I’ll never forget the instructions my old boss gave me when I started out on the trading floor.
I was a freshly-minted analyst for a large European investment bank. My job was to find compelling equity investment opportunities on the US market and sell these ideas to pension and hedge fund managers.
Naturally, I was curious about what kind of companies I should look for. So I asked the boss.
I’ve never forgotten his reply…
I remember it even today. He told me:
‘Tim, don’t even bother looking at companies worth less than a billion dollars. If a stock’s got less market cap than that, our clients can’t build a meaningful position without moving the price too much. In any case, most of their mandates forbid them from even looking at stocks that small. So don’t waste your time on them.’
I was surprised. My managing director was telling me to ignore more than 80% of the potential investments in the market? Well, at least it’ll make my stock searches quicker, I thought.
It’s only now, many years later, that I recognise that the opportunities that big fund managers ignore can be breathtakingly more lucrative than the ones they pursue. Rich rewards tend to come from high-risk investments.
Fund managers’ jobs (not to mention their bonuses) rely on steering multi-billion dollar portfolios to annual percentage returns that are not too far off the return on the index. That means they have to avoid stocks that have the potential to ‘move the needle’ too much one way or another.
But just because fund managers shy away from small-caps doesn’t mean you should.
In fact, as I’ll show you in a moment, the absence of institutional investment leaves rich pickings for you, the individual investor…
An Astonishingly Wide Gap
The simple fact is that smaller companies reliably outperform large ones over the longer term.
Small really is beautiful.
Let me show you the evidence.
The chart below is taken from a long-running research project by two London Business School academics, Elroy Dimson and Paul Marsh.
The chart shows that long-run smaller company outperformance has been great.
It also shows that 2013 was a particularly good year for small-caps around the world.
By the way, you’ll note from the chart that Dimson and Marsh haven’t broken out the Australian market.
If they had, it would have shown the tough time Aussie small-caps endured in 2013.
The factors that dragged on the resource-heavy Aussie small-cap sector last year are well documented…chief among them is the cooling of the mining boom and an investor preference for large-cap dividend yield. That shouldn’t strike you as news.
That being said, the global effect on display in that chart is unmistakable.
The analysis I’m doing right now for Australian Small-Cap Investigator is all pointing to one outcome: when Australian small-caps rejoin this trend of outperformance, 2014 looks set to be a lucrative time for stock investors.
If you compare ‘small versus large’ stock performance across the 30 countries in Dimson and Marsh’s study, the analysis reveals that since 2000, small-caps have beaten their rival large-cap indices by an average of 6.7 percentage points a year.
That’s an astonishingly wide gap.
That’s the potential reward you can get by allocating part of your portfolio from large caps and into emerging small-cap stocks.
The Small-Cap Facts of Life
Those 6.7 percentage points of outperformance reflect a few ‘facts of life’ for the small-cap investor.
These facts of life include higher short-term volatility, poorer liquidity, and more risk.
Those facts can be like kryptonite to generally conservative fund managers.
That explains why my old boss on the equity desk in London told me not to bother researching small-cap stocks for my institutional clients.
But if you’re happy to ride out short-term bumps, and you choose your entry price sensibly, there are fantastic growth opportunities out there just waiting for you to scoop them up.
Don’t get me wrong, I’m not recommending that you run to your broker, sell all your blue chips and replace them with a basket of penny stocks.
Any type of small-cap investing is risky. But what I am saying is that patient investors who know a good business when they see one have the chance to improve their returns in small-caps.
The weight of history supports that theme no matter what time period or geography you choose. But there’s particularly good news here for Aussie investors.
If you choose the time period ’2014′ and geography ‘Australia’, you’ll find a rich vein of small-cap opportunities.
They come from sectors as diverse as high technology, financials, healthcare, biotech…and surprisingly enough, mining.
In fact, my colleague Jason Stevenson has done some fantastic analysis identifying what he says are three of the best value stocks on the Aussie market. You can check out his research here…
Tim Dohrmann
Small-Cap Analyst, Australian Small-Cap Investigator
