The Investors Guide To Profiting From Small-Cap Stocks on the ASX
Discover how to find and invest in small cap companies BEFORE they hit the big time – potentially making gains of up to 1,000% in under a year.
I’ve been researching, advising and writing about investment ideas and money-making strategies for small cap asx trading for over a decade.
A company’s ‘market cap’ is simply the stock market’s best estimate of a company’s total value. Big companies are large caps. Generally speaking, brokers in Australia consider companies with a market cap under $500 million a ‘small-cap stock’.
You might also hear these companies referred to as ‘penny stocks’.
I think small-caps are — hands down — the best way that a private investor can make a fortune on the stock market. (Of course, this comes with some caveats, which I’ll get to in a moment.)
If you’re serious about making a fortune in the stock market — and you have a small pot of money you’re prepared to risk, because small stocks are inherently riskier — I recommend you buy small caps and microcaps.
Jump to section:
- What IS a share?
- What are small-cap shares?
- How do you find the best small cap ASX listing?
- Buying and selling small-cap shares
- When can you buy and sell shares?
- How do you set up a small-cap brokerage account?
- Four questions to ask before you dive into the world of small-cap investing
- Some final tips for trading small caps
With Australian small cap stocks, rogue private investors like you have a unique advantage.
For one thing, big funds cannot invest in small-cap stocks. It’s a liquidity problem. Small investments can’t offer meaningful profit opportunities to large investors. There’s a practical problem, too. Small caps are thinly traded. It’s impossible for them to take large positions without pushing the price up. So in general, the ‘big money’ ignores small-cap stocks.
And because the fund managers aren’t interested, the investment banks don’t bother researching these companies…and the press ignores them, too.
Legions of analysts don’t bother with these companies. The market for larger stocks is efficient — because the market knows all the information about them. It’s hard for you to find pricing anomalies.
The small-cap market is CHOCK-FULL of pricing inefficiencies and undervaluations. In other words, you can find incredible bargains in the small-cap universe — if you bother to look. Most private investors don’t bother.
Small caps can give you HUGE returns. I can think of many that have risen hundreds of percentage points in the last few years. But they can also generate HUGE losses.
That’s why you need to tread carefully.
Now, if you’re retired and your investment goals are ONLY to preserve your capital and make low-risk income, this is not for you. Small-cap stocks are best suited to aggressive investors…like my well-paid school friend. They’re also for older folks with spare capital they’re happy to put on the line for stratospheric returns.
In a moment, I’ll reveal precisely how you could earn massive profits by investing in carefully selected Aussie small-cap stocks…
There’s a little-known sector of the Australian stock market you need to know about — even if you’ve never bought or sold a share in your life: the small-cap sector.
It’s a group of publicly traded companies listed on the Australian Securities Exchange (ASX). These companies are practically invisible to mainstream investors — both private and corporate.
Mention one of these small-cap companies to brokers, and I guarantee they’ll simply scratch their heads. If you have a super fund, it’s almost certain that not one of these shares is in it. The analysts who make a living researching shares don’t make it by researching small caps. In fact, these analysts’ bosses actively encourage them to deny their existence.
90% of hedge funds don’t even track small-cap stocks, let alone buy them.
And it’s pretty much a miracle if you find the financial press mentioning the names of these stocks — even in passing.
For all intents and purposes, small-cap stocks are ‘off-the-grid’. So far under the radar that some go their whole lives as listed companies with only a couple hundred shareholders.
Yet…small-cap stocks have quietly and consistently trounced ‘blue-chip’ index stocks for 50 years, according to research carried out by the London Business School.
They tend to do even better after bear markets.
In What Works on Wall Street by James O’Shaughnessy, there is a comparison of the performance of small-cap stocks with the S&P 500. Following the 1973–74 bear market, small-cap stocks had risen 447% six years later compared to only 264% for the S&P 500.
In 2003, as the markets recovered from the bear market of 2001, small stocks outpaced all others by a nearly two-to-one margin. The same story repeated in 2009. And with current market turmoil and depressed stock prices, the stage is being set for it to happen again.
In fact, small-cap stocks could make you triple-digit returns in under a year…the kinds of gains that buy-and-hold investors in big-name stocks like BHP Billiton Ltd [ASX:BHP] may now never see.
For reasons I’ll show you in a moment, only independently minded private investors have the chance to exploit this little-known stock subset. So what’s it all about?
OK. Let’s start at the beginning.
If you have a basic knowledge of the stock market, then you could choose to skip this question. But before I get to small caps…
What IS a share?
Well, as their name suggests, if you hold shares, you own a share of a company. In practice, this means three things for you as a shareholder:
- You can sell your shares to other people interested in buying them — hopefully for a nice profit!
- You are also entitled to a share of the company’s profits. This is paid out to you by the company every six or 12 months as the ‘dividend’. (Although it’s worth pointing out that many small-cap shares don’t pay dividends regularly. They prefer to reinvest profits in the growth of the business. That’s good for you though: You’re in the small-cap game mainly for the capital gain; any income is a big bonus.)
- You can vote at shareholder meetings.
Again, new companies often take a few years to become profitable. And even successful, established companies can have bad years, when they actually lose money. That means dividends should not be your priority as a small-cap investor.
What are small-cap shares?
Righto. Here’s where things get interesting.
Small caps are the smallest shares that trade in any market. The minnows. Technically mid and small caps are defined as companies outside the top 100 on the ASX, but I tend to consider only stocks outside the top 250 as genuine small-cap contenders.
In 2015, the S&P/ASX Small Ordinaries [ASX:XSO] index, which represents companies ranked between the top 100 and 300 by market capitalisation, returned 7.83%.
Compare this to the S&P/ASX 200 [ASX:XJO] index, which represents the biggest 200 companies on the ASX by market capitalisation. For the whole of 2015, the ASX 200 returned -1.83% – investors lost money.
The Small Ordinaries outperformed the big end of town by 9.66%
While this is impressive and just a guide to what this end of the market can do, the Small Ordinaries index captures companies with market caps largely greater than $100 million. The biggest gains typically come from companies smaller than that (as I said, stocks outside the 250).
Had you picked some of the best small-cap stocks on the Australian market in 2015, you could have made gains like:
Bellamy’s Australia Ltd [ASX:BAL]: +714%
Blackmores Ltd [ASX:BKL]: +534%
Netcomm Wireless Ltd [ASX:NTC]: +523%
Pilbara Minerals Ltd [ASX:PLS]: +700%
Of these stocks, the last two brought investors huge percentage gains in just the last six months of 2015. That’s how quick these stocks can run.
We tipped Bellamy’s to readers of my advisory service, Australian Small-Cap Investigator, in September 2014 — and sold it 14 months later for a 575% gain.
So you can see these gains, if you have the nerve and spare money to put on the line, could be well worth the risk.
And the risk of investing in small-cap stocks can be pretty big.
But there are a whole bunch of other benefits to actively trading small caps right now:
- You’re unlikely to grow 30–50% richer each year with blue chips. Well-run, smaller companies can nimbly adapt to the changing marketplace and react much quicker than their bigger, duller large-cap peers. The maths is simple. It’s a lot easier for $155-million companies to double in size and revenue than for expensive $25-billion companies to do the same.
The ONLY way — and, I repeat, the ONLY way — to grow truly wealthy from stocks is to invest in solid companies trading at affordable prices and hold them until they grow into larger (hopefully much larger) corporations…companies everyone wants to buy.
- Small caps are barely covered by the mainstream — you have the field to yourself. Most people don’t give these tiny companies a second glance, despite the fact that, as I’ve shown, they can provide you with heavyweight profits. Why? Three reasons:
1) Large caps are more likely to generate higher fees for the investment banks who produce broker research.
2) Greater stock liquidity generates more revenue from trading commissions for these same investment banks.
3) Many funds are bound by market-cap restrictions on their portfolio holdings.
Basically, there is less incentive from a broker-dealer perspective to provide coverage for small and micro-cap companies. This means YOU have an excellent chance at identifying under-priced bargains in the lower end of the market. Shares trading for virtually nothing…great investments which the big shots are ignoring like a drunk uncle at a wedding!
- Small caps thrive in ANY market. Small companies typically care less about what’s happening with the economy. They’re constantly innovating anyway. In contrast, research demonstrates that larger companies cut back on innovation during downturns. Many small caps operate in under-penetrated industry niches, devoid of much competition. In other words, their profit opportunities are young…and potentially unlimited.
That’s all well and good. The question is:
How do you find the best small cap ASX listing?
Finding the right small-cap company can be tough. Not every small company has a bright future ahead of it. That’s why you need to consider each stock very carefully before you buy it.
You don’t need to have a business degree, a million dollars in the bank or connections to the worlds of science and finance. What you DO need is that ability to recognise a good story when you see one. Developing this ability takes a bit of time, a bit of experience and a lot of enthusiasm.
Here are some of the things you should look for to decide whether a small-cap stock has the potential to be one of the top small cap stocks on the ASX:
- Do I FULLY understand the business? First off, you need to know exactly what makes a business tick. This has nothing to do with charts and graphs. Talk to people…go to industry functions…absorb facts and figures…get a genuine understanding for the company’s core activity. Whenever possible, pay a personal visit. You don’t need to do this all the time, but you do need to know what a company is about. Ask yourself: What is its ‘Unique Selling Proposition’?
- Do I TRUST the guys at the top? Really good management is like gold. When you come across a company that has it, you know you’re onto something. It’s even more important to screen for BAD management. Right now, hundreds of company directors in Australia have been involved in several company failures. You’ll also want to know if a director owns shares in the company (bad news if he doesn’t…GREAT news if he’s buying) and whether he has a good track record.
- Am I looking at a future household name? Is this small retailer one day going to have outlets in every major shopping mall in Australia? Will the drug that this Perth-based biotech company just patented soon be in every pharmacy in the world? Is this iron ore producer, on the brink of bankruptcy just a few years back, about to become a global player? Remember: The beauty of the perfect small cap is it has almost infinite room for expansion.
- Do the numbers stack up? Hardly exciting stuff, but you simply cannot underestimate the importance of good old-fashioned number crunching to identify good small-cap stocks. No matter how great a company’s product or service is…no matter how adept their PR company is at spinning a compelling story or promising a stellar future…the balance sheet doesn’t lie.
What you are looking for are the nuggets that indicate a richer vein. What most investors find is mud…and a swirl of confusion. But if you want the big strike, that’s where you must do your work: finding a good, well-run business on the cusp of its hockey-stick growth phase.
And here, you can have the advantage over the world’s richest and smartest investors.
Warren Buffett — the ‘Sage of Omaha’ — has this to say on small-cap investing for private investors like you: ‘Having a lot of money to invest forced Berkshire to buy companies that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.’
Small caps are the best way I know to really ‘cream it’ if you’re an average person trying to build wealth over months…rather than decades.
This is where you can make big money, FAST.
With small-cap investing, you’re essentially ‘betting’ that an undiscovered stock is about to get some major exposure soon…maybe even become a future large cap, or maybe just find a few months in the spotlight.
Sometimes it doesn’t happen. Small-cap stocks can be very risky. They can double or halve in the course of a day’s trading.
They’re only for investors who are prepared to risk some money for the opportunity to make a lot more.
But when it does happen — and when you were invested right at the beginning, when a stock was trading for pennies — it’s an amazing feeling!
So, let’s say you’ve unearthed a small cap you think has a big future. You want ‘in’. How do you go about it?
Buying and selling small-cap shares
When you want to buy and sell shares, you have to do this through a stockbroker.
Many online stockbrokers let you make share transactions over the Internet. But you should know that, in small-cap trading, it’s often useful to have a physical broker who can put an order through for you straight away. That’s because sometimes online brokers have a delay before the transaction is carried out.
That can mean you have trouble getting in, or out, of the stock at the price you want. This is especially the case with small-cap shares, which can experience very quick price movements. You’ll have to weigh this against the fact that physical brokers typically charge higher fees.
First of all, you’ll need to set up an account.
This is extremely easy, and loads of brokers are competing for business, so you have lots of choice. I’ll tell you more about that in a moment. For now, let’s get to the interesting part — placing an order.
If you tell your broker to buy a particular share, he or she will look for the latest prices from firms called ‘market makers’, and purchase your shares at the best price he or she can get. By law, brokers are obliged to get you the best price available.
A typical conversation (if you deal over the phone) would go like this:
BROKER: ‘Good morning, Sir/Madam. Please could you give me your account number.’
YOU: ‘It’s XXXXXXX.’
BROKER: ‘Thank you. And how can I help?’
YOU: ‘I’d like to buy shares in XYZ company. What’s your best price?’
BROKER: ‘Let me just see…XYZ Company? The best price is 86.5c to buy.’
You can now decide whether you want to go ahead. If you don’t like the price offered, or you just change your mind at the last minute, you can say, ‘No, thank you’.
Let’s assume you want to go ahead…
You do need to be absolutely certain, because you are entering into a verbal contract to buy the shares. You won’t be able to back out of the deal once you have committed yourself.
YOU: ‘Okay, yes, I’d like to buy 600 shares at 86.5c please.’
The broker will then confirm the number of shares you want to buy and the cost.
BROKER: ‘That’s 600 XYZ shares at 86.5c, total cost including commission $588.95. Would you like to go ahead?’
YOU: ‘Yes please.’
BROKER ‘Thank you, that’s 600 XYZ at 86.5c — the deal’s now gone through for you. The contract note will be with you shortly.’
YOU: ‘Thanks very much. Bye.’
BROKER: ‘Thank you. Goodbye.’
Your broker will then send you a contract note through the post (or over the Internet, if this is how you deal), which gives all the details of your transaction.
The contract note also tells you the date by which you must pay for your shares (many discount brokers want access to your cash before dealing). You must pay by the settlement date — typically (but not always), that’s three business days after the day you place your order. If you don’t pay on time, the broker will have to sell the shares again at whatever price he can get and then repurchase a new block of shares at your expense.
Selling is the same but in reverse — this time you want to get the highest possible price!
When can you buy and sell shares?
The Australian Securities Exchange (ASX) is open for trading in Australian shares from 10am to 4pm (AEST), Monday to Friday.
Take care — if you place an order outside these hours, it will not be carried out until the market reopens at 10am on the next business day.
To avoid being caught out by unexpected price movements, always specify an upper price above which you will not buy. This is known as a ‘limit buy price’.
How do you set up a small-cap brokerage account?
You can choose between three different types of service from a broker.
The cheapest option is where a broker just buys or sells shares, acting on your instructions. The more expensive options are where a broker also starts to give you investment advice, or completely handles your investments for you.
WARNING: Most brokers know no more about small-cap shares than you do.
The three categories are known as:
- Execution-only brokers. With execution-only brokers, all you do is contact a broker and ask him to either buy or sell the shares of your choice. The broker will not give any advice on the shares. He or she is simply there to execute your buy/sell instructions.
- Advisory brokers. You can talk to advisory brokers, for a fee, who provide a service for those who would like to control a portfolio of shares but are not confident enough to go it alone. Most such brokers ask you to come in for an interview to find out what you are looking for, your income and commitments, and your attitude to risk.
- Discretionary brokers. This is the most expensive of the three services. This type of broker buys, sells, advises on and manages your share investments completely. He or she will be in close contact, keeping you informed of the current value of your investments and what he or she is buying and selling, but will have full authority to act for you. As with an advisory broker, you will have to undertake an initial interview to give your broker a clear idea of what he or she should be doing on your behalf.
Whichever broker you decide to use, you will be sent a Client Agreement Letter.
This outlines the services you will be offered and the terms under which the broker will work for you. You will then have to deposit some money into your account – then you are ready to start buying and selling shares.
Four questions to ask before you dive into the world of small-cap investing
Trading small caps can be an excellent way to supplement your investment income and make big returns quickly. But if you don’t begin with a solid foundation, it will cost you money instead of delivering an extra benefit to your portfolio.
Before you plunge into your first small-cap trades, here are four questions you must answer to make your trading better and more profitable.
Question #1: Can I afford to lose the money I invest?
Small-cap investing is a risky business. If you’re risk averse, or don’t have capital you’re prepared to lose, it’s a game you might want to sit out. Look — this is NOT retirement investing.
But it CAN be a great source of extra revenue…made quickly. And it’s pretty damn thrilling.
Here’s a rule of thumb: At the very least, you must not urgently need the money you’re going to put into these speculative stocks. If the money would best be used paying the mortgage or your kids’ school fees, don’t trade with it.
Losses happen. You need to be able to swallow them — monetarily and mentally — if you’re going to make the most of small-cap investing.
Question #2: Are you ready to spend some time before you start trading to learn the basics of the market?
Trading in small caps is not rocket science – but it’s not easy either. More than 2,200 stocks are on the ASX. Finding the best of the small-caps takes time, knowledge and expertise. That’s where an advisory service like my Australian Small-Cap Investigator helps you find the best small-cap stock.
Still, if you boil it all down to it’s bare bones, you basically find a company, find out if it has a promising product or service that could shoot it into the mainstream, and invest.
But you should get some background on how the stock market works and the various sectors that make up the ASX before you start.
Another important aspect is learning to manage the emotional and psychological part of the game. You’ll eventually discover that your own personal psychology is definitely the most important variable that can lead you to the winning or losing side of the market. When the market moves against you, it puts pressure on your willingness to stick with your plan.
Indeed, trading small caps brings joy, anger, despair, regret, euphoria, stress, uncertainty and many other emotions. These emotions must not drive your decisions. It is very hard to take efficient action without a rigorous plan.
Question #3: Are you ready to trade small-caps with a confident, disciplined approach?
There is nothing half-hearted about trading small caps. You’re either in — with a clear idea of the potential risks and rewards of each trade — or you’re out.
This involves setting rigid stop losses — and sticking to them if a trade moves against you.
Over the long term, discipline is essential to profits. Trading discipline helps you maintain focus and adapt to any market conditions. A good trading plan takes into account everything that happens after you have executed this trade and placed your money at risk. It takes into account all your money management rules and all the parts of the process that are in your control…basically anything that involves you taking action.
Why is this important?
Because you need controls on your behaviour. A plan is a practical set of rules that makes it easier for you to stick to your strategy.
Elements of a good small-cap trading plan include:
- Your goal in terms of return (capital gained), risk (maximum loss you are willing to incur while trading) and expectations regarding your capital trading.
- Position sizing, plus all your stop-loss and take-profit rules.
- The number of small-cap shares you believe you can trade well at the same time.
- Scheduling your trading research and analysis.
- The review and assessment of your trading plan on a regular basis.
I can’t create a plan for you. It’s unique for each individual. But hopefully I’ve pointed you in the right direction.
Trading small-caps is a little like life: If you fail to plan, you plan to fail.
A trading plan will help you to maximise your gains when your trading system is right. It’ll also help you minimise your losses when your system is wrong.
Question #4: Are you comfortable with your trading time frame?
The time frame is the period of time you think you’ll need to study and analyse the share, reach your conclusions, and evaluate whether or not it’s worth a punt. It’s also a way of being realistic about your expectations over time.
Depending on several factors — like your educational and professional background, your appetite for risk, your personal temperament, your goals and targets – you’ll have a natural time frame that suits you best.
Your small-cap trading strategy has to be designed for your particular time frame.
Your first duty, then, is to identify exactly what your personal time frame is. Are you keen to try to identify long-term small-cap opportunities…promising tiny companies that have a five-year plan for bringing an innovative product or service to market? Or do you want to trade in a shorter time frame, banking profits and moving onto the next opportunity?
Do you want to deeply study the fundamentals of the small caps you want to trade before you invest? Or are you willing to take a more carefree punt in the hope of getting in quickly on the ground floor?
These are some of the questions you have to ask before constructing a small-cap trading system. For example, if your goal is to double your capital in three years and you expect to spend time researching and studying once a week, you may feel comfortable with a long trading time frame.
You might then open positions based on a weekly or monthly time frame. If your goal is, say, a 10% return per month, with a daily monitoring of your portfolio, you may want to be more proactive with an important trade activity and might need a shorter time frame.
Some final tips for trading small caps
Trading any stock takes a bit of thought and effort, even if they look like the best small cap on the ASX. Small caps are even trickier.
Before you start buying small caps — stocks that trade outside the S&P/ASX 200 [ASX:XJO] index — you need to discover how to acquire these shares at the price you want to pay for them.
Buying a stock on the ASX 200 is pretty simple. Most of the time, you can put in a market order that will be immediately filled right at the price you want. But less liquid, more thinly traded stocks outside the top 200 Australian companies is a tougher proposition.
This is where you can make big money…triple-digit percentage gains in under a year, if you pick wisely. But it’s also a riskier investment, and one that’s harder to physically make at the price you want. Here are some final tips before you begin your small-cap adventure.
- Place ‘limit orders’: Here’s the number one rule: When you find a small cap you want to buy, make sure you place what’s called a ‘limit order’. When I find a penny stock that fits my buying criteria, I first look to see how it trades. If I feel the stock has enough regular trading volume, I know I should have no problem picking up shares on the open market at a favourable price. But if the stock is thinly traded, I never try to buy shares without using a limit order.
- Always check the bid and the ask price. You’ll find that most online brokerages come with loads of useful tools. Perhaps the best is the ‘real-time quote window’. It gives you an almost immediate ‘bid and ask price’. This will give you a clear picture of how much you should pay for a stock before you buy. Remember, the current price of the stock is not necessarily the price you will need to pay to pick up shares. This number is simply the price at which the last transaction occurred.
- BE PATIENT! Weeks can seem like months when you’re invested in a small cap. You can be tempted to act on every little price move or every piece of news. If you like the story — and you’ve done the research — have a little faith. If there’s an unusual amount of buying in the early morning, it often calms down after the first half hour of trading. This ‘rule’ isn’t carved in stone, but it is a helpful tip that could help you save a little money on your next trade.
- If you’re REALLY into a stock for its long term potential, build a position over the long term. You’re not looking to trade…but you think a small cap has the potential, over time, to become an ASX 200 stock. So there’s no rush. Build your positions over days or weeks, instead of putting in a huge order. You’ll have a better chance of getting smaller orders filled right away.
Follow these tips every time you buy small caps, and you’ll have the opportunity to make more money.
Again — this is risky stuff. You should go into this with your eyes wide open, and even seek independent financial advice if you need it.
I’ll finish with another insightful quote from Warren Buffett:
‘The best decade was the 1950s; I was earning 50%-plus returns with small amounts of capital. I know more about business and investing today, but my returns have continued to decline since the ’50s. Money gets to be an anchor on performance. At Berkshire’s size, there would be no more than 200 common stocks in the world that we could invest in if we were running a mutual fund or some other kind of investment business.’
Buffett’s success means he’s stuck in a box. He has so much money that he can’t even think about touching 90% of stocks trading on the market. This is despite the fact he knows he could generate 50% returns from them!
YOU aren’t weighed down by the ‘money anchor’. YOU can invest in the stocks Buffett only dreams about.