Risks to Avoid in Small Cap Stocks
Updated: Apr 12
"All investment evaluations should begin by measuring risk." - Charlie Munger
Small companies, also known as "small caps with a market capitalization of less than $500 million," can be exciting investments because they have the potential for high growth. But they can also be risky because they're often not as established as larger companies.
Let's look at some of the risks of investing in small caps:
Sometimes, companies issue more shares of stock to raise money for new projects or to pay off debt. This can be a good thing for investors if the new projects or debt payments help the company grow and become more profitable.
When a company issues more shares, it also dilutes the value of existing shares, which means current shareholders own a smaller piece of the company. This can be bad news for investors if the company isn't doing well, as it means they might lose money.
High levels of debt
When a company has a lot of debt, it means they owe a lot of money to other people. This can be a bad sign because it might mean the company is having trouble paying its bills. If a company has too much debt, it might have to use most of its cash flow to pay off its debt instead of investing in growth. In the worst-case scenario, if a company can't pay off its debt, it might go bankrupt or have to sell assets to pay off its debt, which could hurt the value of its stock.
Sometimes companies don't have enough money to pay for their growth or to pay off their debt. This can be risky because it might mean the company has to borrow more money or issue more shares of stock, which can dilute the value of existing shares.
Negative operating cash flow
Negative operating cash flow means that a company is spending more money than it's bringing in through its operations. This can be a sign of poor financial management or a lack of profitability. If a company continues to have negative cash flow for an extended period, it may struggle to fund its growth plans and service its debt.
Bankruptcy: A major risk for pre-revenue companies
Some small companies are "pre-revenue," which means they don't have any money coming in yet. These companies can be risky because it's hard to know if they'll be successful or not. If they don't make money, they might go bankrupt.
Bankruptcy is when a company is unable to pay its debts and can no longer operate. When a company goes bankrupt, it can have a devastating impact on investors because they might lose all the money they invested in the company.
For example, in February 2023, LexaGene Holdings, a small-cap biotech company in the US and Canada, filed for bankruptcy after it was unable to secure the necessary funding to continue operations. This resulted in the liquidation of the company's assets and investors didn't receive any distribution of the proceeds.
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