Too much good advice can sometimes be a bad thing. Carrots are good for you, and your grandma was right when she told you to eat them. Eat too many, though, and your skin will literally turn orange. I would argue that this is a suboptimal outcome, since the marginal benefits of consuming an additional carrot likely pale versus the marginal loss of having orange skin.
This analogy describes how I feel about a recent article published on Seeking Alpha, titled Don't Assassinate Your Small Investor Advantage. The author, Evan Bleker (publishing under the profile name Jae Jun), presents a very compelling, well-reasoned, data-supported case for individual investors to consider focusing on small companies. If you haven't already read it, please do so before continuing.
The article starts with a very true statement:
Rather than strategy or temperament, the most significant advantage that small investors have over the Wall Street crowd is that they're not subject to institutional constraints.
It then proceeds to note that many institutional investors simply cannot invest in micro-caps (which is true) and that historically speaking, smaller stocks have yielded higher returns (also true). Yet from a true premise and objectively true, verifiable data, the article takes a wrong turn into an errant conclusion:
"Small investors constantly do themselves a disservice by investing in medium or large cap companies, thereby locking horns with a massive herd of professional money. This is a bad way to invest.
If small retail investors want the best possible returns when picking their own stocks, then they owe it to themselves to invest in small stocks."
Constraints and Externally Imposed Mandates
So let's start with the premise. Institutional investors have constraints. Here is a brief, non-exhaustive list of things that fund managers may be constrained by:
- Market cap, volatility, sector, dividend yield/distribution policy, leverage metrics, valuation metrics, liquidity, security type, corporate social/environmental policy, etc…
There are other constraints as well. For example, index funds must buy a stock whenever it is added to the index, regardless of whether that stock is overvalued or undervalued. They must similarly sell a stock whenever it is dropped.
It is obvious to any first-year management student who has read The Goal or played around with Solver in Excel that constraints are bad. Constraints lead to suboptimal solutions. The more severe constraints you have, the worse the bottleneck, and the worse the "solution". Small constraints are typically unlikely to significantly impact outcome. We all have constraints, and that's okay. Personally, I choose not to invest in companies involved in the manufacture and distribution of alcohol or tobacco (though this avoidance does not extend to second derivative companies, such as those that produce glass bottles or cigarette filters). Given that sin companies make up a very small percentage of all those traded in the capital markets, my constraint is unlikely to significantly impact my portfolio returns.
But stricter constraints can lead to much worse outcomes. Take, for example, the tragic case of a tech fund manager at the height of the dot-com bubble - or a fund manager when real yields on the long bond were close to negative territory. Such a manager is screwed, and if he's smart, he knows it. What, then, is he to do? All he can do is try to find the "least bad" option - but the "outperformance" of losing a mere 30% when similar funds lose 40% is small consolation. If you didn't have that dumb constraint, you could've not lost any money at all - or better yet, even earned some.
While we'll circle back to this topic later, for now, take away one key point: constraints lead to suboptimal outcomes. So it is indeed true that individual investors have an advantage over their institutional peers, in that individual investors have no externally imposed mandates.
The Fallacy of Division
While I hate to jump around, it's important to understand a separate topic before we return to the idea of constraints. That topic: the logical fallacy of division, which is a fancy name for saying what is true of the whole is not always true of the parts.
This is particularly relevant when it comes to statistics and averages. Consider two groups, each of which contains 10 people. Group A has nine fresh college grads (who each earn $40,000 per year) and one Fortune 500 CEO (who earns $10M/yr). Group B is entirely homogeneous, consisting of ten lawyers, each of whom earns $200,000 per year.
If I can still do arithmetic at two in the morning (which is not guaranteed), the average person in Group A earns one million and change (where change is operationally defined as $36,000). The average person in Group B earns $200,000. Yet it is certainly not true that a randomly picked person from Group A will always earn more than a randomly picked person from Group B - in fact, 90% of the time, a randomly picked person from Group A will earn merely 20% of a randomly picked person from Group B, despite the fact that the supposed average person in Group A earns 5x as much.
This is obviously an extreme case. However, it demonstrates a point: averages cannot be considered without accounting for other factors, such as variance, heteroskedasticity, etc. Nobody in Group A actually came within 9x of earning $1M per year, despite that being the average.
And so it is with stocks. While the variance is not so extreme, the article's overreach should now become clear. Do small-cap stocks outperform large-cap stocks, on average? Yes. Does that mean every small cap stock will outperform every large cap stock? Hardly. There is no such thing as the average stock - each has its unique characteristics, and off the top of my head, I could name five or six large caps that are demonstrably superior investments vis-a-vis a very large number of small and micro caps. And that's not even the end of the application of the logical fallacy. Just because small-caps outperform large-caps, on average, over a sufficiently long time frame, does not mean that they will necessarily outperform over every timeframe. While I'm not in the business of studying indices or valuations for entire asset classes, it is certainly worth noting that small caps have had quite the rally of their own - and not just over the past year, either.
Yet the article's conclusion is - and I quote - small investors "do themselves a disservice" by investing in mid-cap or large-cap companies. That's clearly a bit of a stretch.
Now we can go back to constraints…
Combining the two concepts we've discussed leads to an interesting conclusion: by misinterpreting the statistically superior historical returns of small-caps, investors may begin to ignore large-caps and other categories of stocks, thus introducing constraints to their investing style.
But wait, didn't we just agree constraints are bad?
Sure, a constraint to only buy small stocks may be "less bad" than a constraint to buy only household names. It's no myth - small caps do tend to do better over time, for many reasons. But it's still bad to restrict yourself to only investing in tiny companies, especially in periods when small-caps are overvalued - or whenever there are more attractive large-caps to be had.
Investors impose constraints on themselves all the time. Some retail investors, for example, only invest in companies that pay growing dividends, which severely hampers their long-term returns and can lead to myopic disregard of fundamental analysis. But I've seen self-imposed constraints among professional and semi-professional investors, too, and they mostly revolve around small caps.
These investors have the idea that they're smarter than everyone else because they've developed this unique, super-special strategy of focusing on the areas that others don't. To cater to such investors, Seeking Alpha has even developed a new article category titled "Small-Cap Insight". By and large, this small-cap strategy has served my friends well: their portfolios have generally experienced very strong returns.
However, there have been numerous times I've shared large-cap ideas with other investor friends of this persuasion, and their response was almost always along the lines of "thanks, but it's too big". One went as far as to say that I was wasting my time looking at big companies - kid, don't you know all the opportunity is in micro-caps?!?!?!?!
Well, on average, maybe so. But at the end of the day, I care about one thing and one thing only in the investing world: the money I earn. And looking at the following chart, I sure am glad that I didn't say "nope, the market cap's too big for there to be any value here." Not to say I told you so, but… small-cap friends, I told you so.
Despite all the small-caps in my portfolio (and trust me, there are plenty), I'm pretty sure HPQ was either my biggest or second-biggest winner over the past few years. It was neck-and-neck between that and Gramercy Property Trust (GPT), and I'm too lazy to figure out how much of each I bought and sold when and what the annualized return worked out to. They were both very lucrative investments. Point being, when something's trading at 4-5x FCF with no imminent risk of going bankrupt, does it really matter if it's a small company or a large company? Actually, I'd argue that a larger company is probably better, since the cash flow tends to be a bit more diversified and less levered to specific products, customers, etc.
To reiterate what I said earlier, I completely agree that there is likely, ON AVERAGE, more opportunity in smaller, under-followed stocks. However, over the past few years, I have identified numerous large-cap opportunities that presented the opportunity for substantially above-market returns with substantially below-average risk. By investing in these as well as selected small-cap and micro-cap names, I've achieved higher total return that I would have if I'd constrained myself to either category.
So really, my counterargument to the mostly well-written article is simple: I agree that individual investors shouldn't assassinate their advantage. If you're free from mandates, why impose them on yourself? You're only going to limit your returns. Money in your pocket is agnostic of where it came from; your favorite restaurant or grandma doesn't care if your money came from a micro-cap with a lower asset value than the average hedge fund manager, or from a multinational big enough to buy Greenland.
Over time, various asset classes may grow more or less attractive. At any specific point in time, specific securities in certain asset classes may be more or less attractive. There's only one strategy that allows for maximum returns: a go-anywhere strategy that allows you to invest in whatever provides the highest risk-adjusted returns. If you're hunting value, then don't ignore it because it's too big. Size doesn't matter if easy profits are staring you in the face.
There always is one, isn't there? I will admit one small caveat: time is limited. As such, there is an argument to be made that investors should spend more time focusing on the areas (aka small-caps) where more value is likely to be found. I find this hypothesis reasonable. However, this does presuppose, to some degree, that investors randomly go "looking" for value until they find it, and that looking in small caps is mutually exclusive from looking in large-caps. I don't believe this to be the case. I do both quite happily.
The real individual investor advantage is that you don't have anyone to answer to but yourself (and maybe your wife). At the end of the day, all you care about is earning money. So yes, you should certainly be cognizant of the areas where the most money can be made - small, unloved, underfollowed stocks. The fund I work for generally gravitates towards such companies, and I agree with our strategy 100%. That being said, we don't focus on these to the exclusion of all others, and you shouldn't either. As Mr. Mackey would say, that's bad, mmkay? Large caps and mid caps can make nice friends too.
Author's note: If you enjoyed this article, please share it with your friends, colleagues, and fellow investors.
Appendix: Other Minor Quibbles And Broad Thoughts
I have a few assorted smaller quibbles. For example, the article doesn't address the substantially higher risks associated with investing in small companies (especially those under the $50 million market cap threshold he mentions). While it is true that smaller stocks are less analyzed, and that net-nets have theoretical downside protection due to their asset base, the fact is that market participants aren't blind (which also brings up the point that there really aren't that many net-nets out there anymore). I'm by no means a believer in the efficient market hypothesis - mispricings occur all the time. But companies don't often trade below the value of their stated assets for long without either A) somebody noticing and buying it up or B) there being a "reason" for the way it trades. By extension, the same theory usually applies to firms trading at absurdly low multiples on earnings.
Much more common than outright mispricings on plainly obvious financials is mispricing due to incorrect first-level analysis. What is first-level analysis? It's a term I picked up from my friend and mentor Thomas Finser, who is one of the smartest fund managers I know. (If you follow me, you should definitely follow him - he's got way cooler things to say than I do.)
First-level analysis, essentially, is when you don't go deep enough. First-level analysis can often miss important details that change the investment story. Deeper analysis beyond the first level can be quite fruitful. As merely one example, in his write-up of LCAV a year ago, Thomas pointed out that the company owned equipment that originally cost $65 million; it was fully depreciated on the book at a mere $6 million. Recent sales of some of these lasers, however, occurred at over 2x book. This $6 million difference was actually quite significant, given that the company's enterprise value at the time was roughly $30 million - the potential for realizing higher-than-book value on asset sales significantly reduced the downside risk in a scenario where the operating business continued to face challenges. This can cut the other way as well - a supposedly cheap firm may have contingent liabilities or hidden dilution that a quick overview would miss. First-level analysis can take other forms as well. As I discussed in a recent article about Wells Fargo (WFC), consensus often relies on overly simple mental models.
Anyway, just a few bonus thoughts. Thanks for reading.
Additional disclosure: I am long Wells Fargo warrants.