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INTRO
We all want growth. Companies in different stages of their life cycle will experience different levels of growth, and growth is a key factor in value creation.
And as investors, growth in the level of returns (ROI) is certainly desirable. As such, I’ll seek investments that maximize my return for a given risk level. How do I do that? I seek quality companies with a durable competitive advantage and hold on to them for the long-term, as long as fundamentals remain strong. Be sure and check out our prior write-up here: Growth and Value Creation.
But it’s never really simple. And I’ve seen dozens of investors blow their portfolio. Most of them were playing around with small cap companies. Smaller companies tend to be poised for more growth, but as a whole, smaller companies tend to present more risk. That growth requires reinvestment of capital. And as a result, it's oftentimes the case that smaller less established companies, while experiencing accelerating growth, also suffer in terms of profitability and cashflows.
But does that mean small-caps are off limits? Let’s find out.
The Concept Of Size
If you haven’t noticed, I love analogies. So, here's a question to ponder: which animal is faster - an elephant, a zebra, or a hawk? I think we all know the answer.
In this analogy, an elephant symbolizes large cap companies. They move slowly, but it’s difficult to bring them to the ground. They're solid.
The zebras are symbolic of medium sized companies. They’re rather fast, but can still potentially be destroyed. And lastly, hawks fly fast, but that agility also makes them vulnerable. They symbolize small cap companies.
Every company may be unique. But a company's total market value—its market capitalization ("market cap")—is widely used to create a general context for assessing company financial performance and business outlook. Recognizing the relationship between company size, return potential, and risk is essential when selecting investments for your portfolio. So, which of these are best?
Larger companies tend to be more diversified in terms of their business models, including product offerings and market reach. As such, large-cap companies tend to be more stable. Growth may not be as robust, but it can be expected that business performance is more consistent from year to year. Revenues, earnings, and cash flows will typically be far less volatile, lending to less volatility in their share prices.
In contrast, smaller companies tend to have a more narrow business focus. Rapid revenue and profit growth are the underlying theme, but this potential is often more variable, which also tends to translate to more volatility in their share prices.
That being said, this data doesn’t tell the whole picture. Small-caps have their benefits, especially if you cherry-pick them.
The Big Advantage
One perk is that you might outsmart those big-shot institutional investors. Many mutual funds have rules that say they can't buy small-cap stocks.
Plus, there's this Investment Company Act from 1940 that says mutual funds can't gobble up more than 10% of a company's voting stock. So, it's tough for them to really get into the small-cap game.
And one more thing. Back in the 90s, everyone was hyped up about tech, those big-name companies like Microsoft, Cisco, and AOL Time Warner. But when the tech bubble burst in 2000, guess who came out on top? The small-cap stocks. While those big guys took a nosedive, the small fries held their ground and even thrived. Goes to show, sometimes being the underdog pays off.
According to Brown Advisory, small-caps certainly deserve more attention, as they provide a range of complementary features for investors. These include:
· The diversification boost – Basically, small-cap companies are often nimbler and can react faster to change, providing diversification to your portfolio.
· Small-caps, big growth – Catching these as investments early in their life cycle could provide more upside, since they tend to grow revenues and earnings at more rapid rates.
· Spanning the economic landscape –small-caps more broadly capture a greater number of sectors than their large-cap counterparts who are typically concentrated in fewer sectors.
Read more here in this write-up by Brown Advisory: Why U.S. Small-Cap Stocks Deserve More Attention.
So, what now?
Size Diversification
Remember, diversifying your investments is essential, but don't overdue it. It's generally considered prudent to allocate 10-15% of your stock portfolio to smaller companies. As the number of companies within a portfolio go beyond 20 in number, the benefits of diversification start to diminish and a larger portfolio is much more difficult to manage.
However, don't stress too much about the large-cap vs small-cap composition of your portfolio. A fantastic company stands out regardless of its size, so if you've identified a company with excellent business economics and a durable competitive advantage, it may be prudent to add it to your portfolio if the price is right.
As a whole though, you'll achieve better results by prioritizing the company's qualities over its size.
Conclusion
That being said, it's easier for a $2 billion company to double in size than a $1 trillion company. That's just common sense. Perhaps that's why Buffett explored smaller companies when he began investing.
“If I was running $1 million today, or $10 million for that matter, I’d be fully invested … It’s a huge structural advantage not to have a lot of money … The universe I can’t play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.” – W. Buffett
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Disclosure/Disclaimer
As a Tykr affiliate, Raising InvestorIQ earns from qualifying purchases. As a Seeking Alpha affiliate, Raising InvestorIQ earns from qualifying purchases.
Information provided on this site is based on my own personal experience, research, and analysis, and it is not to be construed as professional advice. Please conduct your own research before making any investment decisions. I am not a professional financial advisor, stockbroker, or planner, nor am I a CPA or a CFP. The contents of this site and the resources provided are for informational and entertainment purposes only and do not constitute financial, accounting, or legal advice. The author is not liable for any losses or damages related to actions or failure to act related to the content on this website.
