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Everyone wants to get in early on a hot new stock. Why not? You buy Shlobotky, Inc., at $1 per share and hope it zooms to $98 before lunchtime. Who doesn’t want to buy a stock that could become the next IBM or Microsoft? This possibility is why investors are attracted to small-cap stocks. Small-cap (or small-capitalization) is a reference to the company’s market size. Small-cap stocks are stocks that have a market value under $1 billion. Investors may face more risk with small-caps, but they also have the chance for greater gains.

Out of all the types of stocks, small-cap stocks continue to exhibit the greatest amount of growth. In the same way that a tree planted last year has more opportunity for growth than a mature 100-year-old redwood, small-caps have greater growth potential than established large-cap stocks. Of course, a smallcap doesn’t exhibit spectacular growth just because it’s small. It grows when it does the right things, such as increasing sales and earnings by producing goods and services that customers want.

For every small company that becomes a Fortune 500 firm, hundreds of companies don’t grow at all or go out of business. When you try to guess the next great stock before any evidence of growth, you’re not investing — you’re speculating. Have you heard that one before? Of course you have, and you’ll hear it again. Don’t get me wrong — there’s nothing wrong with speculating. But it’s important to know that you’re speculating when you’re doing it. If you’re going to speculate in small stocks hoping for the next Cisco Systems, then use the guidelines I present in the following sections to increase your chances of success.

Avoid IPOs, unless . . .

Initial public offerings (IPOs) are the birthplace of public stocks, or the proverbial ground floor. The IPO is the first offering to the public of a company’s stock. The IPO is also referred to as “going public.” Because a company’s going public is frequently an unproven enterprise, investing in an IPO can be risky. Here are the two types of IPOs:

Start-up IPO: This is a company that didn’t exist before the IPO. In other words, the entrepreneurs get together and create a business plan. To get the financing they need for the company, they decide to go public immediately by approaching an investment banker. If the investment banker thinks that it’s a good concept, the banker will seek funding (selling the stock to investors) via the IPO.

TIP: Don’t rush to buy IPO stock

When a company goes public, it means that it undergoes an initial public offering (IPO). The IPO is the process by which a private firm seeks the assistance of an investment banking firm to gain financing by issuing stock that the public purchases. IPOs generate a lot of excitement, and many investors consider the IPO to be that proverbial ground-floor opportunity. After all, some people find it appealing to get a stock before its price skyrockets after investors subsequently flock to it. Why wouldn’t people find IPOs appealing? IPOs actually have a poor track record of success in their first year. Studies periodically done by the brokerage industry have revealed that IPOs (more times than not) actually decline in price during the first 12 months 60 percent of the time. In other words, an IPO has a better than even chance of dropping in price. The lesson for investors is that they’re better off waiting to see how the stock and the company perform. Don’t worry about missing that great opportunity; if it’s a bona fide opportunity, you’ll still do well after the IPO.

A private company that decides to go public: In many cases, the IPO is done for a company that already exists and is seeking expansion capital. The company may have been around for a long time as a smaller private concern, but it decides to seek funding through an IPO to grow even larger (or to fund a new product, promotional expenses, and so on). Which of the two IPOs do you think is less risky? That’s right! The private company going public. Why? Because it’s already a proven business, which is a safer bet than a brand-new start-up. Some great examples of successful IPOs in recent years are United Parcel Service and Google (they were both established companies before they went public).

Great stocks started as small companies going public. You may be able to recount the stories of Federal Express, Dell, AOL, Home Depot, and hundreds of other great successes. But do you remember an IPO by the company Lipschitz & Farquar? No? I didn’t think so. It’s among the majority of IPOs that don’t succeed. For investors, the lesson is clear: Wait until a track record appears before you invest in a company. If you don’t, you’re simply rolling the dice (in other words, you’re speculating, not investing!).

If it’s a small-cap stock, make sure it’s making money

I emphasize two points when investing in stocks:

Make sure that a company is established. (Being in business for at least three years is a good minimum.)

Make sure that a company is profitable. These points are especially important for investors in small stocks. Plenty of start-up ventures lose money but hope to make a fortune down the road. A good example is a company in the biotechnology industry. Biotech is an exciting area, but it’s esoteric, and at this early stage, companies are finding it difficult to use the technology in profitable ways. You may say, “But shouldn’t I jump in now in anticipation of future profits?” You may get lucky, but understand that when you invest in unproven, small-cap stocks, you’re speculating.

Investing in small-cap stocks requires analysis

The only difference between a small-cap stock and a large-cap stock is a few zeros in their numbers and the fact that you need to do more research with small-caps. By sheer dint of size, small-caps are riskier than large-caps, so you offset the risk by accruing more information on yourself and the stock in question. Plenty of information is available on large-cap stocks because they’re widely followed. Small-cap stocks don’t get as much press, and fewer analysts issue reports on them. Here are a few points to keep in mind:

Understand your investment style. Small-cap stocks may have more potential rewards, but they also carry more risk. No investor should devote a large portion of his capital to small-cap stocks. If you’re considering retirement money, you’re better off investing in large-cap stocks, Exchange-Traded Funds (ETFs), investment-grade bonds, bank accounts, and mutual funds. For example, retirement money should be in investments that are either very safe or have proven track records of steady growth over an extended period of time (five years or longer).

Check with the SEC. Get the financial reports that the company must file with the SEC. These reports offer more complete information on the company’s activities and finances. Go to the SEC Web site at www.sec.gov and check its massive database of company filings at EDGAR (Electronic Data Gathering, Analysis, and Retrieval system). You can also check to see whether any complaints have been filed against the company.

Check other sources. See whether brokers and independent research services, such as Value Line, follow the stock. If two or more different sources like the stock, it’s worth further investigation. Check the resources in Appendix A for further sources of information before you invest.