This is guest blog post from Tom Beevers, ex-Portfolio Manager at Newton and now CEO and Co-Founder of StockViews.
My Own Thoughts:
Continuing from the last post which can be found here, my own experience over the years is that small to mid cap stocks offer the most interesting risk/reward ratios. The inherent problem with blue-chip stocks are that investors often pay too high a premium for perceived business stability. Any idea taken to the extreme can lead to disastrous outcomes.
Howard Marks in a recent interview remarked how investors who had invested in them lost 90% of their money by 1973 when the shares collapsed.
I’ve attached the valuations of the original Nifty Fifty, and some of the names are instantly recognisable to most of us:
Original Nifty Fifty Valuations pic.twitter.com/pusttmmX5F
— Jun Hao (@theasiareport) September 16, 2015
Exploring the Universe
Of course finding these opportunities is not easy. There’s an almost infinite pool of small cap stocks in a diverse range of industries and it’s impossible to study all of them. A substantial amount of work needs to be done before you can conclude that the stock is materially over-priced or under-priced.
This is why I’m passionate about the ability of crowdsourcing to uncover hidden opportunities.
Even the largest research firm can’t hope to uncover a fraction of the best opportunities in the market. But an army of smart people all looking at stocks that Wall Street has no idea about – this is something that crowdsourcing was made for.
Of course smaller cap companies have risks. They typically don’t have the breadth of products or depth of management expertise and they’re constantly under attack from larger competitors. However, like with any investment, these are risks that can (and must) be factored into your analysis.
On the flip side, smaller cap stocks have advantages that large caps don’t – growth is easier to generate from a smaller base, and they are better adapted to change in a fast-moving industry. Financial dogma tells us that small caps must be more “risky” because they are more volatile.
This is bunk – the measurement of beta is a very poor substitute for understanding the risk profile of the company.
As Warren Buffett has said “risk comes from not knowing what you’re doing”.
But for a small cap strategy to work it will take time. Anomalies among small caps can remain for a long time precisely because they are not well covered. What’s needed here is something that’s in very short supply on Wall Street: Patience.
While these investors are waiting for the anomaly to close, the vacuum of information leaves them vulnerable to fear and uncertainty. They crave validation from the market and when they don’t get it they begin to question if they took the wrong path. I leave you with the words of Benjamin Graham, the father of value investing:
“Traditionally the investor has been the man with patience and the courage of his convictions who would buy when the harried or disheartened speculator was selling.
If the investor is now to hold back until the market itself encourages him, how will he distinguish himself from the speculator, and wherein will he deserve any better than the ordinary speculator’s fate?”
– Benjamin Graham, Security Analysis