A rule of thumb commonly held across the finance professions is that high-reward investments come with a lot of risk. Unlike blue-chip stocks such as Australia and New Zealand Banking Group (ASX: ANZ), Woolworths Limited (ASX: WOW) or BHP Billiton Limited (ASX: BHP), many small-caps have volatile share prices, sales revenues, cash flows and earnings which can swing wildly year-to-year or day-to-day.
However there are two rules which investors can employ to mitigate the downside risks associated with a high-reward portfolio. The first strategy is quite obvious: Only buy well managed companies. The second is even simpler: Diversify (but not too much).
Just to clarify what I mean, I'd rather buy one good company than four average companies for the sake of diversification, because putting all your eggs in one basket is not a smart move. However, there's nothing wrong with employing a concentrated investment strategy – where a small amount of stocks are held, but the investor commits a large proportion of their holdings to each. This is important because, as you'll see below, a small-cap stock can drop 40% in value, unjustifiably, within a month or year of your purchase.
For example Newsat Limited (ASX: NWT), a small-cap telecommunications company with an ambition to place a number of satellites over the Middle East, Asia and Africa, has fallen approximately 43% since I bought the stock in January 2014. The company recently downgraded its earnings guidance to a loss of between $5 million and $6 million as a result of less sales revenue from its Teleport business. So why haven't I sold out?
The Teleport business isn't the reason why I (and presumably other investors) bought into Newsat. Its satellite business, which is yet to launch a craft into space, holds the key to its success, not its Teleport business. Investors in a similar position, who choose to sell out now, could be prematurely exiting with steep losses in the face of much higher earnings and cash flows. It's important to remember, however, it is a high-risk, debt laden company.
But after yesterday's 8% drop I'm still not concerned by Newsat's losses because I stuck to my guns and followed the two rules above. By diversifying into other high-reward companies such as Global Health Limited (ASX: GLH), Admedus (ASX: AHZ) and Liquefied Natural Gas Limited (ASX: LNG) – all multibaggers in the past 12 months – my portfolio is currently up over 76% in the current financial year alone, compared to a return of just 12% from the S&P/ASX200 (ASX: XJO) (INDEX:^AXJO).
The good news is I believe Admedus – formally Allied Healthcare Group – will go even higher than it has since I made it my top stock for October 2013. It's already up over 57% since then, thanks to the ongoing success of its Cardiocel regenerative medical technology.
The last high-reward small-cap with significant medium term potential is Silver Lake Resources Limited. (ASX: SLR). A gold miner trading at less than half its book value. It's fair to say it, along with most other gold miners, are currently up the proverbial creek. However its cost base is OK (now that the Murchison project is on care and maintenance) and production is increasing. What's more, the company has secured a lucrative hedging programme for a large amount of its low grade stockpiles. However one thing to be wary of is that it has issued around 200 million shares in the past five years.
The BEST BUY of all
Finding high-reward investments isn't easy nor is it for the feint hearted. However having one (or more) multibaggers in a concentrated but diversified portfolio can mean the difference between making HUGE gains or substantial losses. However like Peter Lynch says in his best-selling book, One Up on Wall Street, "The more right you are about any one stock, the more wrong you can be on all the others and still triumph as an investor".
