Benefits of Being a Small Investor

This is guest blog post from Tom Beevers, ex-Portfolio Manager at Newton and now CEO and Co-Founder of StockViews.

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:

  1. 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 Worldand 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.
  2. 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.
  3. 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.
  4. 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!

Exploring the Universe

Of course finding these opportunities is not easy. There’s an almost infinite pool of small cap stocks in a diverse range of industries and it’s impossible to study all of them. A substantial amount of work needs to be done before you can conclude that the stock is materially over-priced or under-priced. This is why I’m passionate about the ability of crowdsourcing to uncover hidden opportunities. Even the largest research firm can’t hope to uncover a fraction of the best opportunities in the market. But an army of smart people all looking at stocks that Wall Street has no idea about – this is something that crowdsourcing was made for.

Small-cap Risks

Of course smaller cap companies have risks. They typically don’t have the breadth of products or depth of management expertise and they’re constantly under attack from larger competitors. However, like with any investment, these are risks that can (and must) be factored into your analysis. On the flip side, smaller cap stocks have advantages that large caps don’t – growth is easier to generate from a smaller base, and they are better adapted to change in a fast-moving industry. Financial dogma tells us that small caps must be more “risky” because they are more volatile. This is bunk – the measurement of beta is a very poor substitute for understanding the risk profile of the company. As Warren Buffett has said “risk comes from not knowing what you’re doing”.

But for a small cap strategy to work it will take time. Anomalies among small caps can remain for a long time precisely because they are not well covered. What’s needed here is something that’s in very short supply on Wall Street: Patience. While these investors are waiting for the anomaly to close, the vacuum of information leaves them vulnerable to fear and uncertainty. They crave validation from the market and when they don’t get it they begin to question if they took the wrong path. I leave you with the words of Benjamin Graham, the father of value investing:

“Traditionally the investor has been the man with patience and the courage of his convictions who would buy when the harried or disheartened speculator was selling. If the investor is now to hold back until the market itself encourages him, how will he distinguish himself from the speculator, and wherein will he deserve any better than the ordinary speculator’s fate?”  Benjamin Graham, Security Analysis

Tom Beevers is the CEO and Co-Founder of StockViews, a platform that crowdsources high quality equity research. Original post appeared on StockViews blog.

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