Saturday, July 27, 2013

Why small caps?

I have a confession to make, I'm a lousy analyst.  I can't project earnings, or figure out why earnings will shrink because the cost of some obscure thing is going up.  I'm not good at discount cash flow analysis, and most sell-side research I've read seems heavy on facts but short on anything else.  The good news for my portfolio is I've adopted an investment methodology that doesn't rely on any of my weaknesses, and it exploits my strengths.

I've had people ask me if I invest in large caps but just don't discuss them on the blog.  I own one, Mastercard, they have a tried and true moat (I can spot an oligopoly..), and they're growing nicely.  I purchased years ago and continue to hold them, if I have a chance to buy other monopolies cheap I would.  Otherwise my portfolio is a motley crew of tiny stocks that are unloved and under appreciated. I have invested in large caps in the past, but as I've grown as an investor, and seen the opportunities presented in the small cap space compared to the large cap space, I've drifted to a smaller and smaller capitalization portfolio.  This doesn't mean I avoid large caps, but the deal needs to be considerably more enticing before I'd be interested.

It's a heresy to talk about efficient markets with value investors, but I'm going to break the rules.  My feeling is that with larger stocks the market generally gets things right.  It doesn't always get it right, but it generally does.  To outwit the market in larger stocks one needs to be either a "situational investor" or have a superior understanding of the industry.  Most value investors in large caps are situational investors, these are the people who are buying BP after the spill, or buying BAC at $5.  A situation has arisen which has led to a temporary undervaluation of a large and well known company.  Investors who can spot these temporary blips can do well.  To take advantage of the blips an investor doesn't have to be an expert in the field or have an information advantage, they just need a stomach of steel, and the conviction that the market is wrong.

What's interesting about efficient markets is that Graham expressed a similar notion in the 1940s.  He claimed in Security Analysis that most analysts would be be able to add much value with leading issues (large caps), but value could be added by looking at secondary stocks (small caps, pink sheets etc).

It's rare for a large company to be forgotten by the market, I'd even go a step further and say that any company in the S&P is not forgotten and can't be.  Companies in the S&P at the minimum have their local city paper cheering for them.  In the Pittsburgh newspaper earnings for a company like Allegheny Technologies is a big story in the business section.  While they're a minor blip in the index the paper treats them like kings along with other listed regional companies.  It's hard to argue that even small members of the indexes are ignored.

Investor interest drives the search for information.  There might be 25 investors digging in the weeds to find out information on Regency Affiliates, and many of them are part time investors.  Contrast this to a stock like Coca-Cola Enterprises with 16 paid professionals following the company, and countless other investors.  In total there might be thousands or tens of thousands of people interested in CCE looking for any scrap of information.

It's possible for investors to gain a true informational advantage in small cap companies.  I own one company who publishes their annual report on their website once a year.  They remove the previous annual report and replace it with the current one.  Someone looking at the stock fresh might only be able to see two years worth of information.  With some creative URL manipulation I figured out that I could get a number of past annual reports, I now had a large advantage compared to someone coming in cold looking at the company.

The second advantage of small companies is they're much easier to understand.  A large company might really be equal to 5-10 (or more!) small companies.  For the most part many small companies buy raw goods, do something to them and sell the finished product.  A company making aircraft engines is simply making aircraft engines, they don't have a hedge fund hidden in the back room making mortgage bets.  I will grant that some of these small companies are personal investment vehicles with a tiny business attached, but at least they're transparent.

The third advantage is small companies are accessible.  Unless you're a big investor you'll never be able to call Mastercard and get the CFO on the phone.  I have called countless small companies and spoke directly to the CFO, usually with one transfer from the secretary.  Management at small companies is proud to talk about themselves and their accomplishments.  Most small companies never get shareholder phone calls, because of this management is usually willing to talk to shareholders as they should because they work for them.

For growth/moat investors it's worth considering that all large companies started out as small companies one day.  Why invest in a company with an established moat who's growth is slowing when the next Oracle is just germinating and trading at a cheap valuation?  I have often argued with GARP investors that they're wasting their time looking at large companies growing at 10%, instead they should be finding the small companies with moats that are growing at 30-50%.  Instead of investing in the rear view mirror this is investing looking out the front window.

I have told friends that the only reason I am able to do well investing is because I'm seeking out opportunities that not many others are.  I am truly looking for the oddball stocks of the market, the hidden assets, the strange situations, the stocks that don't trade, and companies in markets no one cares about.  By going against the grain, and digging in the smallest end of the market I find that even small pieces of information can lead to a huge information advantage.  Consider Jeff Moore, he looked at Calloways and instead of seeing a failing nursery operator saw a company with valuable land.  He built out a spreadsheet of their land holdings and realized one property is worth more than their market cap.  These sorts of things don't happen with Fortune 500 companies, if they have an un-monetized asset the writers at Barrons are discussing how they expect to unlock value with it.  Small companies have valuable hidden assets often, the only people who are aware are insiders who are usually working to protect the secrecy, and a few investors who are purchasing as many shares as they can get their hands on.

The best opportunities in the market aren't the ones that no one else understands, they're the ones no one else sees.

Disclosure: Long Mastercard

14 comments:

  1. Nate:

    DTEJD1997 here...

    As usual, great analysis on your part. Small, odd, illiquid stocks are where the bargains can be found. As time progresses, more & more of my portfolio is moving to small & nano cap stocks. Not all of it, but a large percentage.

    The funny thing is, some people simply will NOT invest in small/nano-cap stocks under ANY circumstance.

    Two examples: I saw the Voss Road location of CLWY was likely worth more than the market cap of the company. I discussed it with two local guys. One was a real estate broker, the other a business owner. The real estate broker largely agreed that it was an indeed valuable piece of property, but did not think it was worth investing in. He thought there was not enough value for him to get involved...

    The other business owner thought it was an interesting idea. He wondered what it would be worth in 3 years. I said maybe $2.50-$3/share if they can pay down debt & improve earnings. He decided to take a pass, the returns wouldn't be high enough for him!

    So I have to wonder what type of return these guys are looking to get? Something that is just unrealistic.

    Another example is AWLCF. Shared a lot of research with another business owner at $14.50/share. He decided to take a pass as "I can't be investing in small companies". Why is that, I asked. "Not enough trading volume" was his response. This guy is trading $2,500 or $5k at a time...He is not running a hedge fund.

    So I think there is a LARGE section of investors that simply won't invest in small companies under ANY circumstance. Of course, this behavior is totally irrational. Irrational behavior leads to inefficient markets, and that leads to opportunities for us deep value investors :)

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    1. You make some great points, I forgot to mention volatility, it's a big turnoff for many. Although a friend of mine notes that most stocks rise and fall within a huge band each year.

      People are irrational, they would rather buy a well known "brand" over a local company that they have far superior knowledge of. I've seen this with people I know as well, I'll mention some small local company and they'll bring up a national competitor. The only reason I'm interested in the local company is because they're attractively valued, but people prefer the "brand" to the cheap company, it's strange.

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  2. Nate, I totally agree with this post. The large caps are the ones most analyzed by mutual funds, ratings agencies, and buy-side analysts. The small caps pass under the radar. But I think the volatility is a huge reason why the larger investors overlook these. As Michael Burry said, volatility is not equal to risk, yet most models regard it this way.
    Thus, the low volume, high volatility names (i.e. small-cap) names remain undervalued for us to invest in.

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  3. Superb conclusion!

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  4. I shifted more and more to small caps over the years, exactly because of the reasons you mentioned Nate.
    In most cases a market cap above 1 billion is enough for me to pass on an investment instantly. There's always in my mind "if value was largely out of sync with price, dozens of other people would already know".
    There may be exceptions, but by and large I think individual investors can only outperform the market investing in small caps.

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  5. I agree with your post. I have moved more to small stocks but there is still plenty of value in large cap stocks. It helps that a lot of investors like you and your blog are turning over a lot of rocks and posting the best ideas. I guess I disagree with your post, only that I think there is more value in large cap stocks, while you believe it is more rare.

    The first reason is somewhat echoing DTEJD1997, some investors don't have the patience of a double in 3-5 years. That is a double in any stock, let alone a small cap stock. To say I have this great idea that will double in 3-5 years is not exciting enough for them, they have unrealistic expectations. For example, I will get the question what is your best idea to make 10% fast (fast = 1 month). Ultimately they invest in some stock like this, thinking that they will make 10% fast, doing it again and again. Maybe it works once or twice, but eventually they buy some stock that goes way down and they either throw in the towel or wait around for 3 years to get back to break even. In the end, the annualized returns are poor.

    The second reason for a large cap valuation error is an entire sector is thrown out. Look at housing in the past.

    A good current example, in my opinion is coal. Ask 100 investors if coal usage was larger or smaller worldwide in 2012 and I bet at least 95 would say that coal usage decreased. In the US, coal usage did decrease but worldwide (including US), coal usage increased and will increase again in 2013.

    The real problem with pricing is that supply increased faster (with decisions for projects made 2-3 years in advance) and predicting when pricing will turn. If you think the turn is quick, you can buy a leveraged coal company and make bundles of money. If you think the turn is slow (some coal companies going bk) then you buy the least leveraged and go for a double.

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    1. You raise good points, but you also confirm the thrust of my post. Most values for large caps are situational values, an industry (coal) goes out of fashion for whatever reason. The companies are relatively undervalued, not absolutely undervalued.

      I agree with you that most investors have inflated expectations as well. I've talked to a number of people who look down on anyone doing less than 20% a year. Poor Schloss/Graham/Buffett, they have nothing compared to "upstart xzy investor."

      I am willing to look at any situation, I find the best larger values to be spinoffs. There are often pricing dynamics which generate opportunities. I would love to buy a few well established names below BV that are growing at 10-15% a year, but it's not going to happen unfortunately.

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    2. That is why I said 'I guess' I disagree because I think that values for large stocks are around more often then you think.

      How big is your watch list for small cap stocks? I would guess 100-200 that you check daily/actively and another 200-300 that you look at (or setup alerts) if it goes to a certain price. Or you could just look at once a month. I would guess if you did the same thing on large caps you would have strong returns.

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    3. Stock Chump,

      I wish I could keep track of something like that, but I can't. I don't have a watch list, if I have anything close you're reading it. I'm terrible at doing the structural things in life, like keeping a watch list and updating it. If it was automated maybe I would check.

      There are many days I don't even check the market. I get annual reports mailed to me so I find out about most of the unlisted stuff via the mail. Other companies I stumble across on blogs or Twitter, and if I do want to follow something I'll buy a small position, sometimes a share, or up to 100 shares. If it's in the portfolio then I keep up with it.

      You're probably right, if someone had a watch list like that and was active on it they'd have incredible returns. Almost sounds like something a computer can do as well..

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  6. Nate,

    great post, you clearly mentioned the most important aspects of small cap investing.

    From my experience, I would add the following points which make people hesitant to go into small caps:

    - liquidity
    Even long term investors often do not want to risk being "trapped" into an illiquid small cap. I personally do not care if I like the company. Illiquidity usually results in interesting discounts.

    - language barrier
    especially in European markets, many people avoid investing in companies without English language reports. In the age of Google translate this should be not a big issue. Local language only companies usually trade at interesting discounts. (Installux anybody ?)

    - unique risks
    Clearly, small companies face more unique risks than a big diverssified company. However in my opinion, a portfolio of cheap diversfied small caps gives a much better risk /return relationship than any large diversified company.

    mmi

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    1. Google translate may help, but it's not going to really break the language barrier. Apart from making actual errors (sometimes the automated translation is just plain wrong in very misleading ways), there's plenty of cultural things you will be blind to if you just rely on it, and you won't have access to the full set of local research tools. Unless your selection method is very simple and quantitative (and the data doesn't contain adverse cultural differences you miss...), it's likely to be tricky.

      If you speak English and another mainstream languages or two, you have a very large investable universe, perhaps something like 10000 stocks. Is it really worth going down somewhere where you're intrinsically half blind, when you may not have exhausted all opportunities where you can see?

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  7. I've followed your blog for a while - have you ever posted your returns over time?

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  8. Great post. Only thing I don't agree with is the lousy analyst thing. Keep in mind, that many profi analysts are not better in their results despite knowing DCF models, knowing tons of information, looking on the stocks, sector etc all day long. Because experts get not better in projecting revenues and profits with more knowledge, more variables they look at but actually worse.

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