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Be a Better Investor Part II: Why invest in small companies?

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I don’t know about you or what the markets think. Personally, when I invest, I’m not looking for 20%, 30%, or even 100%. I’m looking for 3x, 5x, 10x the returns on my money invested.

In order to achieve such returns, I go to the most ignored, the most hated, the smallest, uncovered places of the market. I frequently go over companies with less than $300 million in market cap and I almost always (nowadays at least) look at companies that are sub $100 million in market capitalisation.

The reaction of some of the friends I have working in the financial sector is often negative.

Some call me nuts.

Some call me greedy.

Some call me a risk-taker, overly aggressive.

The list goes on.

Funny enough, I don’t think I’m wrong.

An endless fascination of street investors for a majority of the crowd at least) seem to be on the big stocks. For whatever reason, a lot of folks feel safety and assurance investing in the biggest names via brand recall.

How do I know?


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I work as a marketer with specialist knowledge on investing matters. My investment skills were picked up independently because I needed to assess marketing materials and make judgement calls on things regularly.

My marketing tracking tells me consumers respond best when I write something on big companies and respond badly or show almost no interest when I write on something small and unheard of.

This is an interesting paradigm – mainly because research shows that if you want bigger investment returns or better return on your money, you should look at smaller companies.

This isn’t a matter of arcane science or complicated at all in the slightest. You do not and should not need scientists or academics to tell you this intuitive thing.

Use your head.

Giants can’t keep growing.

Microsoft is a giant. Apple is a giant. Facebook is a giant. So is Macdonald’s for that matter. Can the market capitalisation (the total value of their shares in the market) of these giants go up 5x, 10x, 20x, 30x in the next decade or two?

Maybe.

To do so, all of the giants above would have to grow their revenues or free cashflows by 5x, 10x, 20x, 30x in the same amount of time. Can they do that easily? Is there even that much money in the world for these guys to earn? What’s the probability of these guys going on to grow 20x, 30x, 50x? That’s a big disadvantage to have because it isn’t one that is easily solved. If you already dominate the market, you need to enter a new market. You need a whole new pizza, not the one you have 90% of already.

But smaller companies, indeed, even microscopic companies don’t have that disadvantage.

All of these giants above once started as unknowns.

If I told you I was investing in a software and programming company today that just started in a student clubhouse, you’d call me nuts. That company is Microsoft.

Facebook was started in a student dormitory.

Macdonald’s started as a bloody food cart on the street.

Apple was started in a garage, similar to Microsoft.

These giants today were all small and unheard of companies decades ago. Today, they’re trailblazers everyone wants a piece of – when they’re overpriced, overvalued and already too big to deliver the sort of return a person should be looking for. 3x. 5x. 10x.

Why look for those returns specifically? Why look for 3-10x your money back whenever you invest?

It’s a two-fold problem.

#1 – Smaller companies have a greater margin of safety.

We are not oracles or seers capable of divining the heavenly truths within stock prices by dancing around campfires in a drizzle or building detailed financial models.

We must have the humility and common sense to know that we can be wrong on a drastic level and we must bake this probability of being wrong into our investment decision-trees.

This means that we must ask for far more returns in order to make up for the fact that we can be wrong.

Put another way, it’s like your dad or mom telling you to aim for A+ because if you don’t get it, at least you get a B. If you simply aim to pass and miss, you end up with a fail, which is likely to get you disowned since we live in Singapore.

I’m sorry, you want me to gain a potential $0.20, but you’re asking me to pay $1?

You would not feel happy or satisfied if I told you that you had to bet $1 with me to gain $0,10.

Or even $0.20.

Hell, most of you wouldn’t be happy to bet $1 to potentially gain $1.

Many of you out there would only be happy if you could bet $1 to gain $500 – $1,000.

That is why vast lines of people continue to provide what must be a good clean line of revenue to our government in the form of TOTO tickets and gambling stubs.

Yet when we hit the stock market, everyone suddenly thinks it’s good to risk $1 for $0.10. Everyone suddenly feels that it’s better to have “humility” in aiming low. I hate to break it to you but that isn’t humility.

That’s having an inaccurate understanding of probabilities.

  • Person A buys 100 companies, each giving him a chance of gaining him 10% returns on money sunk in.
  • Person B buys 100 companies, each giving him potential returns of 3x to 10x or even a 100x.

Who takes on greater risk per dollar?

  • Person A takes on $1 of risk for $0.10 of potential gains.
  • Person B takes on $1 of risk for $3 to $100 of potential gains.

A takes on greater risk. Simply by not asking for enough returns, he has agreed to take on greater risk on invested dollars.

In professional terms, I’d call that having a shitty Sharpe Ratio. The Sharpe ratio was developed by Nobel laureate William F. Sharpe and is used to help investors understand the return of an investment compared to its risk.

So how does this link back to investing in smaller companies?

Big companies are likely to deliver smaller gains. Smaller companies are likely to deliver gains of 3x-10x or even 100x – just as the giants of today have done for its investors in the past.

I can hear your questions already.

How is it such opportunities exist? Shouldn’t the market be eating it?

Well, no. The market isn’t doing it.

The truth is that such small companies are too small for the biggest players. Imagine running a billion-dollar hedge fund and having to grow it by 20% a year.

When you go to smaller companies, most of these guys have market capitalisations below $100 million with even less available for trading. You’d have to analyse a hundred of these companies in order to make good money if you’re working with a giant pool of cash.

Why do that when the smart money is to just analyse one big company and make more leveraged bets? That’s what I’d do. And voila, the small-cap (sub $300 million) market space gets ignored.

Aren’t smaller companies more speculative, volatile and risky? Are some of them not outright frauds?

Yes, these are all facts!!!!

But history has also shown us that being big doesn’t mean you don’t get sent home packing. Look up Hyflux. Enron. Nokia. Noble Group. Look at the share prices of Creative from a decade ago till today. Look at the share price of Starhub.

Big is good? Big is safe? Give me a break.

Crappy companies remain crappy companies regardless of size.

A piece of shit doesn’t magically become gold when it is rapidly magnified in size.
If you believe otherwise, I’m willing to store my own fecal matter and sell them pound for pound at the going rate of gold.

Now if you don’t believe that, why believe a big company is safe?

The proper move here isn’t to find big companies because they are perceived to have less risk or less rotten but to buy companies that have good practises and good insider ownership because these companies are far less likely to blow up their own wealth.

Besides, big companies can’t grow fast. They have systems and processes and a dozen approvals because they need to move as a whole. A ten-man team can run a marathon and finish together but a thousand-man team can’t do it quite as easily. They need these processes and approvals to keep things together. Ergo, they are bureaucratic, unable to innovate rapidly.

Management of small companies actually gives a shit about share prices

Say you’re CEO of a small company. Not much in revenue. Not much in earnings, profits, free cash flow. But you started the company so you have equity. Maybe 10,000 shares worth 20% of the total company. Say you funded it with $10,000. Or about $1 a share.

What’s the exit plan after an IPO? Is there an exit plan? For most companies, being small after IPO-ing just means they want to get into the large indexes.

Why?

Why is the penultimate goal to get into the NASDAQ or the DOW or the STI? Because when you get there, the flow of funds is way larger. People buy more ETFs nowadays than they ever did before.

That means when you push your company to a certain size and it becomes part of an index, the access to funds who are now mandated to buy a portion of your company grows infinitely larger than when you were a small or micro-cap stock. Making you, as the CEO, or founding management, very, very, very rich.

We want to be on the side of companies who want to grow share prices.

Further, management in large mature companies are typically there for the salary – not the share price appreciation. No one gives a shit about share prices at big firms because the big firms share prices can’t move up much.

Go down the scale and start looking at smaller companies and you realise you have big insider holdings and big insider buying. These management teams want exposure because they know/want the business to do well. They don’t get paid a lot yet because the company is small and so they’re incentivized to grow the share price.

That’s good for you and me as investors. Look at small companies. Look at small market capitalisation stocks. Look for insiders with significant stakeholdership. Look for insiders who bought huge clumps in the past 12 months. The likelihood is that there isn’t a lot of such companies.

Spend 90% of your time and energy and effort on knowing the business and make a decision from there. You’re way more likely to make a lot of money that way versus buying into well-known names. Look for more returns. Look for a margin of safety.

Look for ways to incorporate safety and common sense into your stock research. Look for evidence of reality/market disjointing. Be contrarian. Dare to go against the crowd. And always be aware you can screw up and look for a margin of safety.

Be a better investor.

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2 thoughts on “Be a Better Investor Part II: Why invest in small companies?”

  1. I wish I could agree with you. But years of experience, I and many others have gone through, investing with minute companies- lots of hype, noises, and no track records had come and go and disappeared much much more frequently than those big names that failed. If Im a newbie, I will take your advice, which seems so logical. But following your silly path of betting on small risky companies, losses after losses, and still continue to bang your head against the wall. You have named some big names, what about names of small, risky companies that have failed? They will filled the thickness of the Bible, as compared to the failed big names in your diatribe.

    Irvine, if some years down the road, when and IF I come across a long write in ST of an Irvine Soh, a billionaire, being featured in ST on Prominent Persons and generously donating millions annually to its ST Pocket $ Fund, from a successful career thru betting on small risky stocks, I will still attribute it to another outlier of Blessings from Heaven. I can safely say those old aging senior ‘retail investors’ faithfully queuing weekly at 4-D/Toto shops since young, will continue to do so till death do them part. Ditto for small, risky stocks investors.

    Reply
    • Firstly, I don’t think a sarcastic comment is necessary. You can disagree and state your view without being scathing.

      Secondly, it is not about buying one or two small caps and expect miracles but a diversified group of small caps can outperform. So it is not true that many unfamiliar names are bad stocks. Case in point, Russell 2000 (the bottom 2000 stocks) outperformed S&P 500 (the biggest and most successful companies) in the last 20 years.

      Reply

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