Keys to small-cap success

Given the volatility of 2011 and the uncertain economic climate, investors are asking one central question: How do you pick the winners and avoid the losers?

Jennifer Law, vice-president of CIBC Asset Management, says that making that choice effectively is the key to success in small caps—a market segment comprised of an ever-changing list of 2,000 to 3,000 names.

In contrast, the Canadian large cap universe has only about 200 names, with membership seldom changing. That allows individuals to more easily track the long-term success of a large cap company.

Achieving success through a winning strategy, in Law’s opinion, is as much about avoiding the losers as it is about picking the winners.

The first step is to take a look at your investment process and give it a good, qualitative analysis—your evaluation and investment process must be supported by in-depth analysis of any company in question, as well as strong industry analysis.

In order to choose a company, investors must determine the market position of all potential businesses and their long-term prospects.

The risks associated with incoming competition and pricing pressures must also be considered and weighted.

Once these analyses are completed, investors have to decide if the company has a differentiated product, as well as the prospect of strong, positive growth over the next two to three years specifically.

The company should also have excellent and stable management, with a good track record of execution.

“Once [investors] have these [questions and processes] underpinning your investment process, [they] can clear out and get rid of the potential losers and riskier investments,” says Law.

For instance, if the company or business is only part of a fad, it will not fit the long-term prospects criteria of two to three years, and if a company is poorly managed, then it won’t pass the qualitative analysis.

Investors must focus on good products and management, and zero in on companies with a competitive advantage that can last for several years.

Given the structure of the industry, a company must have excellent margin and growth assumptions in order to be considered a sound investment.

Investors must determine the worth of a company based on these assumptions, and then compare that value to its current trading value in order to produce an approximation of expected return.

“Using both qualitative and quantitative analysis as part of the investment process leads to more educated investment choices,” says Law, “and can also aid in weeding out companies that are too expensive.”

Investors can also determine more easily which companies to buy immediately, and can categorize the remaining choices as businesses they should either watch or bypass.

When looking for profitable names and investment choices, following established criteria is key, but paying attention to the index can also help. Investors in general want to participate in the market but avoid dramatic risks in index weighting as well.

Unfortunately, the makeup of the index is fairly skewed, with over 50% of the small cap index in resources.

Law says that “for a Canadian small cap manager in particular, resources are a huge part of the overall universe and [they] have to be comfortable investing in that space.”