Small cap stocks
Achieving returns is crucial to building wealth over the long term. While no one knows what tomorrow’s stock prices will do, diversification through small cap stocks can provide better returns for per unit of risk. This ensures better long-term outcomes in your investment portfolio.
Because achieving returns is so important to investors, I have listed the 5 best small cap stocks for you. Small cap stocks can be a great addition to a portfolio. They offer both an additional form of diversification and the opportunity for excellent returns. What should you look for when picking small cap stocks? And why exactly are these chosen small stocks a good addition?
What is important when looking for the best small cap stocks?
In times of uncertainty, investors often seek safety. Interest rates on Dutch government bonds are negative again and investors are worried about a possible recession. Small cap stocks are usually avoided by investors in these situations. This provides opportunities for investors who are willing to take risk. Shares of small companies have sunk hard and are therefore valued at low valuations. Profits from these companies will be distributed to shareholders or used to grow the small caps. Small caps are small and have a lot of room to grow. This growth will, in all likelihood, provide higher profits and attractive dividends in the future.
When analyzing small caps, it is important to look at valuation, return on equity and the ability to continue to reinvest in the company at a high rate of return. When the opportunities to reinvest are high then a lack of dividends is fine. However, when valuation is especially low investors like to see some of the investment returned in the form of dividends. An additional risk or opportunity is management. This is because in small companies the differences are greater than in large companies. Moreover, in small companies management can make the difference more often.
How do small cap stocks help the diversification in your portfolio?
Small cap stocks are small and therefore susceptible to specific risks. However, these risks are different and unique. These specific risks and opportunities add diversification to your portfolio. Better diversification makes the entire portfolio less sensitive to market movements. As a group, small cap stocks are volatile. So in addition to diversification, they can actually initiate new movements in the portfolio. These movements can be either upward or downward. Investors have historically been rewarded for taking this volatility though. Therefore, this small cap premium means that, on average, investors in small stocks earn higher returns than investors in larger, more well-known stocks.
1. Melcor Development (MRD) P/E: 7.98
At number one is the Canadian company Melcor Development. Melcor Development is a real estate developer based in Alberta. The real estate market in Alberta has not been easy in recent years, but Melcor has performed well and is also growing in the US. Real estate in Canada does not immediately sound attractive, given the high valuations for real estate in Vancouver and Toronto. In Alberta, prices have not risen and there is even room for recovery. Low oil prices and lack of pipelines have depressed housing prices for a while, but could potentially recover from here. Melcor Development has a market value of CAD 444 million.
The company is valued at 0.42 times its book value. This book value gives a reasonable valuation of the property, but the land is still on the books at cost. It is likely that the land is worth more than twice its historical value. Melcor Development owns as much as 4 million square feet of land and much of this land is strategically located on the outskirts of cities to be developed. This means that the actual book value is probably another CAD 300 million higher. The company is already cheap without the land with a price earnings ratio of 7.98 and 0.42 times book value. The land is just a bonus that shareholders can benefit from in the future, while the dividend is 3.9% per year.