Making investment in small cap stocks is an individual preference that is not suitable for every investor. When you are looking to invest in small cap stocks, remember that the potential to achieve very high returns is fraught sometimes with the danger of risking the entire investment amount. Although there are a number of positive factors associated with small cap investing, they weigh against some strong negative attributes.

It is a fact that many successful big companies started very small and their stocks were small cap stocks during the early stages of their evolution. The stock market is abound with examples of companies such as Starbucks, Yahoo, Ebay and Wal-Mart, to name a few, which were small businesses and had small market capitalization in the beginning. Those individuals who invested in such companies at an early stage and remained invested reaped huge returns over time.

Because small caps are companies with small total values, they have the ability to grow in ways that are simply impossible for large companies. A large company, one with a market cap in the range of $5 billion to $10 billion doesn't have the same potential to double in size as a company with a $200 million market cap. So if you are looking for high-growth companies, small caps are normally the answer.

Most small cap stocks belong to companies that are still at an early stage of development. These companies are normally more focused and devote their attention to a particular business area. It is easier to analyze such companies and properly evaluate their business prospects in the near future as opposed to bigger companies that can have complex operations that are harder to examine.

Small cap stocks are generally neglected by research analysts and often undervalued by an uninformed market. This presents tremendous opportunities for individual investors who can profit from the inefficiencies caused by the lack of coverage devoted to a particular area of the market.

Small cap stocks are often associated with small and unproved businesses that have higher chances of failure. This leads to higher risk for investors. Small businesses often are narrowly focused with little or no diversification to protect against normal fluctuations in business cycles and hence more risk.

Small caps are also more susceptible to volatility, simply due to their size - it takes less volume to move prices. It's common for a small cap to fluctuate 5% or more in a single trading day, something some investors simply cannot stomach.

Although, most small cap stocks are less complex to analyze compared to large cap stocks, it is hard to obtain even basic information on small cap stocks. For individual investors, it becomes hard work to obtain proper qualitative and quantitative information on small cap stocks to conduct adequate investment research. Financial ratios and growth rates are widely published for large companies, but not for small ones. Since there is hardly any analyst coverage on most small cap stocks, one must construct a well-informed opinion of the company with very limited information.

Successful small companies that could sustain their early success and became leaders in their respective industries made millions for their early investors. Early investors in companies like Wal-Mart, Microsoft, Ebay, Intel and Cisco saw their portfolios swell many times over years.

When Microsoft went public 19 years ago, its stock traded at a measly $0.10 a share. As a matter of fact, that's a split-adjusted price. Microsoft has never actually traded below $10. From humble beginnings, Microsoft shares have grown more than 200 times in value, generating returns in excess of 30% every year. Beginning with humble origins but a stellar business model and a management team with vision, Microsoft pounded out rising profits year after year.

For every Microsoft however, the market is littered with hundreds of those small companies that did not go to the next level. Needless to say, their investors lost huge amounts if they stuck with those companies.

So the question is, what makes a company the next Microsoft or the next Ebay? The answer is not always easy. The fact is the odds of succeeding for a small company is extremely small. For every business success story there are numerous companies that quietly burn through their money and disappear.

For a diligent investor interested in finding that next champion amongst the horde of minnows there are some guidelines that can be very handy. Although nothing guarantees success in the investment filed, these rules help an investor in finding a quality small cap company that has several positive things going for it and help an investor identify winners among small cap stocks.

Most growth-oriented companies succeed in new and growing industries. It is hard for companies to grow in a mature industry where the opportunity to innovate and leapfrog the competition is limited. It is easier for a small company to find its feet in a relatively new and growing industry. More often young and inexperience but highly talented and committed leaders who investors either don't care about or don't believe in lead such companies. The best example is Microsoft, a software company 20 years ago. Back in the 1980s, very few people thought much of the software industry. Far fewer felt that Microsoft could compete against the likes of IBM. That kept Microsoft's stock low relative to the company's very high growth rates for a long time during early years. Investors who could recognize the prospects of Microsoft and could discern the changing tides benefited massively by investing in the company during its early years.

Long-term business trends are what turn little companies into big ones over time. The best horse-drawn carriage maker in the world didn't stand a chance in 1910. So look beyond a company's current situation and make sure its business has a realistic chance of prospering over several years. A good example today would be small companies looking to develop technologies to treat water or save energy. Environmental pollution is a big story today in the midst of rapid growth in the fastest and most populous regions of the world. These places will need all the help they could get to solve the problems of explosive energy demand and scarcity of clean drinking water for many years to come. If an investor finds a company that has solutions to satisfy these needs in a commercially viable way, the company is going to be a sure success and will reward its early investors handsomely.

Another characteristic to look for while investing in a small cap stock is the ownership stake and years invested in the company by the top management of the company. Nobody would trust a mechanic who would not drive the car he fixed, so why invest in a company where the top management does not have a big stake in the company? Microsoft for one had a management team with over 50% equity stake in the company at the time the company went public. No wonder that they had a vested interest in creating a successful and long lasting enterprise.

Nothing is more important than having a management team that knows how to grow the business and steer the company through rough water if trouble strikes, and strike it will during the course of expansion for any small company. Skilled managers with proved track record of success are more important than any new technology or new business ideas. While looking to invest in small cap companies, examine carefully who is at the helm at these companies.

A strong and enduring balance sheet signifies efficiency and effectiveness. Investors should endevour to find a company that demonstrates operational focus resulting in a sterling balance sheet. Operational focus is paramount for any company but more so for an early stage small cap company. A focused company is less likely to spread itself thin and stumble. Microsoft was focused on consumer software only during its earlier years when it was still a small cap stock. Apple, a close rival to Microsoft during the early 80s on the other hand tried its hands at different things simultaneously and could not get the same success.

The result of Microsoft focus was a stellar balance sheet with loads of cash and no debt. On the income side, sales grew at over 25% a year for a long time with a healthy and increasing margin. It was no wonder that Microsoft kept on raking up profit and every increasing free cash flow year after year.

Instincts are undervalued in this business, and always give yourself a benefit of doubt. You may have a better handle on how a stock passes the proverbial "smell test" than you think. Don't get fooled by the story and never suspend the good old common. And be wary of stock whose valuations are built on future onetime events, like a FDA approval that always seems to be a few months off. You're better missing a couple of points and buying after the news than amassing stocks whose futures may never arrive.

Investing in a small cap is a courageous decision in itself. That however pales in comparison to another requirement, the need to keep your nerve under check in the midst of all those volatilities that are regular occurrence with small cap stocks. It is imperative that once you've done the legwork in evaluating your small-cap prospect and have made your investment, don't give up on it too fast, unless you can see that something fundamental has changed. Nothing will serve you better when investing in small companies than giving them time to execute on whatever attracted you to them in the first place. Not every position will pan out, but it's almost certain that the ones that do will take some time to do so.

If you want to find the next small-cap winner:

• Look for small cap companies in new and growing industries
• Try to identify favourable trends for finding the next investment
• A strong management team with skin in the game is crucial
• A strong balance sheet is a good indicator of efficiency & effectiveness
• Never underestimate your instincts, perform a common sense "Smell Test" before investing in a small cap stock
• Patience is the key in getting properly rewarded