Last week we discussed if investors can get an edge on large cap stocks. This week is focused on smaller cap stocks (e.g. $3 billion or less). Most investors and academic studies usually concur that one can get an edge on small cap stocks because there can be an informational advantage as smaller companies get less coverage on both the buy and sell sides. Investors can occasionally see their money double or more as Wall Street becomes aware of these underfollowed companies.
That’s the good news. However, for every success story there are dozens of small cap stocks that will continuously languish in obscurity. The investor’s challenge is often not if you can get an informational edge on an underfollowed small cap, the challenge may be determining if anyone besides you will ever care enough about the name to purchase it. This is a major concern, especially with illiquid stocks that can take days, if not weeks, to exit a position if the stock fails to work. Therefore it is crucial to not only know a small cap company and the catalysts that theoretically should propel it higher, but also the ownership structure.
Knowing the ownership structure not only entails knowing how much of the float is owned by management (and oftentimes the management’s family) but also other investors that are currently involved in the name and activities surrounding those investors that could “loosen up” some shares of a small cap company. These activities can include things as changes in Portfolio Managers, tax needs of the investor, estate property changes or modifications, or any number of things other than valuation reasons that can influence the sell decision for an investor.
It also helps to know, or get a sense from your analysis, if there is a secondary offering coming, which improves the number of shares not held by management. Those offerings usually are followed by growth initiatives such as M&A activity, increasing the distribution channels of the company, increasing capacity, international expansion or any number of investment opportunities.
Therefore the investor can likely get an informational edge with a small cap stock, but sometimes that might not be enough. You need to know other factors quite well, such as ownership structure, for that edge to matter and happen within the investor’s time horizon as well for the stock to work.