4 tips to avoid catastrophic small-cap losses

Edward Sheldon looks at how to protect yourself from devastating small-cap losses.

The content of this article was relevant at the time of publishing. Circumstances change continuously and caution should therefore be exercised when relying upon any content contained within this article.

When investing, your capital is at risk. The value of your investments can go down as well as up and you may get back less than you put in.

Read More

The content of this article is provided for information purposes only and is not intended to be, nor does it constitute, any form of personal advice. Investments in a currency other than sterling are exposed to currency exchange risk. Currency exchange rates are constantly changing, which may affect the value of the investment in sterling terms. You could lose money in sterling even if the stock price rises in the currency of origin. Stocks listed on overseas exchanges may be subject to additional dealing and exchange rate charges, and may have other tax implications, and may not provide the same, or any, regulatory protection as in the UK.

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More.

Small-cap shares have been known to generate life-changing returns for many investors. Where a FTSE 100 company may return 10% in a year, it’s not uncommon for a smaller company to return 10 times this amount over the same period. However there’s one fundamental downside to small-caps – higher risk. 

Preservation of capital is one of the keys to being a successful investor, and for this reason caution is warranted with small-caps, because the losses can be devastating. Here are four questions I always ask myself before buying a smaller company.

1. Is the company profitable?

It’s easy to get caught up in the hype of an exciting story when investing in smaller companies. Indeed, many investors buy a stock on the back of a tip from a friend or colleague without doing their research. This is a huge mistake in my opinion.

I’ve found over the years that companies that are already generating profits tend to continue generating profits and conversely, companies that are not making a profit now, may never make a profit. And without a tangible earnings figure, it’s harder for investors to place an estimated valuation on the company.

While it’s no doubt possible to make money from companies that aren’t yet profitable, I’ve learnt that eventually, if no profits materialise, it’s likely the share price rise will go into reverse. Shares are often said to “take the escalator up and the elevator down”, and trust me, you don’t want to be the investor stuck in the elevator heading downwards.

So the first thing I look for now is profitability, and eliminate pie-in-the-sky-type stocks that aren’t yet profitable. 

2. Is cash flow positive?

Next up I check the company’s cash flow. This can be found on the cash flow statement under ‘cash from operations’ or ‘operating cash flow’. Cash flow is the life-blood for any company, large or small. Without adequate cash flow, a business will eventually struggle to operate, unable to pay suppliers, buy raw materials or pay its employees. The cash flow statement will give an indication about a company’s true health, so it’s definitely worth checking to make sure cash flow is positive.

3. Is the valuation reasonable?

So the company is making a profit and generating cash. Great. But what about the valuation? In my opinion, investors need to be cautious when a company is trading at an eye-wateringly high valuation. 

How high is high? Well for a company that is growing earnings by 30% per year, a P/E ratio of 25 to 30 is not that unreasonable. However, a ratio of say, 150 is more dangerous. A valuation of this level suggests that investors have got carried away and have bid the stock up to exuberant levels. And if the company misses expectations, the downside can be brutal.

4 Is it all hype? 

Lastly, I’m wary of over-hyped bulletin boards. I’ve found over the years that the stocks that are hyped the most on bulletin boards, are often the most dangerous. Contributors on these boards will urge you to buy the ‘hot’ stock before the price “takes-off“, however while you’re buying, the chances are they’re selling, a process known as a ‘pump and dump.’

The best opportunities to my mind are stocks that are truly under the radar, and are yet to be discovered by the bulletin board rampers.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

More on Investing Articles

Mixed-race female couple enjoying themselves on a walk
Investing Articles

£7,000 in savings? Here’s what I’d do to turn that into a £1,160 monthly passive income

With some careful consideration, it's possible to make an excellent passive income for life with UK shares. This is how…

Read more »

Investing Articles

If I’d invested £1k in Amazon stock when it went public, here’s what I’d have today

Amazon stock has been one of the biggest winners over the last couple of decades. Muhammad Cheema takes a look…

Read more »

Investing Articles

If I’d put £5,000 in Nvidia stock 5 years ago, here’s what I’d have now

Nvidia stock has been a great success story in the past few years. This Fool breaks down how much he'd…

Read more »

Young black woman walking in Central London for shopping
Investing Articles

Could investing in a Shein IPO make my ISA shine?

With chatter that London might yet see a Shein IPO, our writer shares his view on some possible pros and…

Read more »

Silhouette of a bull standing on top of a landscape with the sun setting behind it
Investing Articles

The FTSE 100 reached record highs in April! Here’s what investors should consider buying in May

The FTSE 100 continues to impress in 2024 as last month it reached new highs. Here are two stocks investors…

Read more »

Investing Articles

Despite hitting a 52-week high, Coca-Cola HBC stock still looks great value

Our writer reckons one flying UK share that has been participating in the recent FTSE 100 bull run remains a…

Read more »

Investing Articles

Is this the best stock to invest in right now?

Roland Head explains why he likes this FTSE 250 business so much and wonders if it could be the best…

Read more »

Cheerful young businesspeople with laptop working in office
Investing Articles

With impressive 7% dividend yields, I’d seriously consider these 2 popular British shares to buy in May

Picking the right dividend shares to buy can result in spectacular returns. This Fool is weighing the prospects of these…

Read more »