Small stocks DOs and DON'Ts

The last few years have favoured the big over the nimble and the facts confirm it. The 200 smallest stocks in the S&P/ASX 300 index have underperformed the 100 largest stocks by 46% over the past three years.

It's why Intelligent Investor Share Advisor is now casting its stock-catcher's net a little wider. Rotating a small proportion of your investment capital out of expensive big, companies into smaller, cheaper ones makes sense.

But it also begs an important question: What's the secret to success in small stocks? 'Small' and 'Risky' may not share the same bed but they do hold hands. You certainly don't want to undo your portfolio's strong performance over the past 18 months.

Alas, the risks inherent in small stocks occasionally encourages investors to take leave of their senses. Proud of their prudence when it comes to the banks, Woolworths and BHP Billiton, they mimic deranged bungee-jumpers when contemplating small companies.

So the first rule to investing in small stocks relates to portfolio allocation. Conservative investors might choose not to invest in small stocks at all. The more adventurous might aim for between 5% and 20% of their total portfolio, with a maximum of 10% in speculative stocks.

Individually, speculative stocks should account for no more than a 2% portfolio weighting each. Let's now look at do's and don'ts.

1. DO look for a market niche. The best small companies do one thing well, often focusing on a particular geography or market niche. Trade Me dominates New Zealand, a market too small for eBay to be bothered with. OzForex offers smaller customers a way to transfer money internationally that's easier and cheaper than the big banks.

2. DO look for revenues and (preferably) earnings. Forget exploration and early stage medical companies. Without revenues you can't value a business. Nanosonics made it onto our buy list because it has regulatory approval, revenues are growing fast and it works a defined niche.

3. DO analyse the competition carefully. Small companies rarely operate in cartel-like industries like grocery retailing or banking. Competitive threats like that posed by cloud-based accounting software provider Xero to industry dominant MYOB need to be understood before you invest. Consider all possible threats.

4. DO worry about debt levels. Generally speaking, small companies and debt are like oil and water. They don't mix. Management errors are magnified by debt, so emergency capital raisings – not to mention premature death – are more likely for small companies.

5. DO look for management ownership. One of the best things about small companies is that director ownership of stock is more common. When management owns a decent chunk of the stock they're less likely to do something stupid. ARB Corporation's management has become very rich by being shareholder friendly.

6. DO consider stock liquidity. Unhappy with how BHP Billiton directors are behaving? You can sell your stock in less than a minute. In smaller stocks it can take weeks to sell your shares. Check stock turnover before you trade.

7. DON'T buy too much. Smaller companies are higher risk so you need to account for this in your portfolio limit. While you can justify up to 6% in a second line stock like Trade Me, much more speculative plays like Somnomed and Nanosonics require lower weightings of around 2%.

Remember that portfolio limits are suggested maximums. It's often wise to buy an initial position at half the suggested maximum. This provides room to move should the stock become cheaper or you become more comfortable with the story.

8. DON'T chase the stock up. Not only is it more difficult to sell a small stock, it's harder dto buy one, too. Poor liquidity means the price can move up quickly but there's no need to chase it. Patience usually pays and the price will come back.

9. DON'T expect miracles. Small stocks can produce higher returns than large stocks, but only a tiny proportion will rise tenfold and even that might take a decade. Some small companies will become very successful, most will be mediocre, and a few will go bankrupt. Expect to buy your share of duds.

With small stocks better value than they've been in years, it's time to dip a toe in risky river. Just remember to follow these rules to avoid being swept downstream.

Nathan Bell is Research Director of Intelligent Investor Share Advisor (AFSL 282288). Unlock all of Share Advisor's stock research and buy recommendations by taking out a 15-day free membership.