A lot of small-cap investors ask how they can find those elusive “home run” stocks. The first answer I give them is simple. I say, “First you need to get on base. Then worry about getting home.”
The point is that most “home run” investments evolve over time. Rarely do they happen overnight. So investors have to put themselves in the right position to “get home” by getting off to a good start with the investment to begin with. This, along with a little luck, dramatically increases the chance of a big winner.
That all said, there are some recurring themes to “home run” style investing that do help your chances, so let’s briefly go over those.
To begin with, invest in misunderstood or undervalued stocks that have significant exposure to a major growth trend or catalyst. Pretty simple place to begin, right?
Taking things one step further, you’ve got to find those companies that are benefitting from a big, long-term trend and that are doing something unique, better or faster than others that make them the most compelling opportunity. And you want to get to them before the rest of the crowd.
You’ll also want a few specific catalysts that'll help propel the stock higher. You’ll figure these out with in-depth research into the company’s market, its financials and its services or products. And these catalysts don’t need to be fancy – they can be a new product, a restructuring of debt, expected dividend growth, turning the corner to profitability … any number of things.
What’s important is that you anticipate the catalyst and understand the link between the event occurring and the effect on the share price.
Armed with all this knowledge, put together an investment thesis and follow the stock for a bit. If it still looks good and the price is right, it’s time to buy.
Always buy in tranches. This keeps the risk of buying at a peak under control. And once you own a stock, you tend to watch it a lot closer. This reinforces your knowledge of how it trades and helps you understand when it's time to buy more or sell.
And finally, sell when valuation gets completely unreasonable or the catalyst you anticipated occurred and your investment thesis has run its course. You can sell either the entire position or just part of it, depending on your confidence in the stock. On the downside, keep a stop loss in mind – usually I'm looking at around 30-35%. If I'm down that much, I'll usually get out of the position.
Further, remember that winning stocks do well for a reason. History suggests that the best quality stocks run longer and higher than many investors expect. To help you stay the course with winners you must understand the fundamentals of the company, as I discussed earlier.
Any changes to the story – good or bad – mean re-considering your thesis. As long as it remains intact, stick with the company and keep yourself in that position to get a little lucky and capture that outsized gain.
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