Itâ€™s easy to see why people donâ€™t like small capitalization stocks these days. Small cap stocksâ€”by which I mean companies with stock market values of less than $1 billionâ€”plunged more than 20% in a span of only six weeks this summer.
The hammering was a painful reminder of the risks that go along with small caps. When â€œliquidityâ€ dries upâ€”as it did this summerâ€”smaller stocks wither, no matter what their prospects. Small caps suffer because they tend to be in early stages of development and thus are more vulnerable than larger firms. Many small caps have only one product. Many need to raise money to fund their expansion. Many also lack management depth and depend on the skills of one or two top executives.
So why would anyone invest in small caps? Because these firms offer opportunities that help offset their risks. Small cap stocks have historically outperformed their larger brethren by about two percentage points a year. While itâ€™s unlikely that your favorite small cap firm will turn into the next Research In Motion, you can make good money in small caps by diversifying, focusing on firms with tangible assets or services, and avoiding glamorous â€œconceptâ€ stocks.
Any small cap investor should hold a minimum of 10 stocks in three or four different industries. Even with this level of diversification, itâ€™s not unusual for your portfolio to move up or down each day by 3%. If that level of volatility is likely to cut into your sleep time, delegate your small cap investing to a small cap mutual fund or buy exchange-traded funds (ETFs) that follow small cap indexes in the U.S. and Canada. A couple of good choices are the Canadian iShares SmallCap Index Fund (TSX: XCS) and the Russell 2000 Growth Index Fund (AMEX: IWO).
If you want to invest directly in small cap stocks, do your research. Here are a few ideas to get you started. In the oil and gas sectors, I like Delta Petroleum (NASDAQ: DPTR) for its natural gas holdings in the U.S. and its potential for a big find in the Columbia River basin. Delta should be able to grow its natural gas production â€œthrough the drill bitâ€ by 8% to 10% a year. That could be very lucrative if natural gas prices bounce back the way I expect.
Hanwei Energy (TSX: HE) operates in the Chinese energy market. The company makes fibreglass-reinforced pipelines, coal scrubbers and wind turbines. Itâ€™s growing earnings at 40% per year but trades at only 14 times next yearâ€™s earnings.
Timminco (TSX: TIM) of Toronto recently developed a breakthrough technology to purify metal silicon to levels that allow the silicon to be used by the solar power industry. Timminco has recently signed three large five-year contracts with solar power companies and those contracts should generate about $2 per share in earnings for Timminco by 2009.
In the uranium space, I like Fronteer Development (TSX: FRG). Fronteerâ€™s largest asset is its 48% interest is Aurora Energy (TSX: AXU), which owns the Michelin uranium deposit in Labrador. Fronteer also has gold and copper interests in Turkey and Nevada and is looking for gold in Yukon.
In health care I like CryoCath (TSX: CYT) and BioMS (TSX: MS) of Calgary. Both companies are in the later stages of gaining U.S. approval for their key products. CryoCathâ€™s Arctic Front product for the treatment of atrial fibrillation is already approved and successfully commercialized in Europe; it expects to win U.S. approval in late 2008. Meanwhile, BioMS is completing a lengthy Phase III trial of its promising drug to treat multiple sclerosis. The market has been disappointed with BioMS for not partnering with a major player, but should the drug prove as effective as in smaller studies, the companyâ€™s go-it-alone strategy could produce far higher returns for shareholders.
Another company that carries a lot of potential for large returns is CY Oriental (Canadian Venture: CYO) of Vancouver. Itâ€™s a Chinese garment manufacturer that focuses on higher margin brands such as Armani and Diesel. The company is nearing completion of a major expansion of capacity that should allow it to grow earnings substantially for the next several years.
Finally, in the materials area, I like Skye Resources (TSX: SKR) of Vancouver for its world-class nickel laterite deposits in Guatemala and Aurelian Resources (TSX: ARU), which recently discovered one of the largest gold deposits in the world at its Fruta del Norte property in Ecuador.