How To Choose A Small Cap Stock That’s Right For You

Readers are probably used to the fact that small caps outperform on both the upside and the downside. But how does an investor take advantage of that?

Of course, you could subscribe to my SmallCapInvestor PRO advisory service, where we’ve averaged 36% per recommendation this year. But that’s probably not the answer you seek (at least not yet)…

Another way to quickly find small cap names for potential investments is to follow the “new highs of the day.” On Yahoo! Finance, they’re called the “Price % Gainers”. This is the list of the stocks that make the biggest moves in a single day, and it’s nearly always dominated by small cap stocks.

Now, the small cap stocks you find on the Top Gainers list have just made a big jump in price. It should be understood that the majority of these stocks are moving on news and will give the gains they’ve just recorded. But, for the discerning eye, the Top Gainers list can be a goldmine for small cap stocks that are breaking out to new highs.

Here are a couple tips for finding the “right” stock in the Top Gainers list.

First and foremost, check the volume. You’ll want to make sure that volume is exceeding the daily average volume for that stock by a wide margin. Like 8X or 10X the daily average. High volume can often be a sign that it’s not just day traders ramping a stock.

Volume could have lead to you to one of my SmallCapInvestor PRO recommendations, China Natural Gas (CHNG). My readers bought it at $6.13 a few months back, but you could have made a quick 20%-30% when it made the Top Gainers on September 5.

Avoid the biotechs. It’s been my experience that biotechs are very difficult to trade based on breakout moves. It happens so often that a biotech gaps and runs higher after what appears to be good news. Then, the stock will give the gains right back. Not that there are never opportunities in breakout biotech stocks, but I sometimes wonder if the phrase “sell the news” was invented for biotech stocks.

Dig into the news driving the stock higher. Stocks usually hit the Top Gainers list due to a news item. The key to finding the right stock is to properly qualify the news. Is the news a one-time event? Or does it represent a fundamental change in the company’s fortunes? The right answer here can lead to big gains.

Just today, Helicos BioSciences (HLCS) jumped 13% on 5X average volume after it announced the first-ever direct sequencing of single molecules of RNA. Unless you’re a scientist, you may not know how important this news is. But I can virtually guarantee that it’s not a surprise.

Check the chart. Always check the chart for a prospective investment on the Top Gainers list. If the news has been anticipated, you’ll likely see a steady rise into the day of the breakout. Investors who have bought are likely to take profits on the big advance you’re seeing. Conversely, if the stock has been flat, and then suddenly breaks higher, it might mean that the news is a surprise and is causing investors to revalue a stock. The chart from early August for troubled trucking company YRC Worldwide (YRCW) clearly shows how new information can affect a stock.

One final note: Beware the downtrend that’s suddenly broken by a sharp up day. That may be short covering. Of course, you can make money on a short squeeze. But it’s also possible that the stock will resume its downtrend once the short has covered.

It was this process that led me to recommend Maguire Properties (MPG) on Tuesday, September 15. I brought Maguire into our conversation because it is a great example of how the Cash for Clunker Stock Rally is working. The government is underwriting risk in the stock market. And we know, as do institutional investors, that the Fed and Treasury are working to prevent systemic failures. They are currently targeting commercial real estate as a potential problem sector. And if they succeed in supporting this sector, companies like Maguire will move higher in valuation.

Stocks reversed and closed in the red yesterday after the FOMC’s interest rate decision. No surprise that interest rates will remain low. But for how long?

The Fed is trying to reassure investors that rates will stay low for a long time, and that risk in the markets will be underwritten by stimulus spending and guarantees. But, at the same time, as the economy improves, investors know that interest rates must rise and stimulus spending must end.

That, to me, is the biggest threat to the Cash for Clunker Stock Rally. So when we see economic data like this morning’s surprise drop in new unemployment claims, it’s a stark reminder that interest rates (and the U.S. dollar) will rise at some point in the future.

I’m not surprised that we’re seeing a little red for stocks. Prices shouldn’t go straight up. In fact, I’d be more concerned if we saw nothing but green. I still believe we see Dow 10,500 this year, so the current weakness will present a buying opportunity sometime soon.

Third quarter earnings season is right around the corner. Alcoa (AA) kicks things off on October 7. I suspect investors are adjusting prices for earnings now, which will set the stage for something of a relief rally when earnings begin. We’ll see…

Subscribe by RSS Subscribe by Email

Comment by Sanjay

2009-10-01 19:27:28

Great article and I would like to be on your distribution list.
I have suffered on Human Genome and Dynavax like mad and re-thinking my strategy on Bio-tech.

Rgds,
sanjay

Reply to this comment

 

Comment by Ian Wyatt

2009-10-02 07:48:48

Sanjay,

Thank you for the compliment. It means a lot when a reader takes time to comment on one of my articles.

I hear your pain about biotechs. That’s why I generally avoid them. They make great news bytes the day they pop, but most are on quick news and quickly drop back to their normal range once all the insiders have sold off their positions.

You mentioned you’re interested in getting on my Small Cap Daily distribution. Legally, I cannot sign you up, but I can point you to where you can in a matter of minutes. Just go to http://www.smallcapinvestor.com and click on the REGISTER button at the top right. You’re coming in a good time as work is underway to thoroughly upgrade that website with more and better content on small cap investing ideas and tips. Look for that in the coming month. In the meantime you’ll continue to receive the free Small Cap Daily.

Ian

Reply to this comment