Although often volatile, you can find small cap growth stocks with strong long-term investing potential.

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

Small cap growth stocks have above-average growth prospects and the potential for strong gains, but they are generally more volatile than large-cap stocks. Although these stocks can be highly volatile, they often make good long-term investments. They may be well-known stars or quiet gems, but they do share one common attribute—they have grown at higher-than-average rates within their industries, or within the market as a whole, for years or decades.

Top small cap growth stocks will likely pay off over time

We always base our recommendations on a small cap growth 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 trading or market timing.

Small cap stocks can be a lot riskier than large caps. They are also typically 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.

The best small cap stocks are well-established firms in growing fields with a record of rising sales.

Cut your risk with small cap growth 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).

Look for hidden value in small cap growth stocks

By definition, a stock’s hidden assets have not had much impact on its price. If you paid little if anything for the assets, you have little to lose. But the best hidden assets will eventually expand a company’s profit, grab investor attention, and push up its stock price. Hidden assets can be found in research spending, real estate, as well as brand names.

The best time to find hidden assets is when they’re still hidden, long before the company begins taking steps to profit from them. Understanding and seeking out hidden assets while you’re evaluating a stock can add enormously to your profits in the course of an investing career. But you need patience to profit from them, because they can stay hidden for a long time after you buy.

Downplay small cap stocks in the broker/media limelight

Small cap stocks that are talked up 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 issue 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.

So always focus on investment quality first, especially when researching aggressive stocks that have the potential for higher returns.

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

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.

And keep in mind that we focus on growth stocks, which have a good long-term history and favourable prospects. We downplay momentum stocks that tend to attract many investors simply because they are moving faster than the market averages, but are liable to fall sharply when their momentum fades.

Are you holding small cap growth stocks in your portfolio? How have they performed for you? Share your experience with us in the comments.