It is often said that small investors (i.e. non-money managers or institutional investors) lack the ability to compete with larger investors due to a disparity of information. However, there are many approaches that small investors can take to either level the playing field or minimize the impact of limited information over time. Below, I offer 3 principles that guide my investing protocol that will allow you to capitalize on the strength of being a small investor.
1. Invest in small, under-the-radar companies and those you have familiarity with. Success on Wall Street is about the access to and use of information. Although the rules put in place by the SEC and other regulatory bodies are intended to reduce unbalanced, or "asymmetrical" information, it is well known that insiders, including those involved in companies and Wall Street traders, have far more information at their disposal than independent investors that must rely primarily upon information in SEC filings such as 10-Q's and 8-K's. However, you can take some steps to reduce this information asymmetry. One is to invest in small, under-the-radar investments, such as small capitalization or thinly traded stocks.
While I would be hard pressed to have some information advantage on Cisco Systems, for instance, through diligence I discovered a company largely unfollowed by Wall Street that had an expanding technology and a number of excellent contracts in place. That company was Hughes Telematics (HUTC), a provider of telecommunications concierge services for Mercedes-Benz and fleet management technology that helps firms with major automotive fleets efficiently operate. HUTC, which had a market capitalization of just $200 million, was followed by no analyst and had average volume of just 2,000 shares per day. This limited market capitalization and volume would cause large investors and institutions to drive up the share price dramatically if they were to purchase shares in the public or private markets. After making a significant investment in the HUTC in November of 2010, I was rewarded in May of 2012 when HUTC was purchased by Verzion (NYSE:VZ) for a significant premium.
Although investors cannot reliably forecast acquisitions, it would have only taken major positions by a handful of institutions to drive up the share price of a largely illiquid issue such as HUTC. Likewise, if there is a company in your area that you are familiar with, or an industry that you have inside knowledge of or contacts within, consider investment in those fields. I have been a shareholder for more than a decade in locally-headquartered F5 Networks (NASDAQ:FFIV), a well managed and rapidly growing player in the technology equipment market dominated by Cisco Systems (NASDAQ:CSCO). FFIV has grown four-fold since just 2009 and has risen from just $4 per share in 2002 to $93.91 per share on August 1, 2012. (See my article on the competitive position of FFIV here). Your familiarity will help protect against the typical information asymmetry in the market.
2. Invest on the basis of long-term trends. Large money managers and institutional investors typically report holdings quarterly and therefore operate on a time-compressed basis that can limit their ability to focus solely on the long-term. Conversely, patience is can be a vitally important virtue for small investors, who lack external short-term pressure. It has been shown that investor psychology that leads to short-term decision making can be highly damaging to returns of individual investors.
Not only are rash decisions based on short term volatility likely to be inopportune due to the emotional forces driving short-term decision making, but transaction costs related to excessive trading can increased expense factors as well. By making investments on the basis of long-term shifts in the economy, you can insulate yourself from being concerned with day-to-day or month-to-month shifts in the economy.
For instance, if you have made a long term investment as I have in advanced medical care systems such as Intuitive Surgical (NASDAQ:ISRG) on the basis of an aging baby boom population that will demand expensive procedures into the future, you will be less likely to panic and sell your investment on the basis of a quarterly 5% earnings miss or some other similarly minor event.
3. Learn to analyze your investments. Professional money managers and institutions are often hamstrung by the investment choices they can make. Often they are restricted to particular sectors, regions, or market capitalizations. They are normally restricted to particular asset classes. However, as a small investor, the choice of portfolio construction and asset classes is eminently yours. Learning to analyze your investments in depth and understanding the potential investments across the breadth of asset classes is vitally important to taking advantage of this opportunity as a small investor.
Utilizing the resources on Seeking Alpha, other financial sites, and the rich literature on finance and investing are all positive ways of expanding your knowledge. I advise that investors be adept in understanding the basics of portfolio construction and diversification and financial analysis. Having these capabilities will allow you to stay current on your investments and detect major changes that occur to companies, such as deterioration in a balance sheet or a change in the quality of earnings in a company in your portfolio. Even if you rely on the advice of a professional, having basic competence in these areas will allow you to ask the proper questions as well.