Investing in Small Cap Technology Companies

You might think that from the above title I am about to give instructions on investing in small cap technology companies, but you’re wrong. This piece will be more of a cautionary notice, rather than a recommendation.

Dealing with small caps, one stumbles across many technology companies, many of them with the promise of a break-through that makes you think, yes, it makes absolutely perfect sense. The world needs this technology. Perchance you would also be thinking, “Wow, I’ve stumbled across this company and this technology, how could anyone else not have realised how wonderful this company is?”

These types of investments are obviously tempting for an investor. Imagine, for you to be an early investor of Apple, Microsoft, or Google. However, the investments also come with plenty of caveats for would be investors and I shall touch on some of them here.

Firstly, and most importantly, you must not do this if you cannot absorb total loss. If this is not your day job, or you are investing with funds you cannot afford to lose, DON’T.

Secondly, thorough research is required and understanding the technology’s impact, potential or disruption factor. What kind of research? Apart from the usual financials, you must not shirk from reading the technical papers and scientific journals, as well as patents and news on competitors. You should become well-versed in the relevant technologies and the most recent developments in the field that you are looking at. You don’t have to be an expert, but you should be able to understand what the technology is you are investing in.

Accounting can weed out the truly fraudulent, but having eliminated the possibility, normal measures like PE, asset, debt, etc. do not work in forecasting future returns. You must look ahead in your valuation. It is intellectual property (IP) that needs to be scrutinised.

Thirdly, despite all the research, you will NOT have all of the information. However, if you wait until the market catches on, you would have missed out on a potentially large gain. Having spent much time researching you could well be kicking yourself if you dither too long about actually investing and missing out when it starts moving. On the other hand, that should not make you a gambler and jump on every possible play. Investing in small cap technology should not be a gamble, because most likely, you will lose.

Fourthly, despite not having all of the information, it is still a numbers game. Some of your picks will encounter some problems along the way and fail, through lack of funding, product failure, competition, bad management or just pure bad luck.  If three out of five of your names succeed, that is already good. Even 1 out of 5 can be profitable if that one winner goes up multiple times. Calculate the confidence interval or probability of success of each company. This is very similar to how venture capitalists operate, backing many and winning big on only a few.

To say this is value investing is a misnomer, because the value lies in the market underestimating the potential of the technology. To say this is a blue sky investing is also a misnomer, because the information you have collected reduces the speculative aspect of the investment. So perhaps, it is somewhere between those two extremes.

Fifth, the advice is usually to ride out your winners. Currently, I see that for these companies, frequent profit-taking is practice du jour for most investors and institutions. The volatility is very high, and depending on your time horizon and necessity of reducing transaction cost, it might be worth your while to ride out the volatility. Of course, this should also depend on your conviction and circumstances of the company as you go along.

Sixth, be patient. It takes time for a company to develop itself, or its product, especially so with a technology company. You could time your entry, but timing entry just before contracts are awarded or products are released is difficult if not impossible to predict, so some waiting is unavoidably required.

Seventh, a small cap company’s management, especially the CEO and CTO are the crux of the company’s direction, and therefore success. A company might start off as a biotechnology specialising in decontamination products but end up as a Life Science specialising in wound treatment. Those decisions in shaping the company’s directions are ultimately the CEO and CTO’s, so it might not be a bad idea to investigate their track records. Serial entrepreneurs in particular are often worth backing.

Eighth, not all technology stocks are equal. Some are more ‘equal’ than others. Some are not even categorised as ‘technology’ but masking as Retail/Services or Consumer/Non-cyc. Should you go for crowded trades? Normally, don’t –that’s usually where the pockets of bubbles are, where the uninformed investors are ‘helping’ to form the bubble. Instead, start from scratch and determine the technology for its own sake.

The advantage lies in the fact that intrinsic value is so difficult to evaluate that in general, others tend to shy away from these stocks, thinking that difficulty equals risky. Although this is true in some cases, often times, it is just a matter of rolling up the sleeves and digging through research and materials. To make large gains you have to be the first, and you have to be bold. You would also want to get into position before the institutional investors, although this is not such a rush, as a large number usually will only do so after the technology company receives several analysts’ coverage and recommendations.

Again, the companies being small cap, analyst coverage, if there is any, is usually sparse and non-technical. If they do mention the special features of the technology in their reports, these are usually not detailed. Therefore, you will be hard-pressed to find a second opinion amongst the analysts when there is no or little coverage.

Ninth, after all that, remember that if the whole technology sector is down because of rotation to other sectors, disenchantment by the market or change of sentiment, your gains can also quickly disappear. Remain focused on the underlying value you have calculated, which should allow for higher discount rates implied by lower prices. Note that the technology sector has always exhibited substantially higher volatility. On top of that small cap stocks also have higher volatility than large cap stocks, and this discrepancy has increased since the latest financial crisis. Understand where the market sentiment and the business cycle is. Don’t be a hero – unless you know what you’re doing and your time horizon is very long.

Lastly, and a point that I would like to emphasise for private investors, is that investment in these kinds of stocks should only make up a small portion of a well-diversified portfolio containing index funds, bonds (including high-yield), currencies and others. So for investors who are not very well-diversified or just dipping their toes, I would not recommend this style of investing at all.

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