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Don’t buy a single small-cap stock until you can answer these 4 questions

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One of the most reliable findings from research into the performance of equities is that small- and micro-cap shares, as a group, hugely outperform those of larger companies over the long term. 

There are a few reasons for this, including their ability to grow profits at a rate that the vast majority of bigger businesses can’t. The fact that a lot of professional investors aren’t permitted to buy such promising firms for their funds also means that these stocks are usually under-researched and often mis-priced.

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Before leaping into purchase a stake in a small business, however, I think it’s essential to have answers to the following…

How risky is this investment?

Some small-caps can be high risk with seriously volatile prices. While the latter is perhaps to be expected if they initially struggle to weather changes as well as their larger counterparts, we want to avoid those picks where there’s a real chance of losing all our money.

I freely admit that some of my earliest investing mistakes involved buying (thankfully small) stakes in speculative stocks where success was dependent on a single product, or securing a contract with a particular client. Not smart.

So if you’re are going to go down this route, just make sure your money is diversified into a sufficient number of shares (although keep an eye on fees). Either that, or buy a small-cap fund that instantly spreads your cash around several hundred/thousand companies in one mouse click.  

How many shares do management own?

Find a market minnow that takes your fancy? Go straight to its website and click on the link that provides information on who the major shareholders are. If you can’t see the names of key management, that’s a potential red flag. 

There’ll be exceptions to this of course but, as a rule of thumb, you probably want to avoid companies that aren’t backed by the people running them. If directors don’t have much or any ‘skin in the game’, how incentivised do you think they’ll be to really grow the business?

For this reason, look to buy into firms where managers are also significant part-owners. This should mean their interests are aligned with those of private investors such as yourself. 

On a related note, it’s also worth checking out the track records of a company’s leaders. A chequered history should be another warning sign. 

What are the finances like?

Naturally, small-cap shares don’t have the resources that their bigger, more established peers do. As such, I make a point of trying to avoid companies with stretched balance sheets.  A lot of debt is a big negative, especially during a downturn.

Holding shares in firms that might require cash in the near term is also problematic since a placing will dilute existing shareholders. Moreover, there’s a chance that sufficient cash can’t be raised.

Do you have the patience?

Investing is a long-term game and this is particularly true of small-caps. While the odd oiler, miner or biotech company might strike it lucky once in a while — rewarding its investors quickly in the process — to really reap the small-cap effect, you’re going to need to have the patience to buy and hold during difficult periods. 

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Paul Summers has no position in any of the shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. 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.

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