The Small Cap Investing Strategies Handbook Part Ten: Conclusion. This is the final part of a ten-part series on small-cap investing.
Throughout this series, I’m looking 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.
The series is a collaboration between ValueWalk and ValueWalk’s new small-cap investing magazine Hidden Value Stocks, a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.
We are planning to turn the series into a white-paper and pay-walling ALL content (although leaving part ten open for a taste for a short while), which we hope will be a comprehensive guide to investing in small caps exclusively for Hidden Value Stock subscribers (not ValueWalk – this the first time we have done this).
For the other parts of this series please follow the links below:
- Part One: Introduction
- Part Two: The Small-Cap Premium
- Part Three: Size Matters
- Part Four: Quality Over Quantity
- Part Five: Peter Lynch’s Rules
- Part Six: Peter’s Principles
- Part Seven & Eight: Lessons From Value Investors
- Part Nine: 5 Rules For Small Caps
Small Cap Investing Strategies : Conclusion
Throughout this Small Cap Investing Strategies series, I’ve looked at the evidence for and against small-cap investing, as tips for investors to get the most out of the premium returns on offer.
In summary, the series has raised some interesting ideas and conclusions around the topic of small-cap investing. First, while it is generally believed that a small-cap premium exists, there’s little evidence to show that this premium has continued to exist across the market since 1980 when it was first discovered.
However, while there is little evidence to show that the small-cap premium has persisted after the 1980s for all small companies, there is evidence which shows that the highest quality small caps have continued to generate outperformance, returning more than their large cap peers. Assuming that the average investor is looking only to invest in the highest quality businesses, those that have a minimal risk of permanent capital impairment, this evidence shows that the small-cap premium continues to exist although if you invest in a poor quality company, you’re not going to outperform.
Most of the high profile investors throughout history have made a name for themselves by investing in small caps as this is where the most opportunity lies. In the small-cap area of the market, there is a higher likelihood of equities being mispriced as these equities tend to be overlooked by Wall Street and underinvested among institutional investors. The world’s greatest investor, Warren Buffett made millions investing in small caps when he first started out, deep value stocks were his specialty. Companies such as the well-known GEICO and lesser known insurer Western Insurance, which had a market capitalization of around $30 million traded over-the-counter and was earning $16 a share but trading in a range of $12-$20. Along with Buffett, Peter Lynch can be considered to be one of the greater small-cap investors of all time buying high quality small, medium and large-cap stocks during his tenure at the Magellan Fund between 1977 and 1990.
The one thing that these observations have in common is quality. It goes without saying that high-quality companies tend to outperform all other businesses over the long term. High-quality Small cap investing strategies is no different. The one difference is that small caps tend to have a longer runway for growth and it’s this combination of growth and high quality that can produce the best results. Finding these businesses does require a bit of extra effort but the returns more than makeup for the additional time required. Businesses with a devoted management, high returns on capital and strong free cash flow are bound to generate solid returns for investors if they can stay ahead of the competition and produce a product consumers want.
Buying high-quality small caps is only part of the equation. No matter how impressive a company’s business model, if you buy at an expensive price you’re likely only to achieve average results. As Benjamin Graham once said, there are no bad assets, just bad prices.
So overall, the evidence shows that yes there is a small-cap premium, but this premium only exists for high-quality small businesses that have a long runway for growth. Just because a company has a small market capitalization is not an indicator of outperformance in itself. An attractive valuation and long runway for growth could be more reliable indicators for outperformance across the market, not just in the small-cap arena. Nonetheless, the chances that a security will be mispriced are significantly higher in the small-cap arena, and it’s this mispricing, coupled with quality and growth that provides a potent cocktail for outperformance.
Small Cap Investing Strategies - The key to success
Small caps can yield some impressive returns for investors over time, but you really need to do your research to make sure you don’t get sucked into a growth or value trap. To help our readers discover the market’s best hidden small caps, ValueWalk publishes a quarterly magazine entitled Hidden Value Stocks.
The magazine is devoted to small-cap investing, and each issue contains four stock ideas. Each idea is put forward by a fund manager who has a record of picking the market’s best stocks. These opportunities are usually hidden from plain sight and are not covered by Wall Street.
This lack of coverage means their valuations are extremely attractive and the stocks trade at a deep discount to intrinsic value. If you want to find out more about the magazine, sign up for a year or just purchase one copy, click here to learn more.