A heavyweight boxer would likely pulverize a flyweight boxer. But with small-cap stocks, David sometimes beats Goliath.
Numerous academic studies have found that—over long periods of time—small-cap stocks tend to outperform large-cap stocks. And by wide margins. That said, small-cap stocks sometimes experience huge volatility swings, especially in declining markets. And many investors can’t stomach this kind of uncertainty.
A small-cap stock is generally held to be one valued at less than $1 billion. For instance, if the price of a stock is $10 a share—and a firm has 50 million shares outstanding—then its market capitalization would be $500 million, and that would be considered a small-cap company. A stock with a market cap of less than $100 million is called a micro-cap. And if that’s not small enough, a company with a market cap of less than $50 million is called a nano-cap, which means very small.
Many famous stock pickers—including Warren Buffett, Peter Lynch, and value investors Joel Greenblatt and Seth Klarman—have made lots of money investing in small-cap stocks. Inevitably, however, as the size of their portfolios became quite large, they skewed their holdings to emphasize larger firms. That’s because it’s a lot easier to put large sums of money to work in big firms. If you manage $10 billion and buy a $100 million company that doubles in price, it has a 1% impact on the portfolio return, barely a rounding error. Plus, you probably wouldn’t buy the entire $100 million of the company’s stock, only a fraction of it. That would further limit the returns on a $10 billion portfolio. And if—like Buffett—you are managing more than $100 billion, it would be like a grain of sand on the beach.
So, most great investors have bought small-cap stocks at one time or another, but few focus exclusively in this area. And that can be an advantage for you.
Why do small-cap stocks historically provide higher returns than large-cap stocks? Studies find they tend to earn an incremental 2 or 3 percentage points more per year than bigger stocks. And though it might not sound like much, these fractional gains can add up to very large differences over time. The answer, in short, is that small-cap stocks historically provide higher returns than large-cap stocks because they are riskier, according to several measures.
The first measure is market risk, known as beta. Beta essentially measures the risk of one stock investment against the market as a whole. For example, technology or biotechnology stocks tend to be more volatile than food or utility stocks. Small-cap stocks also tend to be more volatile, and usually have a higher level of market risk or beta than large-cap stocks. These firms are generally less established, have shakier financials, and often do not pay a dividend, and, therefore, exhibit higher market risks. In addition, small-cap stocks have higher liquidity risk. A liquid asset is one that you can sell quickly and at fair market value. So a liquidity risk entails the danger of trading into, or trading out of, an asset with a narrow investor base.
A U.S. Treasury bill is liquid. Stock in General Electric is liquid. Stock in a small-cap stock is usually not liquid. One way to measure liquidity is by looking at trading volume. Trading volume in General Electric averages about 30 million shares a day. By comparison, trading volume in many small-cap stocks is often less than 50,000 shares a day. When institutional investors inject large amounts of money into a company or withdraw it, the act can very easily push the price of the stock up or down. So it’s hard for institutional investors to quickly establish a position in a small-cap stock without affecting its price.
There is less information about these neglected stocks due to the lack of coverage, which is a negative to investors who want some handholding. We can refer to this as information risk.
Small-cap stocks are also under-followed by analysts and financial reporters. There is less information about these neglected stocks due to the lack of coverage, which is a negative to investors who want some handholding. We can refer to this as information risk. Wall Street firms often have little incentive to follow small-cap stocks. That’s because bankers who employ research analysts typically get paid a percentage of the size of the deals they work on. So a 5% fee for issuing a billion dollars worth of equity—something a large-cap company like Tesla might do—would be a lot more lucrative for an investment bank than would be helping a small-cap firm issue $100 million dollars’ worth of equity. So bankers are more inclined to pour research resources into larger sources of fees than smaller ones.
The Positive Side of Smal-Cap Stocks
Now, the risks we’ve just taken into account—market risk, liquidity risk, and information risk—might be a negative from some perspectives, but they can be positive from another perspective. Higher risk investments generally result in higher realized returns. That’s primarily why small-cap stocks historically return 2 or 3% more a year than do large-cap stocks. But it often takes a long time to capture that extra premium. Often more than a decade.
For example, during the internet bubble in the late 1990s, large technology stocks like Dell, Microsoft and Amazon did very well. Small-cap stocks, especially those outside the tech sector, typically couldn’t keep pace, and their indexes underperformed large-cap stock indexes five years in a row. So, it takes patience to be a small-cap investor. And you need to be able to stomach the volatility. Small-cap stocks historically exhibit about 40% to 50% greater volatility than large-cap stocks do. And, of course, this often comes during down markets. This brings to mind a Wall Street expression, “You don’t know your risk tolerance until you live through a bear market.”
Let’s look at some small-cap strategies, both active and passive. And let’s start with the passive. The easiest way to invest in small cap is through an index fund, or an exchange-traded fund—known as an ETF, for short. Index funds and ETFs are basically baskets of stocks. The first small-cap index was created in 1984 by Frank Russell and Company. It is known as the Russell 2000 Index.
Out of a universe of 3000 stocks, Russell established the first widely referenced small-cap index in 1984 by creating a basket of the lower or smaller 2000 stocks. By lower or smaller I mean as determined by market cap. With this, index funds—and later, exchange-traded funds—created an opportunity for investors to become active in the small-cap market without having to individually research and select small stocks. The index is rebalanced, or reconstituted, each June. The rebalance process accounts for changes in firm size, and for firms leaving the index due to mergers or bankruptcies, as well as firms entering the index due to initial public offerings or spinoffs. The companies in the Russell 2000 Index usually range in size from a couple of hundred million dollars in market cap all the way up to $5 billion. But the average valuation of a stock in the index is about a billion dollars.
The Frank Russell Company was started by its namesake out of Tacoma, Washington, in 1936. It began as a brokerage firm. And Frank’s grandson, George Russell, is the one who really developed the firm. George graduated from Harvard Business School in 1958 and was thrust into running the company a few months later after his grandfather’s unexpected death. George grew the firm, especially in the area of institutional investment consulting. One of the common things consultants do is measure performance. There were well-known stock indexes for large firms, such as the Standard & Poor’s 500 and Dow Jones Industrial Average, but there was nothing for small-cap stocks. Hence, the birth of the Russell 2000 Index. It is the most widely followed small-cap index today. More than 90% of small-cap investment managers use the Russell 2000 as their benchmark. Standard and Poor’s, or S&P, also has a small-cap index of 600 names, but it hasn’t gained as much traction as Russell’s.
In the early 1990s, Eugene Fama at the University of Chicago, and Ken French, then at Chicago—and now at Dartmouth College—provided further insight into the large versus small-cap performance discrepancy. They verified the finding that small cap outperforms large cap over long periods of time. But they combined this with another, which is that value typically outperforms growth over long periods of time. Academics typically differentiate between value and growth by metrics such as price to earnings and price to book. The price to earnings or P/E ratio is measured as the price of a stock per share, divided by the earnings per share. Stocks that have above-average P/E, typically higher than 15, are considered growth stocks. Stocks with a below-average P/E are considered value stocks.
The numerator of the price to book ratio is also the price of a stock. And the denominator, or book value, is the same as the wet worth, or shareholder equity figure, on the balance sheet. It’s measured by starting with all of the assets of the firm and then subtracting all liabilities. A firm with an above-average price to book ratio, typically higher than 2.5, is considered a growth stock. Firms with a price to book value of less than average are considered value stocks.
Fama and French don’t view their findings on small-cap and value investments as the holy grail. Rather, they think small firms and value firms have higher risks, such as being more prone to bankruptcy, and that’s why they have higher returns. The Fama-French findings were put into action by the investment firm Dimensional Fund Advisors or DFA for short. DFA was set up in 1981 by two of Fama’s students from the University of Chicago, David Booth and Rex Sinquefield. You might recognize the Booth name. Later, he donated $300 million to the University of Chicago, and they named their business school after him. DFA put many of the ideas of Fama and French to work across a range of products, including many low-cost index funds. Fama and French also serve on the Board of Directors and act as consultants to DFA. And today, the firm manages in excess of $400 billion for clients.
Tracking Warren Buffet’s Success
Now, Warren Buffett is well-known for his investing prowess in large firms such as Coca-Cola, American Express, and Wells Fargo. But earlier, in his long and storied career, Buffett managed much smaller amounts of capital and had incredible success with small-cap stocks. He’s often said that managing large sums of money results in a performance disadvantage. It forces him to hunt for elephants, or large firms, to have a meaningful impact on his portfolio’s overall performance. In one interview, Buffett said that if he were managing only a million dollars—instead of tens of billions of dollars—he would guarantee that he could achieve returns of 50% a year since he would have no constraints on a target’s size, and not have to worry about his investment’s market impact on the price, when taking a position.
Buffett once was asked where individual investors should look for investments. Buffett replied that he thought small-cap stocks were great hunting grounds because large institutions can’t invest there, practically speaking. He gave the example of investing in small-cap stocks in South Korea, where the price-to-earnings ratios of many firms was only three times earnings, at the time—about 80% cheaper than the values of large U.S Stocks.
Buffett replied that he thought small-cap stocks were great hunting grounds because large institutions can’t invest there, practically speaking.
Berkshire’s acquisition of See’s Candy in 1972 provides a good case study on Buffett’s approach to small caps. See’s Candy is a California-based maker of chocolates and other confectionary items. It was founded in 1921 by Charles See. The company had a great product and a loyal following. And Buffett had a second home in California. He also loved the product, after it was brought to his attention back in 1971 by his business partner, Charlie Munger. Buffett thought there was a lot to like about See’s. The product tastes great. It is a consumable, which ensures recurring revenues. It has a fanatical following and great brand name. It has the ability to raise prices. And the company requires little R&D or capital expenditures to keep the business going. It’s also hard for a firm like Amazon.com to displace it.
In sum, it’s a great business. But the high-end chocolate business is never going to be a huge industry, like the auto industry or the cell phone industry. So, it is destined to stay relatively small, and therefore would be under the radar screen of large fund managers. Besides, See’s was a private, family owned business. And, as the principals of the firm got up in age, they decided to sell the firm to Berkshire for $25 million. At the time, See’s was doing about $30 million in annual revenue and generating $4.2 million a year in profits. Well, fast forward a few years, and the business is doing about $400 million a year in sales and about $100 million a year in profits. Its cumulative profits since Buffett bought the firm are more than $1.5 billion.
Buffet Makes A Bold Investment
Buffett’s most famous small-cap investment was in Berkshire Hathaway itself. Today, Berkshire is one of the largest companies in the world, with a market cap in the hundreds of billions of dollars. But Berkshire started out in 1839 as a textile maker. And although textiles were once a thriving business in America, the business was—like many manufacturing industries—gradually outsourced overseas. Berkshire was also headquartered in the New England area and operated most of its plants there. That was a pricey area to operate factories, especially as the services industry in the Northeast prospered.
Today, Berkshire is one of the largest companies in the world, with a market cap in the hundreds of billions of dollars. But Berkshire started out in 1839 as a textile maker.
Buffett first started buying Berkshire in 1962, at a price of $7.60 a share, for his own investment firm, which he had then called the Buffett Partnership. Even then, Buffett could see that textile manufacturing business was a declining business in the United States. But he saw value in the firm, in the form of its working capital, real estate, plants, and equipment. He also held out hope that the company would be able to turn around, or at least stabilize its declining fortunes. Buffett paid $14.86 a share to gain control of Berkshire in 1965. At the time, Berkshire had net working capital of $19 a share—that is, current assets minus current liabilities—plus valuable property, its plant, and equipment. So, Buffett was getting the company for basically nothing.
And because Berkshire had more than enough capacity to handle its declining business, it didn’t require a lot of new capital expenditures. The business threw off a lot of cash. And although Berkshire eventually left the textile business, the genius of Buffett was that he used its cash flow to help buy many other companies, either outright, or in part through their stock. These included companies such as The Washington Post, See’s Candy, Coca-Cola, Dairy Queen, Burlington Northern, and Wells Fargo, and especially Geico insurance, a business that generated a lot of cash itself. Ultimately, through wise capital-allocation decisions, Buffett turned a small-cap company into one of the largest in the world.
Ultimately, through wise capital-allocation decisions, Buffett turned a small-cap company into one of the largest in the world.
Peter Lynch’s Winning Strategies
Another famous investor that did well with small-cap stocks is Peter Lynch. He turned Fidelity Investments’ Magellan fund into the largest mutual fund in the world by the time he stepped down. A $1000 investment in Magellan when Lynch started there in 1977 had turned into $28,000 by his retirement 13 years later. A significant part of Lynch’s outperformance was due to his investment in small-cap firms. And even after Magellan became large—with an investment portfolio in the tens of billions of dollars—Lynch didn’t completely abandon small caps. He wound up owing more than 1000 stocks in Magellan. It was only by investing in such a large number of small-cap stocks that he was able to get them to have a meaningful effect on Magellan’s returns. And he had the resources of Fidelity to help him find and monitor all of these companies.
Lynch coined the investment term tenbagger, which refers to a stock that increases 10 times or more from the original purchase price. Dunkin Donuts is one of Lynch’s most famous tenbaggers. The relevant point is that it is a lot easier for a small-cap stock to turn into a tenbagger than it is for a large one. For example, if a stock starts with a market cap of $1 billion, a tenbagger increase turns it into $10 billion stock. That’s a 900% total return. By comparison, a company that starts with a market cap of $10 billion needs to go up to $100 billion to be a tenbagger. That’s a pretty rare bird.
Lynch coined the investment term tenbagger, which refers to a stock that increases 10 times or more from the original purchase price
Lynch has shared his thoughts on the small-cap market in several of his books, including One Up on Wall Street and Beating the Street. He suggests that “With small companies, you are better off to wait until they turn a profit before you invest.” This might seem like an obvious point, but it’s an important point since small money-losing firms sometimes tend to go out of business. Being profitable improves your chance to fight another day, as well as to invest in future growth.
Lynch also suggests looking for companies with niches. Many large companies today started out as niche players. Microsoft began as a firm that developed programs for the BASIC computer language. One of its first big breaks was creating the operating system MS-DOS for the IBM Personal Computer. MS-DOS eventually came to dominate the operating system market for computers. But Microsoft also expanded into the business-software marketplace with MS-OFFICE, including Word, Excel, PowerPoint, and so forth. So, the lesson from Lynch is that small-cap companies can eventually dominate its niche, and expand to related fields.
Lynch liked to find companies off of Wall Street’s radar screen. An Apple, General Electric, or Johnson & Johnson is not going to sneak up on any fund managers. Everyone knows about them. But most fund managers don’t know all of the 5000-plus stocks in the U.S. and the more than 50,000 globally. There are just too many to follow in detail. One way to determine if a stock has been discovered, so to speak, is to look at the percentage of the stock owned by institutions. This statistic can easily be found at no cost on many financial websites. As a rule of thumb, if the percentage of institutional ownership is less than 50%, then it is not widely followed by larger investors such as mutual funds, hedge funds, and pension funds. Institutions tend to move in herds, so once institutions pile in, others are likely to follow. A small-cap stock can quickly turn into a mid-cap stock when the institutions get on board.
Another investment consideration is this. Lynch likes small companies that have proven that their concept can be replicated. Starbucks went public in 1992, a couple of years after Lynch stepped down from running Magellan. But it’s a good example of what he means by replication. Starbucks had a concept—a coffee shop that provides a somewhat unique dining experience—that began in Seattle and then was then developed in one region of the country—the Northwest—before being rolled out nationwide. If Peter Lynch saw a concept like this that could be replicated across the country—and the firm was profitable—he’d be inclined to invest in it. Lynch thinks the opportunity to find small-cap investments abounds. He says, “The average person is exposed to interesting local companies and products years before professionals.”
Michael Burry’s Obsession
If you’ve read the book or seen the movie called The Big Short you probably recognize the name Michael Burry. He was one of the first people to recognize the famous bubble that occurred in the U.S. housing market in the mid-2000 period. And he made an enormous amount of money by betting that the housing market would collapse. He did so by using a complicated derivative instrument called a credit-default swap. Although Burry is most famous for that trade, a big part of his financial success can be traced to his investments in small-cap stocks.
Burry was a medical doctor who traded at night and at other times outside of his work hours. He had a passion—or some might say obsession—for the stock market. He self-diagnosed himself with a high functioning form of autism called Asperger Syndrome. Adding to Burry’s unique personal character is the fact that he has one glass eye. Burry considers himself a value investor, and a disciple of value investing pioneers Benjamin Graham and Warren Buffett. Burry’s investment in Hyde Athletic Industries back in 1997 is a good example of his approach to small-cap stocks. Hyde Athletic was a maker of athletic footwear. When Burry bought the stock it was like when Buffett first bought Berkshire Hathaway. That is, it was selling at a deep discount, and less than its net working capital—what Graham called a net-net. Furthermore, the company was growing rapidly.
In a November 1997 post on the Silicon Investor website, Burry wrote,
… That they are growing sales when other shoe companies are floundering is a testament to me of the sublime power of the Saucony brand. To be growing sales at a 24% clip, have a tiny PSR or price-to-sales ratio, and be a net-net, this has to be a stock value investors would love. The only problem is management, but they seem to be doing a better job, and I like the way they are refocusing.
Burry bought the stock for around $5 a share when its market cap was $31 million. But the company was worth at least $37 million based on its net working capital, alone. Hyde Athletic eventually changed its name to Saucony, its most popular brand, which today has a rabid following among runners. And Burry says he made a 50% return on this small-cap investment.
The easiest way to get exposure to small-caps is by investing in an index fund, which typically are well diversified and relatively inexpensive.
So, small cap investing can offer excellent long-term investing possibilities. The easiest way to get exposure to small caps is by investing in an index fund, which typically are well diversified and relatively inexpensive. You could also invest in one of the many actively managed small-cap mutual or exchange-traded funds. Or maybe there’s a local version of See’s Candy that you know about, and Wall Street doesn’t. A common strategy is to invest in a basket of small, young firms in a rapidly growing industry and then, as the evidence becomes clearer, reinvest in the winner. By reinvest, I mean sell the laggards and put the sales proceeds in the winner—or winners. For example, during the early years of the worldwide web, there were a bunch of search engines—Alta Vista, Lycos, Infoseek, Ask.com, Yahoo, and ultimately Google. So a strategy along the basket line of logic would be to invest equally in all the search firms when the internet was in its infancy, and then to reinvest later when it became clear which firms were gaining market share.
A common strategy is to invest in a basket of small, young firms in a rapidly growing industry and then, as the evidence becomes clearer, reinvest in the winner.
You could also take a page out of the playbook of some of the great investors, including Warren Buffett, Peter Lynch, Benjamin Graham, and Michael Burry. They used different approaches. Buffett, Graham, and Burry focused on a deep value approach. They reasoned that the deep value in neglected stocks would eventually be realized by the market. Or you could take the Peter Lynch approach, and focus on small companies that were profitable, had a niche, and the ability to eventually replicate their product on a larger scale.
Many small and risky investments end up losing money, and going out of business. But those that turn out to be winners sometimes return multiples on the initial investment. You can be a good hitter in baseball by making a hit in only one out of every three times you get up at the plate. In the same way with small-cap stocks, you don’t need to bat a thousand to generate a winning long-term return.