Should you invest in smaller companies?

To me, investing is about making the most money possible while taking the least possible risk. To do that, you need to figure out where the big gains exist. Study after study has shown that over the past 100 years, smaller companies share prices’ have outperformed larger companies—often by a massive margin.

Let’s face it, Wal-Mart (NYSE:WMT) is a well-run company. It could double in the next five years. Maybe it could triple. Could it go up 5-fold? Unlikely. 10-fold? Forget it. Yet, there are thousands of smaller companies that will go up 5-fold and hundreds that will go up 10-fold or more in the next five years. The problem is finding them, learning what they do, and figuring out why they are going to go up. This has been my job for the past decade. I have had dozens of companies go up 5-fold for me. Some have even gone up 10-fold and 20-fold.

Too big of a risk?

People always claim that smaller companies are speculative, volatile and risky. Some of them are outright frauds. These are all facts. The events of the past year have shown that large, well-respected companies can also have plenty of these same characteristics. Many of these well-respected companies no longer exist—others trade at fractions of their former price.

Let’s face it, investing is all risk. Economic conditions are always changing. If you don’t want risk, buy a government bond. If you’re willing to take on the risk of owning a large company that could potentially go to zero, you might as well own a smaller one that can at least reward you with 5-fold upside over the next five years (5 in 5’s). How many large companies will go up 5-fold from here?

Finding the 5 in 5’s

You certainly need to be diversified when investing in smaller companies. They are more volatile and more speculative than larger companies, but a dozen positions are usually plenty of diversification. You do not want to dilute out your winners. Having fewer companies also means that you get to know them all better. In the end, small cap investing is all about finding those stocks that can become 5 in 5’s yet not losing badly on your mistakes.

People often wonder how it is that 5 in 5’s exist in the market. The truth is that these little companies are too small to generate investment banking fees—so there is rarely any research about them. They’re too small for most institutional investors to care about—so they’re not very well known. They slip through the cracks of the Wall Street establishment.

It takes time and effort to find these companies—but the rewards are unlike anything that you can achieve when investing in mature companies. Mature companies cannot grow fast. They are bureaucratic, They cannot innovate rapidly. At mature companies, management teams are there for the salary—not the share price appreciation. This is because most mature companies are fairly valued, to begin with. Even the management teams realize that there just isn’t that much upside.

In comparison, smaller companies are often mispriced. The management teams often have significant equity stakes in the business. Smaller companies are leaders in innovation and can grow rapidly from small bases of revenue and profits. The combination can lead to spectacular upside.

There are plenty of great companies out there—but unless you can find those that become 5 in 5’s, it just isn’t worth tying up your capital—or taking on the risk.

—

DISCLAIMER: This article expresses my own ideas and opinions. Any information I have shared are from sources that I believe to be reliable and accurate. I did not receive any financial compensation in writing this post, nor do I own any shares in any company I’ve mentioned. I encourage any reader to do their own diligent research first before making any investment decisions.