Despite the mid-week craziness brought on by the

Trump

–

Greenland

spat,

small-caps

have, finally, started to outperform, after 14 long years of weak performance. The Russell 2000 growth index went on an 11-day up run in mid-January (technically one day was completely flat). This streak was the best for small growth companies in, well, ever. The U.S. small-cap growth index is up about seven per cent this year, well ahead of all the large-cap indexes.

However some caution is advised. First of all, small-caps usually do well in January: the January small-cap effect. A good January is nice, but it does not in any way guarantee a good year for the full calendar year. Second, as noted this week, things in the market can change, and fast. If tensions between the

United States

and North Atlantic Treaty Organization (

NATO

) countries escalate, or if another war breaks out, we at 5i Research highly doubt investors will want stocks, let alone small company stocks.

But let’s enjoy the small-cap party while it lasts. On that note, let’s look at five factors investors should look at before buying any small-cap stock. We call them the “five Ps” of small-cap investing.

People and promoters

With any stock investment, the people running the company have to be the starting point. Look at the prior experience of company executives. Have they built and sold companies before? Have they managed growth? Have they financed the company properly? What is their motivation? Do they own a lot of stock in their own company? Have they met investor expectations or promised too much? Executives are so important at small companies. Often, there is no analyst coverage so investors have to rely entirely on management and to trust what executives are saying.

It is also important to look at the promoters of a small company. There are good promoters and bad promoters. There is nothing inherently wrong with promotion: A small company needs to get the word out or investors will never learn about it. But there is a fine line between a promoter who wants to promote for the good of the company, and those who want to promote for their own good. We tend to believe insiders who own a lot of stock more than an investor relations firm just doing promotion for the contract fee.

Profit and potential

Admittedly, many small companies do not yet make a profit. That’s OK, as companies have to start somewhere. But the potential for profit most certainly needs to be there for investors to care. A company bleeding cash for years or decades (yes, these exist) is not usually a good stock to own. Investors should look at revenue growth and total addressable market (TAM). When looking at small resource companies, investors need to look at how much a potential mine will cost and how many years it will take to build. For biotechs, how much money needs to be spent on clinical trials? A company with a competitive edge could see profitability more quickly, or see faster growth overall. Investors need to look at margins as well as growth, though. If incremental sales do not result in higher margins, the company might just be buying sales at losses. This can only work for so long.

Product

What actually does the small company sell? Is it any different than larger competitors? Does it need to compete on price, or are customers not price-sensitive? What can the company do that a larger company cannot? This is often a tricky area. Companies with high margins will attract a lot of competition. Companies with low profit margins might not be good investments. If a small company cannot compete on price, it needs to offer better service, better terms or simply a better product. This takes investment in research and marketing. Many small companies have great products but do not have the ability to find customers. Getting noticed is expensive, and this ties back into the point about profit, above.

Persistence

A small company is going to see its share of struggles. Many barely scrape by for years before seeing any level of success. Executives need to show faith and persistence. An overnight success story is often 10 years in the making. Truly successful small companies know how to solve problems and survive weak economic periods. But investors need to have persistence as well. Do you sell your small-company investment at the first sign of trouble? When small-caps are weak do you buy more shares? Does a weak quarter mean a deteriorating trend? These answers are never easy.

Investors like to worry, and it can be a true test of faith to own small-caps through a downturn in the market. Drawdowns of 40 per cent, 50 per cent and more are not that unusual. We find it helpful in these cases to separate the stock from the company. Often, a small-cap stock will decline for reasons unrelated to the company, such as interest rates, geopolitical unrest or inflation. None of these are the company’s fault but a stock might still decline. If fundamentals have not changed, a decline is often a good buying opportunity, but it takes a brave investor to step in.

Price

We have left price for last, as, surprisingly, it is the least important. We have seen investors fret over 10 cents when buying a small-cap stock trading at $5 per share. Here they have a stock, they think (or hope) that will triple, quadruple or more, and they are bickering over a 10-cent price differential. We do not want to say price doesn’t matter, because of course it has some influence. But if you have found the next greatest small-cap company, we really think the decision is to own it, or not own it. The decision should not be, “I’ll own it if it gets 10-cents cheaper.” The good stocks don’t tend to go down a lot.

And, while we are on the topic of price, it is important to look at the other side of things. What do you do when one of your small-cap stocks soars? Do you sell just because it is up? We don’t think that’s a wise idea most of the time. Small-caps get more investors looking at them when their price rises. In the investment world, “bigger” often means “higher: as well. It is always important to monitor a company’s fundamentals, but we do not like the idea of selling after a 100 per cent gain on principle. Investors should ask themselves why others are now buying.

  • 5 AI chatbot prompts you can use to help you invest
  • From gold to the world’s largest company, 5 predictions for 2026. Plus, see how we did on 2025 forecasts

Peter Hodson, CFA, is founder of 5i Research Inc., an independent investment research network helping do-it-yourself investors reach their investment goals. He is also portfolio manager for the i2i Long/Short U.S. Equity Fund. (5i Research staff do not own Canadian stocks. i2i Long/Short Fund may own non-Canadian stocks mentioned.)

If you like this story,
sign up for
the FP Investor Newsletter.