By Maj Soueidan. Originally published at ValueWalk.
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
– Warren Buffett, 1999
When I read this Buffett quote for the first time it struck me as peculiar. What would cause the normally conservative Warren Buffett to make such a statement? Is it simply that he knew he would never actually have to prove it, or are there important intuitions to be gained from this quote? Understand that a 50% return in any given year should mean nothing to you if you accept the randomness involved in short-term investment performance. Randomly picked portfolios can have 50% up-years, but I infer from Buffett’s statement that 50% is his average return expectation.
The Buffett quote does not directly imply that you should invest in microcaps, but the structural advantage that Buffett mentions can be very well played in smallcap and microcap stocks. After all, some of the best investors of all time, including Warren Buffett, Peter Lynch, Joel Greenblatt, and many others started their careers investing in microcaps and enjoyed the best returns when they were pursuing opportunities in small capitalized companies.
I don’t mean to discriminate between smallcaps (market cap 300m – 1bn), microcaps (market cap between 50m and 300m), and nanocaps (market cap sub 50m), but I want to lay out general intuitions for why small public companies can offer attractive investment opportunities, and why smaller is often better.
You Can Understand What You’re Buying
If you are a fundamental investor, you want to know what you own. You want to understand what is going on in the business and the moving pieces that make it tick.
Something small and simple is inherently easier to understand than something big and complex. I can understand a small business with two product lines, two main distributors, and maybe three important suppliers.
Can I get a truly realistic understanding of Goldman Sachs’ derivative book, and all the other moving parts of this business? I don’t think I can, and I seriously question the people who claim they can (especially those that claim high or absolute certainty). In fact, I deem many of the big cap companies to be too complex to be thoroughly understood and wonder about analysts making forecasts to the third decimal. I don’t mean to say that there is anything close to certainty in small stocks. The future is always uncertain and quarter-to-quarter results can be very volatile in microcaps. I feel I can make long-term predictions on a business level with a higher degree of confidence if I understand the moving pieces. More importantly, I can better gauge how much randomness exists in the business.
Access to Management of Microcap Stocks
Many great investors, including Warren Buffett, stress the importance of investing in companies run by quality management teams. You might argue that in small companies the quality of management is of even greater importance.
If you subscribe to the idea that management is a main driver of company value, you certainly want to perform due diligence on the management teams you invest in. During that due diligence process, personal contact can be an enormously helpful tool. GeoInvesting founder Maj Soueidan stresses the importance of management interviews, and has developed an intuitive interview technique over a long investing career. You can read more about his tips on interviewing management here and here. Other great investors like Guy Spier have said that they shy away from personal contact with senior management because of their fear of becoming influenced by charismatic personalities.
If you like to have personal contact with company management during the research process, you will often find that the smaller the company, the more accessible management will likely be. I can call the CEO of a small company I am invested in, and he’ll be happy to explain how a newly announced contract impacts his business. Good luck getting Tim Cook, CEO of Apple Inc. (NMS:AAPL) on the phone.
In addition to accessibility, microcap company management teams tend to own a higher percentage of company shares. While this does not guarantee success, it makes sense to assume that high insider ownership helps to align management interests with those of the company’s investors.
More Growth Potential
Similar to animals, companies have natural size limitations and must abide by the laws of larger numbers. Coca Cola cannot organically double its revenue over the next few years. There is only so much people can drink in a day. By contrast, many microcap companies can easily increase their revenues tenfold without having any material impact on the overall industry. The best companies might even be those that occupy a dominant spot in a small but growing industry. Remember that almost every company started as a small company. In fact, some of the best-performing public companies ever, including Berkshire Hathaway (BRK-B), Wal-Mart (NYSE:WMT), Amgen (NMS:AMGN), Netflix (NMS:NFLX), and many others were once microcap companies.
New growth often requires doing things differently. In other words, innovation. Numerous studies have discussed how and why big companies fail to innovate.
There are of course many factors contributing to the ability to innovate, and it is certainly wrong to generalize that all small companies are innovative. I believe the basic intuition holds true: the smaller the company, the more potential it has for growth, and the more innovative it can be.
More Opportunities in Microcap Stocks
Microcap companies represent roughly 50% of all publicly traded companies in North America. There are around 12,000 publicly traded microcap companies in the US and Canada alone and many more internationally. Most investors restrict themselves to a universe of very few big cap companies and ignore the majority of publicly traded companies. Generally speaking, the more opportunities, the higher the probability that something extraordinary will be hiding among them.
Just think of a distribution with a certain volatility and mean. The more data points you have, the higher the chance that one of them is far off the mean. This intuition is also reflected in Peter Lynch’s stock discovery process. Lynch believed in “turning over as many rocks” as possible.
The Incremental Buyer
When you buy a share of stock at $0.50 that is worth $1, you are a heroic value investor, right? But who is eventually going to pay you $1? This idea is related to important questions every investor should ask before initiating a position. How does my view differ from the consensus view? What is going to cause the market to adopt my view? Who is the incremental buyer that will buy my shares at a higher price?
Microcap stocks have the attractive feature that they are not investable for many institutional buyers for a multitude of reasons (current lack of liquidity
The post Microcap Stocks – There’s A Lot To Like About Them appeared first on ValueWalk.
Sign up for ValueWalk’s free newsletter here.
