Small Company Stock Investing
This quarter’s letter will be a little shorter as I have been writing quite a bit for MarketWatch of the Wall Street Journal network and Motley Fool. As clients know, for several (not all) of our investment strategies, I prefer to carry a higher percentage of our asset allocation in small company stocks than what many other advisors do. This is so for one simple reason, in general, smaller companies have historically provided more growth than larger companies.
There is a perception that investing in smaller companies is more risky than investing in larger companies. While in the case of start-ups that applies, once a company has reached a certain critical mass, the risk difference mostly disappears. I point out regularly that companies such as General Electric, Microsoft, Pfizer, AT&T, among other large well known companies have been trading 50% to 70% below their historical share price highs for years now.
Since 1982, small company stocks have outperformed large company stocks by about 1% per year. This is a smaller margin of difference than the prior sixty years when small company stocks outperformed larger company stocks by about 2% per year. Further, over virtually every rolling ten year time frame, smaller company stocks have outperformed larger company stocks.
As I pointed out above, over the past thirty years the difference between small and large company stock performance has contracted. Why has this happened? In my opinion, due to two words, globalization and politics. During the past three decades, multinational companies have gained primacy among the corporate universe. This happened as larger companies have often been better equiped to deal with global trade than small companies. It also occured though because politicians helped unlevel the playing field in favor of the larger companies. Why would they do this? One need do more than follow the campaign contribution money.
It is interesting that at a time when we are inundated by politicians with the fact that small companies are responsible for most hiring, that larger companies have been given more advantages via politics than small companies. Right now, we are at a cross-roads. Small companies are already at a disadvantage in the market place versus large companies from the standpoint of regulation. Will that continue? It is a coin flip from what I can tell. While unpopular, the health care reform favors small companies over large companies. We will see what happens with that. If small companies continue to get the short end of the regulatory stick, then it might indeed be time to rethink asset allocation strategy.
From a current investment standpoint, there does appear to be an opportunity for certain small company stocks to outperform. With less small company competition surviving, those that do survive can make very large returns on their share prices. The trick of course is finding the survivors.
Small companies that make it past the non-profitable, in danger of failing stage, are those companies which we can look to for winning stocks. Below is a chart I use to describe what I am looking for.
If we can identify a company after it has made it past its “start up” or “birth stage” identified on the left hand side of the “S” chart and invest as it has achieved a measure of stability buoyed by positive business developments, then we have the makings for a fine longer term investment. Right now, many of those companies are involved with oil shale exploration and production. I have written extensively about these companies at MarketWatch.com and encourage you to browse those articles which talk about some of our specific holdings.
Now, to be sure, from time to time, the market treats small companies, profitable or not, as potential “failure” candidates. In those cases, it is up to us to make a decision as to whether or not we agree with the market. More often than not, if a company is making money, or has been making money, and nothing material to its long-term survival has changed much, then short-term price swings are an opportunity to buy, not sell.
Emotionally, the volatility of small company investing can be disconcerting on a stock by stock basis. But, with adequate diversification, an overweight in small company stocks offers the greatest growth potential for a long-term investor.
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This letter contains forward looking statements that may not come true. Past performance does not guarantee future results. This letter is intended for informational purposes only, and reflects only my thoughts and opinions in general, and do not constitute individual advice. Opinions expressed may change without prior notice.