A Case For Investing in Small Companies

Let’s first talk about Mcdonald’s for a minute.  Sure, it is a very well-run company.  It could potentially double (yet again) in the next five years.  But could it go up 5x or 10x?  Unlikely.  On the other hand, hundreds or thousands of small companies will go up 5X within the next 5 years.  The hard part is finding them, and determining why they will go up.

Studies have shown that over the past 100 years, smaller company share prices have outperformed larger companies, often by a large margin.  However, people claim that smaller companies are speculative, volatile and risky.  Sure, this can be true, but the financial crisis has also shown us that large, well respected companies can also have plenty of these same characteristics.

Economic conditions are always changing.  So, if one is willing to take on the risk of owning a stock, why not own a smaller company stock instead, one with great potential upside, say over the next 5 years? Remember, stocks are all risk. Why take on this risk, unless you have the chance of earning enough to make it worthwhile?

Benefits of Investing in Small Companies

• Best way to compound returns:

  • The 500 largest publicly traded companies in the US, over the last 100 years, have compounded at roughly 7-10%.

  • The next 1500 largest companies have compounded returns in the low teens.

  • Even smaller companies, even more!

• Mature companies cannot grow fast.

  • They are bureaucratic and cannot innovate rapidly.

  • At mature companies, management teams are there for the salary, not the share price appreciation.  The management teams realize that there just isn’t that much upside.  I recall when I was working at Microsoft, most employees who participated in the Employee Stock Purchase Plan used to sell those the day after they were purchased (although we did get a 10% discount)!

• Fair Prices and lower competition

  • Few Wall Street Analysts cover small companies and as a result, these companies are not as well known, and slip through the cracks.  As a result, lesser known companies, have the potential to be found trading at good prices.

  • Large success funds are structurally unable to invest in small companies, because the sums are too small to move the needle .

• Acquisition Targets

  • Most small companies never become the next Mcdonalds.  They either go bankrupt, hit some plateau or get acquired.  Acquisitions create cost savings and synergies for the acquirer and hence, an acquirer can pay a lot more for a company than the broader market is willing to.

Drawbacks of Investing in Small Companies

• Small companies are more likely to go bankrupt compared to their larger counterparts. (However, our goal is to identify companies that we believe will exist for a long time, hence buying discipline is important.)

• Generally speaking, every few years, there tends to be a severe downturn.  This could severely wipe out investors.  What if you invested at the beginning of such a year? (That’s why we give ourselves at least 3-5 years for the investment to work out over time. Meaningful returns need time to actualize.)

• It takes a lot more time, research and effort to invest in such small companies.

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