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Why you shouldn't invest in Small-Cap shares

by , 29 January 2016

Yeah, yeah, we all know the story of how Shoprite was a R1 share in 1994 and shot up to R200 in 2012. Or how Capitec was 91c in 2002 and today it is trading at R430.

You might have even heard me speak about how I first invested in Adapt IT at R1.30 and today it is at R13.

But that's not what I want to tell you about today.

I want to tell you why you shouldn't invest in small cap shares…

Forget the next ‘shoot the lights out stock’

Whenever I speak to investors about small cap shares they almost invariably ask me about one or another obscure company they’ve heard about that will shoot the lights out…

Sometimes it’s a hot tip they’ve heard whispers about… Other times it’s merely a hyped up company with good marketing and low quality.

But one thing’s for sure… All these kinds of companies have poor fundamentals. These companies have low quality (or sometimes) no real earnings.

They are bought by investors on speculation with no real investment case.

Think of Wesizwe Platinum.

This platinum company found a stash of platinum underground and started raising cash to build a mine.

Investors were promised the world… And thanks to the incredible growth story of the company investors sent the share price soaring from R2 in September 2006 to R16.50 in April 2007.

And as the share started falling speculators just kept buying more of it…

Today Wesizwe trades at 38c share. And still I get asked whether I think its share price will head back to R20 again.

My answer remains, ‘Show me why’. You see, the company has no ‘fundamentals’ to speak of. It has been (and is still) building a mine for the past ten years. That means no revenue, no profits and hardly any investment case for you and I.

The fact is, if you listen to stories like this without looking at the real investment case of a company you shouldn’t invest in small cap shares. You will wipe out your own bank account and be angry at me.

Do I still have your attention?

I’m sure that all the mindless speculators in small caps won’t reach this point of my article…

So now I’ll share my real secret with you:

Small-cap stocks provide the best returns. Since 1996 the small cap index has returned 929.76% compared to 631.79% from the Top 40 index. That’s a huge difference, 297.97% to be exact!

And investing prudently in small cap shares can be very profitable if you follow the right set of rules…

Small-Cap investing rule #1:Don’t lust after exciting stories

You hear about a stock that has such a sexy story you just have to own it. All of a sudden, things like fundamentals, balance sheets and cash flow statements don’t matter. You are drawn to the possibility of triple-digit gains. And nothing is going to stop you from investing. You need to resist your lust. Remember, the best opportunities in the small cap market aren’t those everyone is talking about already!

Small-Cap investing rule #2: Laziness will make you broke

Whatever you do, don’t buy a stock without doing research of your own… Maybe you hear about a hot tip from a friend. You read an article in the newspaper about a sure-fire idea. At the end of the day you think to yourself, “I am tired. I don’t have any time to do this research on my own. I trust my friend. So why not?” And you buy the share.

Are you crazy!

Would you buy a house without ever seeing it, just having heard a story from someone that it’s a nice house? Would you buy a business just because someone says it is a good business? Of course not! So why not make sure you know in what company you are investing your money? Read a company’s annual report. Look at its balance sheet. Look at some simple ratios. Try to find a research report or two on it, go to the annual general meeting and speak to management. It won’t take you months to do this, and it might make you a fortune, or save you one!

Small-Cap investing rule #3: Remember, dividends are much more powerful than you realise...

In 16 years after investing in it Warren Buffett received SEVEN TIMES his capital in dividends from GEICO.

Imagine that! You're 40 years old today. You put R10,000 into a single share. By the time you're 56 you get R70,000 JUST IN DIVIDENDS from the company per year!

Think that's impossible?

It’s not.

For instance, Datacentrix traded at 260c in 2008. If you invested in the company back then you’ll have returned 73% in capital growth. But your dividends will be at 77% of your buying price.

And this isn’t even the best dividend payer out there. Right now there are shares in the Red Hot Portfolio yielding as high as 10% a year. Simple growth of 16.5%  a year would ensure you receive your capital back in dividends each year in 16 years’ time. It’s a stretch, but it is possible.

The fact is, small cap shares have great potential. But only if you’re willing to do it right. You need to do the research, focus on the fundamentals that drive these businesses and invest accordingly.

If, and only if it sounds like that’s something you’re willing to do, I invite you to check out the research I share using my Red Hot Penny Shares newsletter.

Here’s to unleashing real value

Francois Joubert
Editor, Red Hot Penny Shares 
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The ONLY thing that always makes stocks go shooting up is a big news story. 

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Why you shouldn't invest in Small-Cap shares
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