What should we look out for differently when evaluating a small cap stock?

Actually we should not defer when we are looking at different companies - meaning I do not defer between looking at a blue chip or a small cap stock.

Here are some things I would personally look out for:

1)Thoroughly read through at least past 2/3 years annual report and past year quarter fillings + earnings call transcripts to really understand the business. DONT just buy because you think the sector is growing in general. Buy because you think the firm can grow alongside the industry- small cap investing is very firm specific.

2)Make sure growth is organic and not been fueled by rising debt or equity financing. It is not good for small caps to be heavily levered unless they can generate consistent cashflows to justify increasing leverage.

3) Determine that the product or service they are selling is viable and demand is present, are customers ordering it, are there repeat orders, is the customer base expanding?

4)Look back through past managment statements to see if they have achieved what they said they would do(builds on point 1)

5)For a simple valuation approach use Lynch’s PEG ratio and Al Mayers P/S rule of thumb. You can also use some of Graham’s formulas to get a ball park figure.

6)Try and find companies with management who are frugal and strive to increase efficiency. Fast growth attracts competition and in order for a company to offer customers a cheaper or superior product than its peers it must constantly reduce waste and increase efficiencies.

7)Lastly, do not be afraid of contacting management. Very often it is possible to get in touch through phone and email to ask them queries you have regarding the business. Get a feel for the company, ask who their biggest competitior is, where they see the company heading and how things have panned out thus far. Make sure to do you research first, if the person you are talking to knows that you have done your homework and are geniuinely interested they will be more forthcoming and honest with what they tell you.