Research has shown that smaller companies tend to outperform larger companies over time. For this reason, it can be worth allocating a proportion of your retirement portfolio to this section of the market in order to boost returns. However, small-cap stocks can also be significantly more volatile than large-caps – meaning it’s easier to lose money – so you do have to approach this asset class carefully.
Today, I want to share with you four things I’ve learnt about small-cap investing over the last 15 years or so. Following these tips could enable you to boost your portfolio returns significantly while minimising the chances of losing money.
One of the most important things to do when investing in small caps, in my view, is to spread your money out. While going ‘all-in’ on a stock can produce large returns, this approach can also end up losing you a lot of money if it backfires. And that’s never good. Remember, if a stock falls 50%, you need to make a 100% return just to break even.
So, for example, if you have £10,000 to allocate to smaller companies, I’d recommend spreading that out over five to 10 firms instead of buying just one stock, with the expectation that a couple will underperform, a handful will generate solid returns and a few will really take off.
Run your winners
This brings me to my next point: one of the keys to making big profits from small-caps is to run your winners. It may be tempting to lock in a profit of 30% or so, but if you’re prepared to be patient and hold on to the company while it keeps increasing its profits, you’ll often end up generating much larger gains.
For example, I made a small investment in email technology group dotDigital back in late 2013 when the shares were trading around 24p. At the time, the company has just reported earnings per share (EPS) of 1.3p for the year. Fast forward to today and the group last year reported EPS of 3.1p, showing that it has grown significantly in five years. The result? The shares now trade for 93p, meaning I’m sitting on a gain of 290%. By holding on to a winning stock for five years or more, you give yourself a chance of making powerful returns.
That said, locking in some gains is also often a good idea. It’s generally not sensible to have your portfolio heavily weighted to one or two stocks that have outperformed. What I’ll often do is take a little profit off the table after a stock doubles, by selling 20% to 50% of my stake. That way, I have the best of both worlds – I’ve locked in some profits that can be deployed into other opportunities, and I’m also letting the winner run.
Focus on profits
Finally, I’ve found that a focus on companies that are already profitable can help you avoid disasters. It’s easy to get excited about ‘story’ stocks that promise investors the world, yet a lot of the time, these kinds of companies don’t deliver and you just end up losing money.
By focusing on companies that are already making consistent profits, you give yourself a much better shot at making large profits from the small-cap section of the market.
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Edward Sheldon owns shares in dotDigital Group. The Motley Fool UK has recommended dotDigital Group. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.