The Small-Cap Investing Handbook Part One: Introduction

This is the first part of what will be a ten part series on small-cap investing.

Throughout this series, I’m going to take a look at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small cap investing magazine Hidden Value Stocks.

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.

 

small-cap investing
small-cap investing

The Small-Cap Investing Handbook Part One: Introduction

Small-capp stocks have a reputation that’s not necessarily good but at the same time, it is not necessarily bad. The majority of the world’s most renowned investors started their early careers by investing in small caps.

The reason why is because the likelihood of the market mispricing securities in the small-cap arena is much higher than with blue chips. Blue-chip stocks tend to be well covered by Wall Street analysts and owned by the largest funds. Small caps, on the other hand, are generally overlooked by Wall Street as it’s not lucrative enough to produce coverage on smaller names.

As a result, some small caps fly completely under the radar of most investors, and it’s here where the largest mispricings exist.

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Warren Buffett is perhaps the most famous example (barring his tutor Benjamin Graham) of an investor who has used small caps to make a name for himself. In his early days, Warren Buffett made millions for his investors by investing in such names as Dempster Mill and Sanborn Map. Both of these examples were trading at a deep discount to net asset value when Buffett became involved because Wall Street had no idea of how much they were worth. Warren Buffett took the time to do the legwork and was richly rewarded as a result.

Peter Lynch is another investor who made a name for himself in the small-cap arena. Lynch is considered to be one of the greatest money managers of all time and he achieved this accolade by finding small-cap companies that weren’t yet on institutional investors’ radar.

Lynch firmly believed that individual investors had inherent advantages over large institutions because the large firms either wouldn’t or couldn’t invest in smaller cap companies that have yet to receive big attention from analysts or mutual funds.

Still, while Buffett and Lynch have made names for themselves by investing in small caps, investors should be under no illusion that small-cap investing is easy.

It is considered (although as you will see later not entirely factually correct) that because small caps can produce high returns than the market, investing in small caps comes with greater risk. Even though the evidence does not support this statement 100%, it is an important observation.

Unloved small caps can outperform because they fall under the radar of larger investors and research houses. However, because these small caps are not well researched, it is vital that you conduct your own rigorous due diligence. It’s here where most investors trip up.

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Both Warren Buffett and Peter Lynch are known for their researching ability. Buffett is known for his love of figures and continual study of company earnings reports, while Lynch was known for his hectic travel schedule to visit company managements when he was running the Fidelity Magellan Fund from 1977 to 1990.

Yes, small caps can outperform the market, but unfortunately, these premium returns don’t come easy.

Can small caps outperform?

The first study that seemed to suggest small caps can outperform appeared in 1980. Titled “The Relationship Between Return And Market Value Of Common Stocks” the study found that smaller firms have higher risk-adjusted returns, on average, than larger enterprises and this ‘size effect’ has been in existence for at least 40 years.

To arrive at this result, the relatively simplistic study broke companies down into market capitalization deciles and found that companies in the lowest decile and the higher returns, after adjusting for conventional risk. Figures showed that the average excess return from holding very small firms long and very large firm short is, on average, 1.52% per month or 19.8% on an annualized basis.

By replicating the above study and extending the sample period through to the end of 2014, Aswath Damodaran professor of corporate finance and valuation at the Stern School of Business at New York University found that this small-cap performance anomaly has continued with companies falling into the lowest decile during the period 1926 to 2014 earning 4.33% more than the market after adjusting for risk.

The 1980 small-cap study has been used again and again as the basis for other academic studies on the topic and by actively managed small-cap funds in marketing materials. But today, there’s a growing debate over whether or not the small-cap premium actually continues to exist or if it has been arbitraged away by those seeking to profit from this market anomaly.

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