How to Invest in Small Cap Stocks – Passive or Aggressive

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Small-cap investing can offer excellent long-term investing possibilities. The easiest way to invest in small-cap stocks is through what is referred to as a “passive” strategy, and invest through an index fund or an exchange-traded fund (ETF), which is basically just a basket of small cap stocks. This strategy gives investors an opportunity to be active in the small cap market without having to do individual research to choose small stocks. Examples of a small cap index include the Russell 2000 ETF (IWM), SPDR S&P 600 Small Cap ETF (SLY), Vanguard Russell 2000 ETF (VTWO) and Vanguard Small Cap Index Fund (VB).

A passive strategy example could be to invest in a group of small, early stage firms in a fast growing industry, then eventually selling the laggards and adding to the winner, or winners.

Another method in choosing which small cap stocks to invest in is called an “aggressive” strategy, where you research and select your own small cap stocks. You can try to find companies that have a niche and that can dominate its field. Also, try to focus on deep value, a method used by Warren Buffett, which could eventually lead neglected stocks being realized by the market.

A famous quote by Peter Lynch says, “The average person is exposed to interesting local companies and products years before professionals.” An aggressive way of choosing which small cap companies to invest in is to find companies that have a niche, and that can dominate its market.

A good question to ask yourself when considering whether to invest in a small cap company, according to Peter Lynch, is “Can the company be replicated?”. A good example of replication is Starbucks, can its concept be replicated across the country, and is the company profitable?

But how do you find companies off the radar from wall street? You might be asking yourself, “haven’t all these good companies already been found?”. Believe it or not, most fund managers are not aware of the 5,000+ stocks in the U.S., and over 50,000 globally, because there are just too many companies to follow in great detail. If institutional ownership is less than 50%, then the stock is not widely followed by institutional mutual funds, hedge funds or pension funds.

But institutions tend to move in herds, so when one institution finds and invests in a good undiscovered small cap company, others follow which can quickly turn a small cap stock into a successful mid cap stock.

Many small and risky investments end up losing money, and many small cap companies end up going out of business. But those that turn out to be winners can sometimes return multiples on the initial investment. In baseball, a good hitter is one that can get a base hit in just 1 out of 3 plate at-bats. It’s the same way with trading or investing in small-cap stocks, you don’t need to bat a thousand to generate a winning long-term return. Nor do you always need to hit a home run. Putting a successful string of singles and doubles together can help to ensure your success as a small cap trader or investor.

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“Where to Invest in Small Cap Stocks” reprinted from Penny Picks Stock Forum

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