What Are The Benefits Of Being A Small Investor? Part 1/2 by Jun Hao, The Asia Report

Off the Beaten Path

Throughout the financial world being large is considered an advantage – banks, brokers and insurers all benefit from significant economies of scale. But for an investor, being small offers a huge advantage. Because your investment universe is not limited to large-cap stocks, you are free to go places where large institutions would never tread.

And because Wall Street ignores these investments, the chances of finding a real opportunity are much greater. Unfortunately this advantage is not always recognized or capitalized upon by smaller institutions and individuals.

In a Business Week article in 1999, Buffett explained how profitable these lesser-known investments can be:

“You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all…

Having a lot of money to invest forced Berkshire to buy those that were less attractive. With less capital, I could have put all my money into the most attractive issues and really creamed it.”

Investors can be apprehensive about exploring these opportunities because they are associated with “high risk”. It is true that there are some risks specific to small-cap investment, but this doesn’t preclude an investment. You simply need to be aware of the risks and factor them into your decision-making.

Wall Street Hates Small Caps

Why does Wall Street ignore these opportunities? Largely because the big brokers don’t make money from small caps. Clients can’t trade in small-cap stocks since it takes several days or weeks to build up a position.

These investments are never going to generate large execution fees for the broker. In any case, many institutional managers aren’t themselves interested in going off the beaten path. There are a number of (mostly bad) reasons for this:

  • Fear of illiquidity. Most experienced fund managers can remember at least one disastrous investment they made in a small cap stock.

They remember everyone rushing for the exit, like something out of Jurassic World and the pain of that memory is still etched on their brains. Not being able to exit a bad investment is something that investors just can’t stomach.

  • The fact that the stock isn’t covered by Wall Street brokers actually scares some managers. They’re deeply uncomfortable with the idea that nobody is formally “responsible” for it (i.e. nobody to blame if it goes wrong).

The idea that a stock isn’t being watched at all times just gives them the heebie-jeebies, and in extreme cases can bring on an existential crisis.

  • More obscure stocks suffer from management teams that are less polished. They don’t have a glossy pitch deck or a quarterly roadshow and they usually mess up the earnings call (though it’s not like anyone’s listening). For fund managers used to the slick marketing machine of the S&P500, this is like going from HBO to Ukrainian State television.
  • Fund managers hate high volatility. Many of them are so obsessed with daily movements in the stock that they get freaked out by a few down days. Eventually they sell the stock in question just so they can get a decent night’s sleep.

The Gift of Volatility

The very things that scare most institutional managers provide an opportunity for the intelligent investor. The intelligent investor always welcomes volatility because it provides a greater chance for a stock to diverge from its intrinsic value. Without that volatility you might never get a sufficient “margin of safety”.

Sometimes with a small-cap stock, you look at the chart and it’s clear to see that a large institution has been selling down a massive stake. In the ensuing panic, other institutions have capitulated and the price has been depressed further.

This is a gift for a smaller investor, who can pick through the carnage looking for a bargain. To borrow from Buffett’s baseball analogy, this is when you swing!

McKinsey smaller investors favor bigger shops