Stock Investing For Dummies, 5th Edition - Paul Mladjenovic (2016)

Part III. Picking Winners

Chapter 14. Small Cap Stocks, IPOs, and Motif Investing

IN THIS CHAPTER

Surveying small caps

Considering IPOs

Discovering motif investing

If you’re an investor (or a speculator) who wants to use a relatively small amount of money to buy stock in a single company or a set of companies (much like a mutual fund but requiring less money), this chapter is for you! Many investors dream of buying a cheap stock (referred to as micro caps and small caps) and watching it become a real investment powerhouse. It can be done, but you need to do it right; the first part of this chapter addresses this topic.

Another consideration is investing in a company’s IPO (initial public offering). The right IPO can make you a fortune, but too many people lose money because they miss some crucial points (which, of course, I cover here).

One way to potentially turn a small grubstake (like a few hundred dollars) into big money is through a relatively new innovation called motif investing. Motif investing gives you the ability to invest as little as $250 into a batch of stocks and/or exchange-traded funds (ETFs) that have a particular theme or a specific outlook that you expect to occur. You can get the scoop in this chapter.

Exploring Small Caps

Everyone wants to get in early on a hot new stock. Why not? You buy Shlobotky, Inc., at $1 per share and hope it zooms to $98 before lunchtime. Who doesn’t want to buy a cheapy-deepy stock today that could become the next Apple or Walmart? This possibility is why investors are attracted to small cap stocks.

Small cap (or small capitalization) is a reference to the company’s market size, as I explain in Chapter 1Small cap stocks are stocks that have a market value under $1 billion (some consider the cutoff to be $2 billion). And small cap stocks that are under $250 million are referred to as micro caps. (Note: Some consider micro caps to be under $100 million, and the stocks of these relatively small companies are often referred to as penny stocks. For the most part, I simply refer to them as small caps.) Investors may face more risk with small caps, but they also have the chance for greater gains.

Out of all the types of stocks, small cap stocks continue to exhibit the greatest amount of growth. In the same way that a tree planted last year has more opportunity for growth than a mature 100-year-old redwood, small caps have greater growth potential than established large cap stocks. Of course, a small cap doesn’t exhibit spectacular growth just because it’s small. It grows when it does the right things, such as increasing sales and earnings by producing goods and services that customers want.

warning For every small company that becomes a Fortune 500 firm, hundreds of companies don’t grow at all or go out of business. When you try to guess the next great stock before any evidence of growth, you’re not investing — you’re speculating. Even worse than speculating is buying the stock of a company that’s losing money (net loss instead of net profit), and then hoping or expecting that it will go up.

Don’t get me wrong — there’s nothing wrong with speculating in small cap stocks (of companies that aren’t proven in sales and profits). But it’s important to know that you’re speculating when you’re doing it. If you’re going to speculate in small stocks hoping for the next Microsoft or Apple, use the guidelines I present in the following sections to increase your chances of success.

Checking that a small cap stock is making money

remember I emphasize two points when investing in stocks:

·        Make sure that a company is established. Being in business for at least three years is a good minimum.

·        Make sure that a company is profitable. It should show net profits of 10 percent or more over two years or longer.

These points are especially important for investors in small stocks. Plenty of start-up ventures lose money but hope to make a fortune down the road. A good example is a company in the biotechnology industry. Biotech is an exciting area, but it’s esoteric, and at this early stage, companies are finding it difficult to use the technology in profitable ways. You may say, “But shouldn’t I jump in now in anticipation of future profits?” You may get lucky, but understand that when you invest in unproven, small cap stocks, you’re speculating.

Analyzing small cap stocks before you invest

The only difference between a small cap stock and a large cap stock is a few zeros in their numbers and the fact that you need to do more research with small caps. By sheer dint of size, small caps are riskier than large caps, so you offset the risk by accruing more information on yourself and the stock in question. Plenty of information is available on large cap stocks because they’re widely followed. Small cap stocks don’t get as much press, and fewer analysts issue reports on them. Here are a few points to keep in mind:

·        warning Understand your investment style. Small cap stocks may have more potential rewards, but they also carry more risk. No investor should devote a large portion of his capital to small cap stocks. If you’re considering retirement money, you’re better off investing in large cap stocks, ETFs (see Chapter 5), investment-grade bonds, bank accounts, and/or mutual funds. Retirement money should be in investments that are either very safe or have proven track records of steady growth over an extended period of time (five years or longer).

·        Check with the Securities and Exchange Commission (SEC). Get the financial reports that the company must file with the SEC (such as its 10Ks and 10Qs — see Chapter 12 for more details). These reports offer more complete information on the company’s activities and finances. Go to the SEC website at www.sec.gov and check its massive database of company filings at EDGAR (Electronic Data Gathering, Analysis, and Retrieval system). You can also check to see whether any complaints have been filed against the company.

·        Check other sources. See whether brokers and independent research services, such as Value Line, follow the stock. If two or more different sources like the stock, it’s worth further investigation. Check the resources in Appendix A for additional sources of information before you invest.

Picking out principles for small cap success

Micro caps and small cap stocks are perfect for speculators. Whether you’re doing short-term speculating (such as trading) or long-term speculating (hoping your choice eventually becomes a major investment later), you’re gambling. You may not be putting a fortune on the line, but it is your hard-earned money. Here are some small cap guidelines to keep you sane — and hopefully profitable:

·        Know your goals. You should know as much about yourself as you know about the company and its small cap stock potential. What is your approach? What do you aim to do with small cap stocks?

·        Short-term speculation: There’s nothing wrong with seeking quick gains if you don’t mind the potential risks. With speculating, a company’s fundamentals aren’t that great of a concern because you don’t plan on holding the stock for very long. As a speculator, you would use technical analysis to evaluate the stock (see Chapter 10).

·        Long-term investing: Here you approach the stock as a value investor, much as you would with larger cap stocks. Think growing sales and increasing earnings (net profits). Use fundamental analysis, which I cover in Chapter 8.

·        Designate risk capital. You allocate your funds for a variety of purposes — emergency funds in the bank, investment funds in your IRA and/or 401(k) plan, and so on. For small cap stocks, allocate a sum of money that you’re comfortable losing in a worst-case scenario; this sum is called risk capital.

This sum has to be high enough for you to diversify your small cap holdings but small enough that losing the money won’t alter your life or general prosperity. Unless you’re more experienced with small cap stocks, consider limiting your exposure to less than 10 percent (or less than 5 percent for novice investors).

·        Become proficient in an industry. When an industry does well, many of the stocks in that industry tend to do well, and the small cap stocks tend to do very well. The more you know about an industry and the major factors that influence it, the better you’ll be as a stock picker. Check out Chapter 13 for an introduction to sectors and industries.

·        Diversify. Yes, if you have 100,000 shares of one small cap stock, you’ll have a fortune if you’re right. But the odds are definitely against you. Losing all or most of your money is too strong of a possibility to ignore. You’re better off having, say, 20,000 shares in each of five companies.

In the world of small cap stocks, you could have a situation where you end up with four losers and one winner and still come out ahead in total market value.

·        Buy some, sell some. If you bought 1,000 shares of a stock and it’s up a few hundred percent, take some money off the table and cash out enough to get (at the very least) your original investment back. Then hold the remaining stock for the long term if you’re an investor. If the worst case occurs and the company goes bankrupt, then at least you got back your original grubstake.

·        Get to know the company through a phone call (or visit). Usually, company executives like to discuss the business with investors and other interested parties, and a call or visit gives you the opportunity to pick up some valuable information. Ask about the company’s short-term and long-term objectives. If possible, get on the company’s distribution list for email updates and press releases.

·        Check for news and insider disclosure. Many financial websites give you the ability to receive alerts when major events happen with your stock. Many financial websites also let you see what the insiders are doing. Take advantage of that (see Chapter 20 for more details).

·        Use limit orders. Use what brokerage orders are available to minimize risk and potential losses and to maximize gains. Use limit orders rather than market orders with small cap stocks so you can control what prices you pay or receive when you enter or exit positions. Find out more about these types of orders in Chapter 17.

·        Choose a batch of potential winners. When you’re investing in micro caps and/or small caps, get five to ten in your chosen industry or sector. This strategy enhances your chance of a total winning portfolio. When you choose a hot industry or sector, then your chance of getting one or more winning stocks is greatly enhanced.

Reading up on what history’s great investors have done is always a good idea, and one of my favorites is John Templeton. He started his legendary multimillion-dollar fortunes investing in micro cap stocks during the Great Depression. Templeton made sure that the companies he invested in had true value (profitability, valuable assets, and so on), where the stock price was significantly below the company’s value. To find out more about John Templeton and his successful stocking investing career, head over to www.sirjohntempleton.org.

tip Consider reading up on small caps and micro caps. A good book on the topic is Penny Stocks For Dummies by Peter Leeds (published by Wiley). The term “penny stocks” is frequently synonymous with micro cap stocks.

Finding small cap gems

Consider starting your search for good small cap stocks by checking out top organizations that already have those stocks in their portfolios. If experts chose small cap stocks for an ETF portfolio or for a mutual fund that specializes in small cap stocks, those stocks probably offer a good starting point for your research. These experts did the heavy lifting of choosing small caps for their portfolios, so you can learn from them and use this approach as a shortcut in finding quality small cap stocks.

tip To look for micro caps and small caps, go to sites such as the following (along with other sources in Appendix A):

·        Nasdaq (www.nasdaq.com): This is a premier site for stocks, but it’s also the hub of activity for small cap stocks. You can find stock reports and SEC filings for virtually any small cap (or larger) company.

·        OTC Markets (www.otcmarkets.com): Find small cap stock listings and prices as well as the most active small cap stocks.

·        Stockwatch (www.stockwatch.com): This very active site is packed with news and views of stocks in general but emphasizes small cap stocks.

·        SmallCap Network (www.smallcapnetwork.com): This extensive site has research and reports on small cap stocks.

·        Small Cap Directory (www.smallcapdirectory.com): This site is a search engine for doing research on small cap stocks.

Also, consider alternatives to directly owning small cap stocks. Buying ETFs that have a diversified portfolio of small cap stocks can be a safer and more convenient way of adding small cap stocks to your portfolio. To find great ETFs on small cap stocks, do a search at www.etfdb.com.

Investigating IPOs

Initial public offerings (IPOs) are the birthplaces of public stocks, or the proverbial ground floor. The IPO is the first offering to the public of a company’s stock. The IPO is also referred to as “going public.” Because a company going public is frequently an unproven enterprise, investing in an IPO can be risky. Here are the two types of IPOs:

·        Start-up IPO: This is a company that didn’t exist before the IPO. In other words, the entrepreneurs get together and create a business plan. To get the financing they need for the company, they decide to go public immediately by approaching an investment banker. If the investment banker thinks that it’s a good concept, the banker will seek funding (selling the stock to investors) via the IPO.

·        A private company that decides to go public: In many cases, the IPO is done for a company that already exists and is seeking expansion capital. The company may have been around for a long time as a smaller private concern but now decides to seek funding through an IPO to grow even larger (or to fund a new product, promotional expenses, and so on).

Which of the two IPOs do you think is less risky? That’s right — the private company going public. Why? Because it’s already a proven business, which is a safer bet than a brand-new start-up. Some great examples of successful IPOs in recent years are United Parcel Service and Google (they were established companies before they went public).

Great stocks started as small companies going public. You may be able to recount the stories of Federal Express, Dell, United Parcel Service, Home Depot, and hundreds of other great successes. But do you remember an IPO by the company Lipschitz & Farquar? No? I didn’t think so. It’s among the majority of IPOs that don’t succeed.

warning IPOs have a dubious track record of success in their first year. Studies periodically done by the brokerage industry have revealed that IPOs actually decline in price 60 percent of the time (more often than not) during the first 12 months. In other words, an IPO has a better-than-even chance of dropping in price.

remember For investors, the lesson is clear: Wait until a track record appears before you invest in a company. If you don’t, you’re simply rolling the dice (in other words, you’re speculating, not investing!). Don’t worry about missing that great opportunity; if it’s a bona fide opportunity, you’ll still do well after the IPO.

Getting the Scoop on Motif Investing

For many investors, choosing a small cap stock or considering an IPO may be a daunting task. Fortunately, there are innovative ways to invest in stocks today that weren’t around when I first started investing.

There are ETFs as well as mutual funds in small cap stocks. There are also investment vehicles called “motifs” that specialize in small cap stocks and in IPOs. A motif is a relatively new way to invest and offers an interesting twist on mutual funds and ETFs.

remember A motif is a basket of stocks and/or ETFs that mirror a specific idea, trend, or theme. Some motifs are designed to be very targeted and can fit any person’s outlook or expectation. The motif may be as few as 1 or 2 stocks and/or ETFs or as many as 30. It may be a predefined motif designed by the brokerage firm (also called professional motifs; as of January 2016, about 150–160 different motifs are available). You can create your own motif or modify an existing one (these are called community motifs because they are user-defined by customers). Find out the basics of motif investing in the following sections.

Discovering what you get with motifs

When you look at the interesting variety of motifs, it will make you go “ooh!” Here’s a sample of available motifs (as of this writing):

·        Caffeine Fix: This basket of stocks is for those who want to profit from the public’s enjoyment of coffee and related caffeine products.

·        Rising Food Prices: If you expect (or see) rising food prices, this motif is designed to profit from that scenario.

·        High Spirits: Profit from owning stocks of companies that sell adult beverages.

·        Drug Patent Cliffs: Own stocks that benefit when drug patents expire.

·        Democratic Donors: Invest in those companies that are political contributors to President Barack Obama and that may benefit from his administration’s economic policies (there’s a Republican Donors motif too).

It seems like you’re limited only by your imagination and the types of securities available. These are the securities that can be in a motif:

·        Stocks (both large and small cap)

·        Exchange-traded funds (ETFs)

·        American depository receipts (ADRs), which are essentially foreign securities that trade on U.S. exchanges

LOOKING AT MOTIFS’ PERFORMANCE

When you look at the range of available motifs, the performance (how well did the basket of stocks and ETFs do for the year?) is as varied as the selection. Here are the top three performing motifs for 2015 (as of this writing):

·        Online Gaming World: Benefit as the world of online gaming keeps growing. Up 49.1 percent for the year.

·        Couch Commerce: Benefit from the world of online retailers. Up 34.1 percent.

·        Rest in Peace: With the aging of America comes the, uh, inevitable. This motif holds stock in the “death care industry.” Up 23.6 percent.

Of course, there were losing motifs in 2015 too:

·        Dr. Copper: This motif invests in base metals (such as copper), which tend to coincide with economic growth. Down a whopping 40.3 percent (not a good sign for the global economy).

·        For-Profit Colleges: Invests in online, for-profit colleges. Down 41.6 percent.

·        Shale Gas: Invests in energy companies tied to natural gas and the fracking boom (which went bust in 2015). Down 47.6 percent.

Keep in mind that the preceding lists (both good and bad performances) were for a single year. Don’t assume that they will experience the same in 2016 and beyond as the economy and financial markets keep ebbing and flowing.

Focusing on motif features

A motif is more than a theme-based approach to investing; it’s also a broker. You open an account with the company (at www.motifinvesting.com) just as you would with any traditional broker. Here are the main features:

·        You can open an account with as little as $300 (cash account). For a margin account, the minimum is $2,000. (See Chapter 17 for details on using margin.)

·        The cash account can be a regular account or an Individual Retirement Account (IRA) — either a traditional or a Roth. Margin trading is available only as a regular account.

·        You can choose a preexisting motif (and modify it if you like) or you can build your own on the company’s website. You can even suggest a theme for a motif and the company can create one for its catalog.

·        The transaction cost (as of this writing) is a $9.95 commission to buy the motif (for the entire basket of securities).

·        You have to view a detailed profile (and the securities) of the motif at the site (the catalog) before you buy it.

Considering motif categories

All these varied motifs do fall into definable categories, so start your search there:

·        General: This is the catch-all for new and trendy motifs and those that may not be neatly categorized.

·        Values-based: If you want your investing approach to embrace a particular social cause or political theme, check out this category.

·        Sectors: Whether you like healthcare, technology, or financial services, you’ll find a suitable motif here. (Find out more about sectors in Chapter 13).

·        Global opportunities: Want to invest in developed markets or emerging markets? Check them out here.

·        Asset allocation: Here you find motifs that try to emulate portfolios for a particular target date (such as for those retiring in a specific year, like 2030 or 2035).

·        Income strategies: If you want income from dividends or from bond interest (through an ETF), this category is for you.

·        Trading strategies: Want to trade with technical analysis or based on short-term events? Check out the motifs in this category.

Understanding the risks

Motifs sound pretty good, but what are the risks? A motif, much like an ETF or a traditional mutual fund, is only as good as the securities in the portfolio. All the risks of buying and holding stocks, ETFs, and ADRs are present in the motif, just as they would be in any other investment.

warning The risk with a motif is really tied to your viewpoint. If you believe that a certain scenario will play out, such as a bear market, inflation, or some other economic or social scenario, and it doesn’t materialize, then your motif’s performance will suffer.

For more details on motif investing, check out www.motifinvesting.com.