So a reality check is in order. Small-cap stocks can be risky. Smaller companies that bring a great idea to the marketplace
can find that it's not enough—bigger fish can wade in, take the idea, and beat a smaller competitor into bankruptcy. Economic
factors like interest rates, consumer demand, and employment trends are more easily absorbed by larger, more stable companies
like Genentech, Amgen, and Johnson & Johnson. Not so small-cap companies: such factors can turn a smaller company's bottom
line from black ink to red fairly easily (like Depomed). And small-cap companies are harder to evaluate. They have shorter
track records, little historical data, and usually a shortage of good, hard information.
But small caps do offer a wealth of opportunity for investors. Think about Fortune 500 mainstays like Proctor & Gamble, Microsoft,
Amazon.com, or Google. All began as small companies. Traders on Wall Street say that they're not sure where the next Microsoft
is coming from, but it will most certainly start out as a small company. Growth is another factor—it's much easier to double
or triple the sales of a company that does $10 million in sales annually, than a company that does $5 billion in sales.
I particularly favor small-cap growth companies, which flourish in the risk and reward nature of the biopharmaceutical industry.
As recent history attests, small-cap growth stocks have packed plenty of portfolio punch in recent years. On an annualized
basis, the S&P Small-Cap 600/BARRA Growth Index posted 14.7% gains during the past three years, surpassing the performance
of all other small-cap asset classes, as well as mid-cap and large-cap stocks.
Growth stocks are usually defined as companies whose earnings are projected to grow faster than the entire market as a whole.
That's good news at times of economic peak performance; growth stocks historically outpace other asset classes in good economic
climates. Conversely, when the economy recedes, growth stockholders are often left holding the bag, as smaller, riskier growth
stock companies can't absorb the body blows of a tough economy.
But that's the risk you take when you invest in small-cap growth companies, which are traditionally younger and more economically
vulnerable. That's simply because younger, smaller companies with an aggressive mindset can grow significantly faster than
other companies. Investors adopt that mindset because they believe that growth in earnings and revenues will trigger an accompanying
boost in stock price. That's why high-flying, high-risk industries like technology and life sciences are chock full of small-cap
growth firms. Usually in such companies, profits are earned through capital gains instead of dividends. When looking for small-cap
growth stocks, one of the first things you'll learn is that they don't pay investors a dividend.
How do you judge the merits and the value of a growth company? It's not easy, because there is no one simple formula. Wall
Street gurus advise focusing on strong historical earnings growth, based on annual revenues. Another key factor is solid forward
earnings growth. Look for a five-year growth rate of about 10–15%. Check for other competitors in the industry. How does your
potential small-cap growth company stack up? Also make sure that management has its eyes on the ball financially. If management
isn't controlling costs, or doesn't have a lot of cash on hand, it can fall prey to any number of economic and competitive
industry events. Lastly, look to the future and evaluate whether the growth company has a realistic shot at doubling its revenues
over the next five years. Look for a growth rate of 15% annually. If there are no signs of such growth, you don't have a growth
stock on your hands.
Stick with familiar territory and focus on real-world issues like debt loads and cash on hand. Don't attempt to time the market
with small-cap stocks, either. Pick a few companies that pass your due diligence muster and then be patient. Good stock market
stories can often take a long time to develop, and that's been the history of small cap stocks, especially in the life sciences
sector. At first, keep your small-cap exposure to no more than 10% of your portfolio, then gradually increase your small cap
After all, 10 years from now we'll be talking about new life sciences giants that could supplant the Genentechs of the world.
When we do have that discussion, the companies in question will likely come from the small-cap universe.
Celebrity author and business/finance commentator for CNN and Fox News, Brian O'Connell has written for The Wall Street Journal and Newsweek, Doylestown, PA, 215.230-3711, firstname.lastname@example.org