Why I Like Small Companies
(or… how I get to act like a real analyst)
In future posts I will get back to my investing mistakes. Today, I wanted to talk about small companies. Tiny companies really. These are termed micro-caps – for companies under $500m market cap – or nano-caps – companies under $50m market cap (although there are no strict definitions). With over 20,000 companies in North America (US and Canada) somewhere around half fall into the micro-cap category. These companies are generally unknown and unloved by the average investor. Even among professional and institutional investors, these companies are chronically under followed – I’ll touch on that in a bit.
This is my fishing ground. I spend 100% of my research time on companies in this bucket. Of the companies that I am currently invested in only 15-20% would fit into the mid-cap to large cap bucket. The remainder are micro and nano-caps. Most of the companies that I purchased in the last decade were below $500m in market cap when I bought them. I have bought companies with market caps as low as $8m. I am currently researching one company with a market cap of $5m.
Why bother with these tiny companies? First of all, it’s great fun. Exploring these small companies is the wild west of investing. No… a carnival in the wild west. One bizarre example: I once stumbled on a company founded to find Big Foot. In general, I find it very interesting and rewarding to sift through unknown companies both mundane and exciting. It feels very much like understanding the true heart of capitalism.
I gravitated to tiny companies quite naturally over time. I relayed previously that my investment process really improved when I started to focus on value investing and fundamental analysis. At the time when I started with this type of investing all the best values were in tiny companies. If you wanted to invest in a company with a price-to-earnings ratio of 4X, then it was likely a tiny company. And since I couldn’t find anyone who had written any coherent investment cases for these types of companies, I started to do it myself. Over time, I found many people and more resources for this type of investing. The requirement to do my own research remains.
Here is a not-exhaustive list of reasons that I enjoy researching and investing in tiny companies:
It is a good use of analysis time: I’m never going to be a top-flight analyst. I’m an average business analyst at best. I am not going to add much to the discussion of Google or Tesla. There are lots of really, really smart people that are much better connected than me pouring over the largest companies in the world. If I spend a few of hours a week researching a tiny company, over the course of time, I may be one of a handful of people (outside of company insiders) that understand it. This is a significant advantage. I don’t want to compete against the smartest people in the world.
You get to know management: Several years ago, I was investigating a company on a Saturday morning. I had already spent several hours on the company and was starting to come to an understanding of how they operated. I had a few questions that I needed answered, so I sent them off to the investor relations email. I almost always do this – I like to see how they respond to and deal with shareholders. As I was packing up my laptop, I got an email from the CFO who happened to be working. He offered to chat with me about my questions. We spent an hour on the phone talking about the company. I walked away impressed. After the conversation, I reflected that he seemed to know the operating metrics and valuation of all the private and public peers very well. I developed the theory that the reason he knew them so well, was because they were trying to sell the company. A year later, the company was sold at a significant premium. I’m unlikely to repeat this type of experience if I spent 20 hours researching Netflix.
The returns can be fantastic: If you invest in this space, the volatility can be crazy. That is both a feature and a bug. Yes, your investment can drop in value 50% for just about any reason – or no reason at all. But they can also increase in value 100%, 200% and more. I’ve personally owned a handful of multi-bagger companies: investments that have gone up multiples of their value. Think 2X, 3X, 5X or more. I have not had a “ten-bagger” yet – that is an investment that goes up 10X. I’m hopeful that there is one in my future.
You meet interesting people: Once you are involved in the micro investing space for a while, you will meet some interesting investors. There are both retail (non-professional) and professional investors in the space who are very generous with their time and knowledge. I would have imagined that this was a very stingy space. Who in their right mind is going to give away a great investment idea? I find the opposite is true. There are so many small companies, and we aren’t going to be able to investigate them all, so sharing is the norm. Plus, for these small companies to be successful they must eventually be discovered by larger groups of investors. As a result, investors in the space are happy to share investment ideas and talk about yours.
·Professional investors won’t look at them: Most professional investors won’t be able to invest in these tiny companies. If you run a fund with $5 billion dollars, you won’t be able to invest in a $50m company, you won’t even be able to invest in a $500m company. Most funds won’t want to own more than 10% of a company because it increases the disclosure requirements. A $5m investment in a $50m company is just not going to move the needle for a big fund.
I’ve never worked on Wall Street and probably never will. I do feel like I do solid business analysis on these smaller companies. And because of the institutional and other constraints, I feel like I can add value to the process that impacts the returns I experience. I still occasionally invest in larger companies, but I spend hardly any time doing analysis. Rather, I look at a variety of published analysis covering the companies I’m interested in. There are great resources to learn about virtually any large publicly traded companies, and I’m happy to use them when I shop in that space. However, in the micro-cap space, there is no substitute for rolling up your sleeves and doing the analytical work yourself.
