Streetwise: Small cap firms are the race cars of Wall Street
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Virtually anyone can invest successfully. There are dozens of well-known, high quality blue-chip companies that have long histories of earnings and dividend growth with which you can build a solid portfolio that will enjoy steady investment gains over time.
The difficulty for most investors is that while solid blue chip companies should be the bedrock of every portfolio, they do not have the rapid growth and return rate that you find in small cap companies. By way of definition, a small cap company is one whose market capitalization is under a billion dollars, with market capitalization being defined as share price multiplied by the number of shares outstanding.
Small cap companies are the race cars of Wall Street. They can shift gears and change direction with minimal effort as they find holes in their industry that others have not seen or cannot fit into. Nonetheless, any small cap investment strategy is not without risk and the punishment for inadequate research can be quite severe. Therefore, you want to look for companies that excel at keeping costs low and have a solid strategic plan designed around a patented core technology, or a highly visible brand.
Being a small cap company in today's world is similar to being a small fish surrounded by sharks. To be successful a small cap company must be able to elucidate the value received with a 30-second explanation of the what, the why and the wherefore.
While you need to scrutinize the financials of any company you invest in, this is especially true of small caps. Look for unexplained changes in financial accounting measures, such as margins. An increase in margins usually will signal an increase in share price. Any accounting change begs for more in-depth analysis. If you cannot do it yourself, get some assistance.
In analyzing small cap companies, you need to go beyond the financials and investigate such areas as a company's relationship with its suppliers and customers. Suppliers and customers that readily advertise their relationship with a company are an indication of product moving smoothly through the pipeline from production to sales.
Be aware of any acrimonious behavior in the executive suite. Squabbling among management is more prevalent in small caps, as founders are often forced to relinquish control in order to raise capital and quiet dissident shareholders.
An excellent example of a small cap company on its way to becoming a profitable large cap company is Actuate Corp. [Ticker ACTU]. Actuate manufacturers computer software that enables organizations to easily access the data necessary to maximize their revenue and profits by streamlining the decision process. The company has more than 4,000 customers worldwide in a wide spectrum of industries.
Actuate is a true small cap with a market capitalization that is roughly $447 million. During the first half of the year, the company earned 13 cents per share, and I am projecting that it will earn 8 cents this quarter and 10 cents in the fourth quarter, for a total of 31 cents per share in 2007 and 38 cents per share in 2008.
The company is expected to announce its third-quarter earnings on Oct. 29. A result equal to or exceeding 8 cents should have a positive impact on the stock price, which is currently at a 52-week high of $7.38 per share. Anything less than 8 cents will likely have a negative impact.
An intrinsic analysis should be an integral part of any analysis, and Actuate is no exception. Using a discounted earnings approach, with an earnings growth rate of 20 percent and a discount rate of 15 percent, the intrinsic value is $11.49 per share. The more conservative free cash flow to the firm approach yields an intrinsic value of $9.68. My 12 month price target for the shares is $9.75, for a potential annual gain of 32 percent.
First Published October 14, 2007 12:00 am