Efficient market theory claims that a stock’s price reflects the knowledge and expectations of all investors. If a new development happens it instantly (in a matter of minutes) becomes priced into a stock. Therefore, the market is very difficult to beat because you must either know news before it breaks or understand a company or industry better than the rest of its investors.
While I tend to side with the efficient market theorists regarding well followed stocks, it is the small stock traded for pennies or a few dollars that often times is not well followed by individual institutional investors that I believe does not operate that efficiently. Breaking news about a small company does not always price itself into the stock immediately. At times the magnitude of the news is not understood or the amount of investors needed to full price in the magnitude of the news is lacking.
I’ve said this before…If you know of a small company that is not followed by many or any analysts, look ahead to pivotal events in the company’s history. What upcoming products or ventures will change the direction of the company? When are these events expected to occur? Laying in wait until that event happens can be a very smart strategy. Since the stock is not followed by many (or any) institutions, you likely will have a window of opportunity to buy once the news breaks before the stock significantly moves.
When a relatively unknown stock realizes significant price movement, it will attract other ‘traders’ that are looking for momentum plays. This has the potential to over exaggerate the event’s significance in terms of the stock’s price. You may see shortly after a sizable climb up a sharp pull-back. Thus, it’s never a bad idea to protect yourself by taking some profits when you’ve have a sizable gain over a short period of time.