see if the company has enough cash or other current assets to continue operating for the foreseeable future. I typically want the current ratio (current assets/current liabilities) to be greater than 2. This means that the company has enough liquidity to meet all its current obligations in the short to intermediate term.

Lastly, it is always a good idea to select companies that do not have onerous long term debt. Zero long term debt is the best. This means that the management has the flexibility to undertake any action they need to enhance the value of the company without worrying about debt payments and violating and debt covenants.

When economic conditions are depressed, it is possible to find many small cap value opportunities. These are also some of the best times to invest as the stock prices tend to get lower than they do in good economic times. As the market improves, and the company bounces back, an investor with the foresight to buy into these stocks at the bottom will do very well.

Shailesh Kumar owns and runs a popular value investing service at Value Stock Guide. He focuses on mainly small cap value stocks and has delivered outstanding long term returns for his members. Find out more about which stocks to buy for excellent returns with minimal risk.

Source: EzineArticles
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