Beware the Risks of Small Cap Stocks

This article was originally published by Zacks.com.

If investing in small cap stocks was easy, then everyone would be rich. The fact is small caps carry a lot of inherent risks:

• Lack of insight

Wall Street focuses on the biggest firms. So you have 47 analysts covering Apple, but virtually no one reviewing the merits of the stocks under $1 billion in market cap.

• Lack of news

The investment media is no different. So the TV networks, magazines and websites rarely give much attention to these smaller firms.

• Lack of personal experience

Most of these companies are "out of sight and out of mind," meaning we don't normally interact with these firms in our daily lives.

Gladly, there is a solution to get you into these exciting stocks. It gets you in the rare small caps that are poised to continue to move higher, while limiting your risks on the back end of the trade.

A Big Bang followed by...

The big positive earnings surprise, the huge beat, the excitement of the stock going up 15% or more in a single day. How many times have we watched that happen? Hundreds, maybe thousands. The stock moved and we all thought, well that ship has sailed.

What if I told you the idea of that ship sailing isn't always true. Most of the voyage is still yet to come after the ship leaves port, and if you are looking at a small cap, that journey has really just begun.

I could point back to a stock that reported early in March. A big 16% pop cleared out a lot of shorts and had many thinking that the move was already made. The following four weeks were a different story — a great story in fact. The stock moved higher by another 40% … and that is on top of the big first day move.

So what would you prefer, a 16% gain or that 40% gain?

Of course you want that 40% gain, but this will generally only happen with small cap stocks. But before we dive headlong into this space, we have to further explore the potential downside of these stocks. That will help pave the way for how to trade them the right way.

Rough sailing

Small cap stocks are the riskiest class of stocks. The big caps have safety in their size, liquidity and Wall Street coverage. The small caps will not have the wide base of customers, institutional interest or that coveted broad coverage from Wall Street.

They have a limited liquidity, which makes trading them that much more difficult. Even a rumor could have our ship taking on water, and that could send the stock down 5% or more. These are dangerous waters, no doubt about it.

One earnings miss on a small cap can be devastating with many sinking 20% to 30% in the blink of an eye. Even when thoroughly researched, the earnings announcements can contain a hidden squall in the form of lowered guidance! That means getting it correct is even harder than you think. The beat has to also come with upside in guidance.

Charting a course for success

We developed a strategy that holds water. First, look at the earnings reports and find the small caps that have posted solid earnings surprises. It is important that we don't just look at the 20% positive earnings surprises; we have to include the 5% winners too. We now have our boat structure in place.

The second step is to use the Zacks Rank to find the stocks that were already getting the analyst love. The Zacks Rank is prone to move after a report, so you need to know the rank BEFORE the event. We will focus on the stocks that were Zacks Rank #1 (Strong Buy) and Zacks Rank #2 (Buy). This will be our mast and sails.

Next we want to make sure that the positive earnings surprises have legs. What does it mean “to have legs”? We want to see that the surprise wasn't caused by a one-time event. So look for an operational improvement, an increase in new customers or the best case scenario of improved margins. Reading research reports and reviewing conference calls will help us see if these types of events happened. This is the wind that will power our sails.

Risk on vs. risk off

Now that we have our target destination, we set sail and glide on smooth waters. We avoid the storms and the choppy waters and LIMIT RISK.

Did we just miss that big pop on the day of earnings? We sure did, but we get to ride the smooth breeze after the earnings have proven the story.

At this point, the risk is off. We know how the last quarter shook out and the next quarter's guidance is now baked into the stock price. The benefit comes as more market participants learn about the story. Few investors can shoot from the hip and consistently make profits on small caps. They need to take the time to research the story.

Before these companies report earnings again, we will move to limit our risk. In fact, limiting risk by 100% is the strategy. Sure we might see another beat, but the guidance is too hard to game. Taking your profits before the next earnings report helps you avoid 100% of those 20% to 30% blow ups. Dropping anchor and waiting out the earnings storm assures us of not being lost at sea.

Summary

Small caps are not easy to find, but if you focus on the ones that post positive earnings surprises and have great prospects going forward, you set yourself up for a better chance of success. Layer in the Zacks Rank and some details from the conference calls and research reports, and you have a winning formula.

To limit risks, seek a harbor in the tempest and take gains before earnings reports.

Brian is Zacks.com’s Aggressive Growth Strategist and provides commentary and recommendations for the Zacks Breakout Growth Trader.

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