[#throwback] Small Caps and Micro Caps: An Outline

This is another old article I wrote for my uni investment club. I’ve learnt a lot since I wrote this piece, especially after working part-time during uni in a extremely well run microcap fund. (Although I am currently working full time as a management consultant, my interest in stocks and investments have never waned). An update to the below article:

  • My previous thinking to the advantages of micro-caps and small caps to uni students are just plain wrong.
    • 1) Cheaper brokerage cost per share does not create any advantages because on an absolute basis (the brokerage cost itself), there is no difference between microcaps and large caps. To effectively evaluate brok
      erage cost, you have to see it as a % of total amount.
    • 2) Amazing price growth potential is just looking at 1 side of the coin. Microcaps are by nature a more volatile and less liquid asset class than large caps. Hence, while it can have amazing price growth, it can also turn the other way very suddenly (as I have found out firsthand). The impact a large buyer/seller has on the share price is more pronounced in micro caps due to its illiquidity. Nevertheless, you can turn this proverbial lemon, into your lemonade. Due to the large swings in price, if you do your work and have patient money, you can find some undervalued gems.
      Some large-cap fund managers found out the high volatility the hard way when large swathes of insititutional money came to the smaller end of the ASX markets over the past few years. Now, they have reversed the tide and pulled the money back to the large-caps, leaving large falls in price in some microcap shares.
  • The only advantage that I think microcap has is that due to its structure, it is more inefficiently priced and attracts less large/more sophisticated investors
  • My portfolio is now predominantly micro caps and is more or less a highly concentrated portfolio. I am in Warren Buffett and Charlie Munger’s camp:
    • “If you are a professional and have confidence, then I would advocate lots of concentration. For everyone else, if it’s not your game, participate in total diversification. If it’s your game, diversification doesn’t make sense. It’s crazy to put money in your twentieth choice rather than your first choice. . . . [Berkshire vice-chairman] Charlie [Munger] and I operated mostly with five positions. If I were running $50, $100, $200 million, I would have 80 percent in five positions, with 25 percent for the largest.” Warren Buffett
  • I hardly go into commodities investing. This is perhaps due to lack of research and my general laziness, but I have always found it a strange business where you can do everything right and have the lowest cost of production and the right deposit, but you are still at the mercy of the commodity price

It’s a bit of a long one, so without further ado here it is below…

Small Caps and Micro Caps: An Outline

“Investment is essentially the arbitrage of ignorance.” Jim Slater

In my opinion, the share market’s valuation of investments is usually correct. Usually being the key word here. In terms of the whole market, there will be occasions when shares will become overvalued and undervalued to a wide degree. Essentially, this is the method which you create money in investments. You have a differing opinion on the valuation of a certain asset and you back that opinion by investing in it. Through research, you form your ‘value’ for the stock.  It does not matter if you are a day trader or long-term investor, a value or growth, a “big-picture” or a “trend” investor; you are essentially aiming to profit from value discrepancy. The subject of this article is small caps and micro caps, two groups of stocks which are more likely to be mispriced.

I first got interested in small caps and micro caps companies due to the opportunities they offer. It was during my reading of the Zulu Principle, by Jim Slater, that I was exposed to their advantages, and also their disadvantages. Zulu Principle was one of the first books that I had ever read on investment strategies, and it was one which yielded me an idea that has been quite profitable (to date it is my most profitable idea yet, on a rate of return basis).

The terms ‘small caps’ and ‘micro caps’ are used to categorize shares by market value (or market capitalization). Market capitalization is calculated as share price times the number of shares outstanding. ‘Micro cap’ stocks are anything under $250 million market cap ; while small caps are usually between $250 million and $1 billion (in my opinion).

The basic advantage of small and micro cap stocks was referred to in my introductory paragraph. Small and micro cap stocks are less likely to be well researched by professional stock analysts and followed by the big funds. Contrary to the large cap stocks, which usually have an entourage of stock analysts and is owned by a lot of the major funds. “You are therefore more likely to find a bargain in this relatively under-exploited area of the stockmarket.” This is the core strategy of the Zulu Principle, that is, to find and develop an edge and focus on it. The principle is similar to Warren Buffet’s margin of safety.

These groups of shares are also suited to university student investors because of their usually cheap prices. The advantages are two-fold. Firstly, since it is cheaper and you could get more shares with a small amount of money (let’s say $2000), mathematically your brokerage costs per share will be less cost per share as opposed to buying expensive shares. Secondly, because they are usually start-ups, their price growth if they do become successful can be amazing. Fortescue, which I will talk about further down in this article, achieved a price increase from $0.05 to currently be $6.15, with a high of $13.15 (that is a 123fold increase if you invested at $0.05. N.B. That is a BIG if. A more realistic situation is if you invested when it was $1, which is still a 6 fold increase)

However, disadvantages are also present with these two groups of stocks. Always remember that behind each stock is a business entity. As with any companies on the start-ups stage (which is usually the stage on which micro and small cap stocks are on), there are high failure rates. Only a handful of these companies will make it large enough to be included in the benchmark index of Australian shares, the ASX 200. This is why diversification is particularly useful in a portfolio consisting of small companies. Moreover, since it is not as covered by a lot of stock analysts, there will often be a lack of information on the companies regarding history of its management amongst other things. This is one of the main impediments in picking these groups of stocks, since it is imperative to research the stock well due to the high failure rate, yet sometimes this information is difficult to obtain.

In Taming the Lion, an excellent book by Richard Farleigh, Farleigh outlines the basic five-point checklist for small companies. Firstly, the quality of the company’s management is the most crucial factor in determining its success. Bad management can turn great potential into a disaster, while brilliant management can turn average ideas into a success story. ABC Learning Centre’s collapse exemplifies the result of bad management, whilst Facebook’s success symbolizes the latter (MySpace and Friendster were foreruners). Secondly, is the valuation based on some ridiculous potential? The tech bubble of late 90s is perhaps the most vivid example of this. Companies consisting of a group of teenagers in a room of computers were getting obscene P/E ratios. Thirdly, what is the company’s comparative advantage? JB Hi-Fi (ASX code: JBH) had a unique comparative advantage, which is that their inventories are stored on the shop floors, therefore saving on inventory costs, while simultaneously allowing them to open stores in more shopping centres than their competitors. Fourthly, determine if the business is sustainable, that is, will the business last? Finally, research if the product is actually being adopted by the market and if it has the ability to handle growth.

Fortescue Metal Group (ASX code: FMG) is one of the success stories which ticked all the boxes. Fortescue was a small mining company, which was previously named Allied Mining & Processing. However, in five years it rose to become the one of the major iron ore producers in the world. The arrival of Andrew Forrest as CEO for Fortescue marked a turning point for the company, demonstrating the importance of good management. Forrest had a vision for the company, which was to become the “third infrastructure force” behind BHP and Rio Tinto in Pilbara and eventually to become the “lowest cost, most profitable and safest iron ore producer.” His track record was stained by his previous post at Anaconda Nickel, however his ability to raise capital and his ‘never say die’ attitude in the troubled circumstances provided glimpses of his brilliance which would prove to be vital in Fortescue’s success. The circumstances surrounding the rise of Fortescue must not be overlooked; the mining boom provided the room necessary to sustain Forrest’s vision. If not for the rising iron ore prices and its subsequent boom for mining companies, Fortescue would not have been sustainable. Whilst its valuation might have been ridiculous, it is a case of opportunism for Fortescue. They used their high valuation to build something concrete. This is made only possible by the competency of their management.

This is the price chart of FMG.

Small and micro cap stocks can provide great opportunities. Despite their high failure rate, they can provide the best risk-reward ratio, particularly if diversification is used. One or two stocks which hit it big time can compensate for the part of your portfolio which tanked. Personally, I would not allocate my entire portfolio entirely to small stocks, however it can be a viable strategy if done correctly. Australia’s small market means that a large proportion of the small and micro cap stocks will be located in the commodities sector. Therefore, if you do venture out into small companies investing, it is recommended that you familiarize yourself with commodities and their nature. This includes the rollercoaster ride in share prices resulting from news of mining discoveries and the basis of a particular commodity’s demand.

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