Tips on Finding the Next Low Cap Gems in Any Market

Richard Montana | January 30, 2022

Tips on Finding the Next Low Cap Gems in Any Market

We all want to find the next low-cap gem. But after a while, it feels like you’re hunting for a needle in a haystack. It’s not a good place to be – the more frustrated you are, the less likely you’ll find equities that offer those mythical 10x returns.

But if you want results like that, you’ve got to stop randomly digging through straw. In short, you need a system. By assembling a rock-solid process, it’ll be easier to quickly narrow the field to the best potential opportunities.

In this article, we’ll share how you can possibly find undervalued small-cap stocks with upside potential. Let’s get started!

Wait – What’s a Low-Cap Stock?

To properly define this term, we first need to understand market capitalization. Simply put, it’s the total value of a company’s outstanding shares.

To calculate this figure, take a firm’s stock price and multiply it by the number of shares outstanding.

So now that you’ve attached a valuation to an equity, is it a low-cap stock? According to market sources, a low-cap stock (AKA a small-cap stock) is an equity with a market capitalization between 300 million and 1 billion USD.

However, this is just a rule of thumb – the SEC does not currently have a definition on its books for low-cap stocks. But we digress.

Look for Low Cap Companies with Strong Fundamentals

You now know how to identify a low-cap stock, so let’s start sorting the wheat from the chaff. At this stage, you’ll be hunting for low-cap public companies with solid fundamentals.

But what does that mean? First, it means highlighting firms with high earnings and sales growth, low levels of debt, and attractive returns on equity (also known as ROE). The first two are self-explanatory, but what’s ROE?

Simply put, ROE is a measure of how efficiently a company is using shareholder equity to generate profits. To calculate it, you divide net income by average shareholders’ equity.

Companies with good numbers in the above three categories are often seen as long-term investments. These figures can show that they have an excellent product/service, are responsible stewards of investor capital, and that they spend that capital in high-yield areas.

Lastly, we realize that reviewing a company’s numbers is essential, but poring over financial reports offers little qualitative insight. To get a more balanced view, you should also do extensive media research. Search for mentions in the mainstream financial media and online sources like Insider Financial.

This way, you’ll understand what pundits, seasoned traders, and the general population think about a prospective company and its management.

Ask Yourself: Does This Stock Offer Good Value?

By now, you should have a shortlist of low-cap companies with potential. Next, we’ll assess their value.

But how?

Begin by comparing them to their peers. And the best way to do this is through ratios like price-to-earnings (P/E), price-to-book (P/B), and price-to-sales (P/S).

The P/E ratio measures the current price of an equity against its earnings per share. For example, if a firm is making loads of money per share, but its price is low (as often happens during market corrections), you should pick up its stock.

Now, let’s look at the P/B ratio. P/B ratios weigh a firm’s market cap to the total value of its assets (or its book value). So if a company you’re checking out has an impressive market cap, but the full value of its inventory, equipment, and intellectual property is underwhelmingly low, some people may think twice before buying.

Lastly, the P/S ratio compares a company’s stock price to its annual sales. Not sure whether a firm is for real or if they’re being hyped? If a firm’s stock price is elevated, but they have meager sales figures, many may choose to stay away (or wait for a possible collapse before getting in).

Confused? In general, the lower the number in all three cases, the better off they coul be.

Holding Indefinitely? One Word: Dividends.

These days, the /r/wallstreetbets crowd has glorified the “get-in, get-out” approach to day trading. But not everyone is on board with this philosophy.

You might be one of them – after all, Warren Buffett made his billions through value investing, which emphasizes buy-and-holding equities for an indefinite period.

But what stocks should you buy and hold?

In a word, dividends. Favored by the FIRE (Financial Independence, Retire Early) crowd, dividends are stocks that offer quarterly payments to their shareholders. These payments are usually made quarterly and are distributed from profits. They can be issued in stock, but most are in cash.

But why should someone invest significantly in this financial instrument? Because it could possibly provide a steady, predictable income – a must for those who want to try and be free from the rat race.

To generate a livable income, though, someone could need two things: (a) significant principal and (b) dividends that offer substantial yields. But just because a dividend stock pays a high yield doesn’t mean it is a good investment. So how do you find one that balances both concerns?

First, you could identify firms with a long track record of paying dividends. For instance, the Bank of Montreal has paid dividends to its shareholders each quarter since 1829.

Next, put their yields up against the S&P 500 yield (which is currently around 2%). If your prospect’s yield beats the market, you may think about keeping it around. After that, apply the same due diligence you would to any other stock. Research their financials, their management, their ratios, and so forth. Everyone is different with different needs.

To Sell High, You Gotta Buy Low

If you want to live the trading dream, some people thnk that you need to stop buying the latest hot stock on CNBC. Instead, they may want to direct attention to low-cap stocks, as the right ones can possible give upside potential.

However, there’s no way around it – you must do your homework first. Make sure you understand what you’re buying, and NEVER invest with rent/grocery money. If you stay disciplined, you too can enjoy the long-term, low-cap returns you’ve been thinking about. Of course, there can never be any guarantees.

About the Author

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Richard Montana
Richard has many years of experience in broker research, testing, analysis and reviews. He knows what to look for through years of trading himself with different brokers and listening to the feedback of others.

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