How to invest in small-cap gems | Fin24

How to invest in small-cap gems

Aug 23 2018 09:08
Simon Brown

Picture this. 

You are looking for a small undiscovered gem to invest in – a potential ten or even twenty bagger. 

Heck, maybe even a hundred bagger. You do your research, finding and discarding many possible candidates, until you finally find it. 

You have read the last ten years’ annual reports and the results have revealed a true hidden gem. 

Valuations are seriously cheap and the industry the company operates in offers real growth potential, while it has the absolute capacity to grow faster than its peers within the industry.

You jump in, excitedly building a position in the share and then you wait for the rest of the market to wake up to the gem, while you are already planning on how you will spend the untold riches coming your way.

Yet nothing happens. The company continues to issue great results and hike the dividend – but the share price does nothing. On the contrary, it slips lower. 

Frustrated, you double down on your research into the company and the sector it operates in. 

You re-read the last 20 years of annual reports and results. You do site visits (if viable) and compare the company to international peers. 

Everything you thought about the company remains true – this is the best share to own in the entire market. 

Yet, nothing.

The issue here is not necessarily your research. Let’s assume it is correct and this is a great company. 

The issue here is the rest of the market is not getting on the bus. For a share price to move higher you need new buyers. 

And lots of them. In short, something needs to happen that will trigger a wave of buyers to arrive, and great results are not always going to do it – especially if they have not done it so far.

With a small cap the issue is often that the stock is simply too small for institutional investors to invest in, and without institutional buying a share will struggle. 

In time it may creep higher, eventually getting onto the radar of the larger asset managers who will then start buying and pushing the price higher. But that is a long wait.

A share price needs a trigger. It could be that the company finally becomes large enough. Or maybe there are talks about a merger or acquisition that will increase size or will draw attention. 

But quality on its own is not always enough to push a share price higher.

That said, as an investor you should not shy away from these gems. However, you should maybe be smarter in how you buy them, and which ones you buy.

Dividends become very important, as they may be your only return for many years while you wait for buyers to arrive. 

Furthermore, if results are improving, the dividend should be increasing every year. 

Eventually, if nothing else, a wildly high dividend yield will start to attract at least some additional buyers.

The other trick is to scale into the stock rather than buying all at once. Build a position slowly and be smart about the price you pay. 

Don’t just buy at the current offer price. Have a look at the charts and check if there seems to be a trading range. 

If there is, put in offers to buy at the lower end of the range. You can also buy half of what you want and then wait another six to twelve months before coming back to buy more at what may be a cheaper price.

The bottom line is that you should not abandon the gem. Be patient and enjoy the dividends while you wait for other buyers to arrive. 

Lastly, look for more than just one gem. A few gems will improve your odds.

This article originally appeared in the 30 August edition of finweek. Buy and download the magazine here or subscribe to our newsletter here.

investment  |  shares  |  market cap

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