In helping clients invest, I’ve had on more than one occasion where someone has expressed a real desire for higher growth investments as opposed to more “pension-like” blue-chip large company dividend payors. Inevitably, the conversation turns toward smaller companies.
It is true that smaller companies tend to have higher earnings yields than larger companies – and hence more value. As well, smaller companies tend to have higher earnings growth. But smaller companies may not have as strong a competitive advantage, may not have a strong balance sheet, and they may be much more vulnerable to changes in their industry or the overall economy. It is no wonder than when the stock market corrects, small companies tend to drop several times more – possibly up to a staggering 75% assuming that they’re even able to survive.
This deadly volatility is what keeps most of my retired clients away from small companies. They just don’t need the small company volatility and are happy with more stable income payers.
But assuming you’re someone who has that hunger to get involved in companies that have the ability to double or possibly become a ten-bagger, let’s try and look at the kind of investment parameters that a venture capitalist might use so as not to lose their shirt.
Rule #1: Never bet the farm
Limit your smaller companies exposure to say no more than 10% to 20% of your total portfolio. So let’s say we have a portfolio worth $500,000. Depending on your situation and tolerance for risk, that might mean we limit your small company exposure to $50,000 to $100,000. Let’s say we’ll invest $50,000 now.
Rule #2: Never bet on just one crop
For the money to be allocated to small companies, search for at least 10 businesses. For each business we are to invest in, we should make equal dollar bets. So that would mean $5,000 for each business. And for those 10 businesses, we should try to have them invested in different industries. Let’s say no more than two businesses in the same industry.
Rule #3: Always have cash reserves
As the stock market can correct at any time and small company stock prices can move violently, even without any public news, we’ll keep the other $50,000 cash as cash to be opportunistic to take advantage when a good business goes on sale (assuming the business is still a quality business).
So, if a stock drops by 50%, then we’ll top up that stock back up to a $5,000 position. (Always keep in mind that if it is a broken company, we don’t want to put good money into a bad business).
Rule #4: Take Profits
If a stock doubles and is still a good business, then let’s sell half that $10,000 valued position and bring it back to a $5,000 position. Think, we don’t have a real profit until we sell something.
Rule #5: Stay away from highly debt-ridden businesses
Debt = death. This is one of the top reasons why a small business crumbles and goes into bankruptcy. So limit debt to 20% of total capitalization.
Rule #6: It’s about earnings
Seek a company with a good earnings yield (= EPS / market price) where the earnings are stable and growing. Given enough time, the stock price will eventually follow earnings.
Rule #7: Quality is just as important
Look for a business that makes a great product and sells it at a fair price for which it is able to make a good profit. Think about potential competition and any competitive advantages it might have.
Rule #8: Cash in the bank
Seek businesses that have cash in the bank and need not have to borrow for normal operations.
Rule #9: Stay away from management that uses company like an ATM machine
We want to have management make decisions that are in the best interests of shareholders as opposed to lining their pockets with high salaries, high bonuses, and excessive grants of stocks and options.
Rule #10: Do your homework
Lastly, do your homework and stay on top of developments of those companies. So read their news releases, read their quarterly and annual reports, read their MD&A and Annual Information Form, listen to conference calls, and watch their stock price – at least weekly.
Hopefully these rules will keep you out of trouble and get in the black!