The Blueprint: Investing In Small-Cap Stocks

The HiddenGems Blueprint:Investing inSmall-Cap StocksMOTLEY FOOL CANADA SPECIAL REPORT

The Hidden Gems Blueprint:Investing in Small-Cap StocksThere’s nothing more exciting in the world of investingthan when you push the “Buy” button and open up abrand-new position in a “small cap” stock.Generally, these stocks tend to offer great promise, andit’s hard not to feel rather giddy with anticipation as thatinitial purchase is made.Problem is, though seemingly filled with promise,these stocks can often find a way to disappoint. Whichis perhaps why the emotional angle to investing in thesmall cap arena is the most important of all.But -- I’m getting ahead of myself.The purpose of this report is to set the table for ourMotley Fool Hidden Gems service here in Canada.The first of it’s kind north of the border, this is aservice that will recommend the very best in small capcompanies from both the Canadian and U.S. market inthe years to come. All while doing our best to managewhat can be the rather delicate emotional angle.Ruling them out, we find that 688 public companiesland in our 50 million to 2 billion range. That,Fools, is our Hidden Gems universe in Canada asit stands today. And frankly, that’s not very many,especially given only about 2/3rds or just 470 of themare actually revenue generating businesses.However, we pride ourselves on turning over rocks andindeed, finding those hidden gems that exist.(I think we’ve already proven we can be quitesuccessful if you’ve followed our recommendationsinside of our sister service, Stock Advisor Canada!)Importantly, this is only half of our recipe for success.We’re also providing U.S. recommendations, and wherethe Canadian market is relatively narrow, the U.S.market is filled with small cap companies.In addition, there’s a significant difference in relativecompany size between the two markets, therefore ourdefinition of a U.S. small cap is different. To quicklyFirst things first though. Taking it right back to basics illustrate, the largest company in Canada is the RoyalBank of Canada with a market capitalization of 153The largest company in the U.S. is Apple with aWhat exactly is a “small cap” stock? billion.market cap of 901 billion. Heck, the smallest companyExtending that term we get “small market capitalization” in the S&P 500 is worth more than 3 billion vs. 393stock which generally translates to companies that aremillion for the S&P/TSX Composite.under a certain market capitalization threshold (sharesTo account for this, U.S. small caps will be consideredoutstanding * current stock price).between 100 million and 5 billion.You see, the market is filled with companies of allOut of 5,595 total listings on all major U.S. exchanges,shapes and sizes. Widely held, well known “large cap”2,604 of them fit in this range.companies. Slightly less known “mid cap” companies.Where our Canadian universe is rather narrow, the U.S.And “small cap companies” that round things out.is not which means it may be the side of the ScorecardFor our purposes - and this is largely based on my (Iainthat generates the most excitement over time. After all,here) experience with small caps in the Canadian marketmore companies to choose from should mean the more- the definition that we’re going to apply to the Canadianchance there is for the big winners that we all so crave.Hidden Gems recommendations that we make is thatthey’ll fit within a market capitalization between 50Nitty gritty of the Canadian marketmillion and 2 billion. Generally - and again, based onmy experience - large caps check-in north of 5 billionThe number of listings and sheer company size is notand mid-caps in that 2- 5 billion range with micro caps the only difference between these two markets.and what not falling below the 50 million mark.Even though resource companies have been miredA scan of the two primary exchanges in Canada, theTSX and TSX Venture, indicates there are a combined3,350 listings between them. Increasingly, a lot ofthese listings involve ETFs or other fund-like vehicles.2The Motley Fool in a slump, energy and materials stocks continue todominate the Canadian market and this is especiallytrue at the small end of the range.fool.ca

Combined, these two sectors account for 50% of theS&P/TSX Small Cap Index with Materials at 27%and Energy 23%. The following helps to illustratethis dynamic:For one, those energy and materials stocks that wereflying high into 2011 subsequently caused the overallVenture exchange to lose about 80% of its value.Indeed, many of these companies disappearedaltogether. Between March 2013 and March 2014, 60companies disappeared from the exchange. BetweenMarch 2014 and March 2015 that figure reached 119companies. This carnage caused many a Canadianinvestor to flee.Recently however, this stampede has reversed course.But it’s not because of resource stocks. Thanks tothe ongoing crypto/marijuana mania, the VentureExchange is back. Healthcare (marijuana) andTechnology (crypto) now account for about 20% of theExchange, a far cry from where they were in 2011.Despite what’s occurred in the recent past with regardsto either marijuana or crypto, bigger picture, the glaringhole in the Canadian market, and this is a blanketstatement across all market capitalizations, is that ourInformation Technology and Healthcare sectors arevirtually non-existent,.Source: S&P Global Market IntelligenceWhat I’ll add about this dynamic is that generallyspeaking, resource stocks don’t fit very well with ourbusiness-first investing philosophy.Granted, it’s more difficult in general to adhere tothis business-first philosophy when it comes to smallcaps because often times, a fundamental case won’tnecessarily exist. The thesis will almost entirely bebased on perceived opportunity.Thing is, when it comes to resource stocks, theiroutcomes are almost entirely dictated by the underlyingcommodities. And predicting commodity prices is amugs game, if there ever was. To be sure, we’ll beinvolved with the resource sectors, we’re just hesitantto recommend a company that claims to have somepotential commodity buried in a corner of the Nevadadessert, or some other far flung locale.Even though these are two of the most fertile sectorswhen it comes to finding companies that offer thepotential that we crave.Which is another reason why tapping the U.S. market,which has loads of both, is sure to make this productmore robust (ie. better) than it otherwise would be.Small Cap Investing: Finding Hyper-GrowthWith a lay of the land in mind, let’s consider some of thebenefits of investing in small companies.Something that’s probably best illustrated.Have a look at the following three charts:MTY Food Group: Up Over 18,000%!That said, given recent market developments, thislandscape has begun to shift. Though not necessarily forthe better.If we turn our attention to the TSX Venture Exchangewhere almost every company is considered either asmall- or micro-cap, we see that in 2011, which wasabout the time commodity prices began to tank, energyand materials stocks accounted for more than 90% ofthe Venture’s value. That share has since declined tobelow 60%, for a couple of reasons.fool.ca The Motley Fool3

Constellation Software: Up Over 3,900%!Small Cap Investing: Where toWatch Out We could very easily follow up those three monsterreturns with three complete disasters. Indeed, and asindicated by the Venture Exchange carnage mentionedearlier, finding these monster returns is not without risk.There are ways around this however and frankly, thisisn’t really even much of a consideration as far aswe’re concerned.Computer Modeling Group: Up Over 3,200%!A primary reason being, the downside for anyinvestment is 100%. The upside however is unlimited.A return 3,000% can go a long way when it comes toerasing – and then some - the bad experiences that arevirtually inevitable in this type of investing. High risk,high reward.There is a more significant consideration when it comesto small cap investing, and it’s one that we’ll spendconsiderable time on in the months and years to come.The consideration is time.Often times, and I speak from personal experience, we’llfind a small company that we perceive has potential andmake an investment only to sell that investment afterrealizing a gain that we deem adequate.Source: S&P Global Market IntelligenceThese three charts almost perfectly illustrate small capinvesting gone right.Not only does the potential for these kinds of returnsexist, it’s just plain cool to hunt for companies thatare disrupting their respective industries and literallytrying to change the world. Even if it is but onesmall corner of the world. We love the concept ofunlimited possibility, and this concept nicely framesthe services’ mindset.Not to mention that if you invest wisely, these typesof returns have the real potential to super-power yourportfolio for years to come!In case you need more evidence, consider this Over the past decade, 94% of the TOP GAINERS inthe Canadian market started out as small cap stocks. Infact, out of the stocks with the Top 10 highest returns,all 10 began as small cap companies.4We’re generally happy with this arrangement untilthat company goes on to realize the potential we firstperceived. Thus making the return we booked looklike a pittance.Time is critical regardless of where in the market you’reinvesting, but to truly experience the life altering gainsthat small caps offer, it’s an absolutely critical variableto get right. And almost entirely encapsulates thedelicate emotional angle that goes along with small capinvesting alluded to in the opening.So, Fools, make sure when you invest in small capstocks, that you adhere to our guidance and giveyourself the time to see these potential returns cometo fruition!Foolish bottom lineAs your Hidden Gems advisors, our role is reallytwo-fold.Not only are we here to serve up opportunities that wefeel are well suited to providing outsized (though notrisk-free) returns, we plan to work just as hard on theThe Motley Fool fool.ca

emotional angle to help ensure you’re not leaving thosepotentially life altering gains on the table. All the whilenavigating the dynamics that exist in both the Canadianand U.S. markets.We’re so pleased that you’ve decided to join us and arealong for what’s bound to be a rather thrilling journey.If you haven’t already, please make sure to check outour four Starter Stocks – the four stocks we think aregreat buys, today!Fool on!The Motley Fool Hidden Gems Canada Teamfool.ca The Motley Fool5

MOTLEY FOOL CANADA SPECIAL REPORT. 2 The Motley Fool fool.ca . is not which means it may be the side of the Scorecard