The Two Biggest Mistakes That Small-Cap Investors Make…and How You Can Avoid Them

You can think of them as your insider’s guide to big capital gains.

Investing in small-caps is the best way that you make money in the stock market.

But you should know that small-cap stocks bring danger as well as opportunity.

Unseasoned investors fall into traps.

You might find that losing money in the stock market can be educational. Sometimes it’s even character-building. But losing money is rarely fun, and it’s often an expensive education.

I want to give you that education without the price tag.

Today I’ll show you the two biggest mistakes that cost small-cap investors real money. The first mistake comes from backing a loser…and the second mistake comes from missing a winner.

Whether you’re a beginner or a veteran, I trust you’ll find these warnings handy.

Warning #1: Don’t let losers run
This is a simple warning, but it would amaze you how often professional investors ignore it and blow themselves up.

Let your winners run, and cut your losers short. You achieve this by setting and sticking to a trailing stop-loss level.

That’s a stock price where you’ll admit that your idea hasn’t worked and you want to move your capital onto more exciting opportunities.

Depending on your tolerance for risk and loss, you might set a trailing stop loss 30%, 40% or 50% below your buy price.

We do this so that when we take a loss, we take as small a loss as we can.

It ensures that if I make a huge mistake and recommend that you buy a total dog, the stock market won’t wipe you out with a 100% loss.

Once you’ve identified an interesting stock, here are the key points: Establish your buy price, your sell price, and set your trailing stop-loss. This takes emotional anchor points out of the picture.

You’ll determine those points based on what you think the company’s worth and your appetite for risk. Those are personal decisions that only you can make.

This is the best way to lock in speculative gains when you make them, and limit losses when a story doesn’t play out.

Of course, I watch all of our stocks every day…and I don’t let losers run.

Warning #2: Small-caps — not low-priced stocks — hold the keys to riches
Here’s the single biggest threat to your success as a small-cap investor: obsessing about share price instead of position size and percentage gains.

Most investors — maybe even you — have an unhealthy fixation on share price. And that’s a problem.

Media and society have programmed Aussies to obsess over share prices. You see them in your lounge room every night, just before the weather report on the news.

That puts a bias in people’s brains that a value of dollars per share north of $20 or $30 must be good. I’m talking about stocks that hog the press coverage, like BHP Billion Ltd [ASX:BHP] or Commonwealth Bank of Australia [ASX:CBA].

That same bias leads people to think that dollars per share south of $1 must be a bad thing.

Well, that’s bulldust.

Sure, if you own a stock, you want its value to travel as far from zero as possible.

But there’s a big difference between a low price and a small company.

You might not realise this, but a company can determine its share price with a simple vote.

When a company changes its number of shares outstanding (a move called a split or reverse split, depending on whether the number goes up or down), the share price changes too.

For example, a company could double the number of shares it has outstanding, leaving each share worth half its original value. Or the board could decrease the number of outstanding shares by half — and double the price of each share.

That doesn’t change your investment in the company. Whether you have 100 shares of a $1 stock or one share of a $100 stock, your position is worth $100.

The share count is a simple lever for a company’s CFO to pull. What companies can’t control is their total value…their market capitalisation.

That’s the number you should pay attention to if you’re trying to identify a small-cap opportunity.

In other words, if you think of a company as a pie, then each piece of the pie is a share.

A company can vote to cut each share into more pieces, but that doesn’t create more pie — just smaller pieces.

The only way to create value for shareholders is to bake another pie. And it’s much easier to achieve big percentage gains in value from a small base than a big one.

At last count there were 82 large-cap Australian stocks (companies worth more than $1 billion) with share prices under $5. None of them are small companies.

But by only focusing on price, you could fool yourself into thinking they were.

It’s normal to get fixated on a stock’s share price — it’s the first thing you see when you pull up a quote, after all. But price isn’t what matters.

Small companies with explosive growth potential should be your focus, no matter their price.

Some of our hottest tips trade for just cents on the dollar. But we have just as exciting small-cap stocks on our buy list currently trading for well over $5 per share.

It’s these small-caps…not low-priced stocks…that hold the keys to riches.

Tim Dohrmann

Small-Cap Analyst, Australian Small-Cap Investigator


Markets and Money offers an independent and critical perspective on the Australian and global investment markets. Slightly offbeat and far from institutional, Markets and Money delivers you straight-forward, humorous, and useful investment insights from a world wide network of analysts, contrarians, and successful investors.

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