The best small cap stocks can offer great opportunities for gains for investors

Small cap stocks are companies with a “market cap” (the value of all the shares they have outstanding) below, say, $250 million, or some other arbitrary figure.

The best small cap stocks have the potential for large gains, but they are generally more volatile than large-cap stocks. Temporary setbacks, such as a poor quarterly earnings report, or the loss of a major contract, can quickly cut their share prices. That’s why we view even the best small cap stocks as aggressive.

To find the best small cap stocks for lower-risk gains, we recommend looking for sound companies that stand to benefit as the economy continues to improve. It’s also important for these stocks to be well established, with strong management and prominent positions in their markets.

The best small caps can offer above-average growth potential. As well, small caps, good and bad, can fall out of investor favour during periods of market volatility. When this happens, successful investors can have opportunities to buy the best small cap stocks at discounted prices.

Many investors think of the “small cap group” as the place to look for aggressive investments, such as junior companies that will develop into seniors and make huge gains for investors. Some small caps will indeed turn out that way, but you’ll need to choose carefully. That’s because small cap stocks vary widely in quality.

The best small cap stocks will likely pay off over time

Small-cap stocks are typically a lot riskier than large caps. They are also much more volatile. One bad quarter of earnings, or the loss of a major contract, for example, can quickly cut a firm’s share price. That’s why we view even the best small-caps as holdings for the aggressive component of your portfolio.

We always base our recommendations on a small cap stock’s investment quality. We look for sound companies that stand to benefit as the economy continues to improve. We also look for companies with proven management and long-term growth plans. It’s an approach based on company fundamentals, rather than short-term trading or market timing.

We also recommend staying out of so-called concept stocks, which mainly include start ups or companies that look to profit from current investor fads. These companies can put on a great performance while investor interest is hot—but in the long run, though, they’re likely to cost you money.

We always advise investors not to overindulge in any one group of stocks. That’s especially true of small caps, which can be more volatile than other investments. But selected high-quality small-cap stocks can boost your portfolio returns.

The best small cap stocks are well-established firms in growing fields with a least a record of rising sales. However, many small caps are start ups that have yet to make their first profit. Some succeed brilliantly, and these are the hot small cap stocks we aim to help you spot in our Stock Pickers Digest newsletter, but lots of others go broke. Then too, some small caps are former large-cap companies that have serious problems. These stocks now trade as small caps, but may be on their way to zero.

4 tips for investing in the best small cap stocks

1. Limit small cap stocks to no more than, say, 20% to 30% of your portfolio.

   Ultimately of course, the percentage of your portfolio that should be held in either conservative or aggressive investments depends on your personal circumstances. An investor with a longer time horizon, or without the need for current income from a portfolio, can invest more money in small cap stocks. But we think 20% to 30% is a good rule of thumb.

2. Cut your risk with small cap stocks by taking a conservative approach to your aggressive investing.

   Hold your best small cap stocks within a portfolio that invests mainly in well-established companies and spreads your money out across most if not all of the five main economic sectors (Manufacturing, Resources, Consumer, Finance, Utilities).

3. Downplay small cap stocks in the broker/media limelight

   The limelight fosters bloated investor expectations. Small cap stocks that are talked up like this may seem like ideal candidates for big gains, with lots of investors getting on board. But when stocks fail to live up to those expectations, brutal downturns follow. Applying this aspect of our conservative philosophy to an aggressive portfolio leads us to stay out of most new small cap stocks. Rarely will you find a new issue to be one of the best small cap stocks in your portfolio. Most new issues come to market when it’s typically a good time for the company or insiders to sell. That’s rarely a good time for you to buy.

4. Look for hidden value in small cap stocks

   Hidden assets can consist of real estate or underused brand names. For example, companies often carry their real-estate assets on the corporate books at their purchase price, even though their value may have multiplied many times over the years. The purchase price goes on its balance sheet as the historical value of the asset. Over a period of years or decades, the market value of that real estate may climb substantially. But the historical purchase price remains unchanged on the balance sheet.

Do you keep a separate portfolio for your best small cap stocks? Have you had any large gains with some of the small caps you’re invested in? Share your experience with us.