A step-by-step guide to successful stock picking.

Jeremy

Updated: Jul 10, 2021 at 1:54PM

Theres no more important question facing investors than how to find great stocks. Just one stock can make a difference of tens of thousands or even hundreds of thousands of dollars, but finding tomorrows big winners isnt easy.

If youre looking for potentially life-changing returns, investing in small-cap stocks is a good start. These are smaller companies than the blue-chip stocks that make up the Dow Jones Industrial Average and much of the S&P 500, but they tend to offer the most growth potential. That makes small caps among the most exciting segments in the stock market today, and, while they are definitely volatile, you wont find any other slice of the market that matches their potential upside.

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Image source: Getty Images.

Step 1: Identify a small cap

The first thing you need to do when looking for great small caps is to start with small companies. For our purposes, that means any company with a market capitalization (market cap) between $300 million and $2 billion.

According to the stock screener Finviz.com, there are 1,684 companies trading on the major U.S. exchanges valued between $300 million and $2 billion. Thats too many to work with, which means we need additional criteria.

Step 2: Identify a strong business

There are any number of ways to identify a strong business, but what makes small-cap stocks appealing for most investors is their growth potential. Therefore, investors should focus their search efforts around finding companies that could deliver explosive growth, or the possibility of being the next Amazon or Netflix. Below are a number of metrics to look at to determine if a small-cap stock can be a big winner.

  • Revenue growth: Of all the ways of measuring a business, revenue growth is probably the most important for finding big potential winners. Generally investors should look for a company with at least 20% revenue growth, which often demonstrates disruptive potential, and the ability to sustain that growth. If a companys revenue growth is decelerating, thats a sign that either its business is rapidly maturing or the industry was based on a fad. You can find some recent examples of the latter phenomenon, like Groupon and Blue Apron.
  • Past price appreciation: Investors generally respond to strong businesses by sending the stock price up; past stock price appreciation is a good sign of a company that has what it takes to outperform over the long term. Alternatively, stocks that have languished for several years or mirrored the market are less likely to deliver monster growth. While underlying performance in the business is ultimately more important than the movement in the stock price, past price appreciation is an easy quality to look for and recognize.
  • Total addressable market (TAM): Its also important to consider how big a company can become. Often, companies cite their total addressable market, which could be in the tens of billions, the hundreds of billions, or even the trillions, to show how big their growth opportunity is. Some categories, like e-commerce, tend to have huge TAMs, as these companies are disrupting physical retail, a multitrillon-dollar industry. Other businesses, meanwhile, are more focused and wont have as much room to grow. A large TAM alone isnt evidence of a strong business, but in combination with other metrics like revenue growth, it can point to a potential juggernaut.
  • Profit potential: Many small-cap stocks arent profitable. Often these are young companies still growing rapidly and investing in the future. However, even if a given stock isnt in the black, its important to consider its ability to turn a profit. This could come from its business model, competitive advantages, or a valuable asset. Similarly, youll want to look at the companys margins to see if they are moving toward profitability. If the company isnt profitable according to generally accepted accounting principles (GAAP), its also worth looking at metrics like non-GAAP earnings, EBITDA, and free cash flow. If a stock is profitable, earnings per share (EPS) growth is the best metric to follow.

Step 3: Identify a good value

Again, there are many ways to measure the valuation of a small-cap stock, but the two most common are the price-to-earnings (P/E) ratio and the price-to-sales (P/S) ratio.

For solidly profitable stocks, the P/E ratio is generally the most important one. Its helpful to look at it in the context of the companys overall growth, as high-growth companies tend to have higher P/E ratios. Youll also want to use the P/E ratio to compare companies within the same industry with each other, as the metric can vary widely in the overall market, from single-digit P/Es for stocks like mature automakers to triple-digit ratios for high-growth tech stocks. Keep in the mind that the P/E of the S&P 500 has hovered around 25 in recent years, representing what most investors are paying for a mature stock. The P/E of the most closely tracked small-cap index, the Russell 2000, is often much higher because so many of the companies in it are losing money.

For stocks that are unprofitable, the P/S ratio offers a better guideline. The metric works similarly to the P/E but uses sales in place of earnings, as revenue is generally the best measurement of the size of unprofitable companies. Price-to-sales ratios have a broad range among companies, and like P/Es should be used in the context of growth and industry peers. Some software-as-a-service (SaaS) stocks have seen their P/S ratios jump to more than 50, implying tremendous future growth from these stocks. In other sectors, a P/S of 10 or higher would generally be considered expensive.

Additionally, with small-cap stocks, its worth considering analyst coverage. Some of these stocks may have only a handful of Wall Street analysts following them, leading to minimal media coverage. These stocks are more likely than others to be undervalued for the simple reason that not as many investors are aware of them or the opportunity they may represent.

Its important to remember that a low P/E or P/S ratio alone isnt a good reason to buy a stock. You must first consider the quality of the business before looking at the valuation. 

Step 4: Identify a shareholder-friendly firm

This can be a difficult quality to screen for, but two proxies you can use are insider ownership and whether or not a company pays a dividend. If a small-cap stock is significantly owned by its managers and pays a dividend to shareholders, the companys interests are likely aligned with those of outside investors. Keep in mind that its rare for a growth stock to pay a dividend, however.

In addition to shareholder-friendly policies, youll want to consider the leadership more generally. To assess company management, its a good idea to look at employee reviews on Glassdoor, how long management has been in their current roles, if the company is led by its founder, and how the company communicates with investors on earnings calls and quarterly releases. Ultimately, leadership is the most important qualitative aspect of a business, as leaders are the ones tasked with executing, meeting, and hopefully exceeding company goals.

Put it all together 

Its not easy to find the next 100-bagger, of course, but youre looking in the right place if youre considering small-cap stocks. By investing in small caps, individual investors can give themselves an advantage over institutional investors, who tend to avoid stocks of this size, as they arent big enough for them to make significant investments that would move the needle on their portfolios. 

The tools above should give you a good start in your search, and using a screener is always a good idea, as most of these companies wont be household names. Narrowing your search to a few small-cap stocks that have the greatest potential of generating high returns will increase your chances of owning the next Amazon or Netflix.

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Jeremy Bowman owns shares of Amazon and Netflix. The Motley Fool owns shares of and recommends Amazon and Netflix and recommends the following options: short January 2022 $1940 calls on Amazon and long January 2022 $1920 calls on Amazon. The Motley Fool has a disclosure policy.

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