It’s fair to say that Sirius Minerals (LSE: SXX) has been an absolute disaster for investors. As I write this, its share price stands at just 3.7p, versus 29p this time last year, meaning that the stock has lost nearly 90% of its value over the last 12 months. Many investors will have lost a fortune.
Avoiding large losses is absolutely crucial if you want to make money from stocks as they will really set you back. For example, if you lose 90% of your money on a stock, you need to generate a return of 900% just to break even. With that in mind, here’s a look at four strategies that can help you avoid big losses when investing in smaller companies.
Focus on profits
One thing that always concerned me about Sirius was that it had no revenues or profits, yet it had a huge valuation. In other words, it was a classic ‘story’ stock that had attracted a lot of investor attention and had risen on overly optimistic expectations about potential profits.
Having lost a fair amount of money on these kinds of companies myself in the past, one thing I always do now when investing in small-caps is focus on companies that are already profitable. In my experience, story stocks that have no profits often fail to deliver for investors. Things go wrong, both operationally and financially, and profits often never materialise which eventually leads to a share price crash. I’ve found that it’s much safer to focus on companies that are already profitable and more specifically, companies that are growing their profits.
Check cash flow
However, just because a company is making a profit, doesn’t mean it will turn out to be a good investment. There are a number of tricks that management can use to artificially inflate profits. For this reason, when researching a company, it also pays to look at cash flow (the lifeblood of any business) as cash flow is much harder to manipulate. You can do this by looking at the company’s cash flow statement. Ideally, you want to see operating cash flow rising in line with profits.
Look at short interest
It’s also worth checking to see if hedge funds are shorting the stock. If they’re shorting it, they think that something is fundamentally wrong with the company and expect its share price to fall. Shorters don’t always get it right, of course, but quite often they do. Back in March, I noted that shorters were targeting Sirius, so that was a clear warning sign.
Finally, when investing in individual stocks, make sure you have sound risk management practices in place. Putting your life savings into one stock just isn’t sensible. No matter how promising a company looks, things can go wrong, so it pays to diversify.
Also, bear in mind that small-cap stocks are riskier than large-cap stocks. So, only invest what you can afford to lose. If I invest in a small-cap stock these days, I generally only invest 1% to 2% of my total portfolio in it. That way, if it does underperform, it’s not the end of the world.
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Edward Sheldon has no position in any 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.