More Thoughts on Small Cap Investing

On October 4, 2010, I wrote a post entitled Small Stock Investing: The Path to Riches?, which outlined some of the differences between investing in small caps and large caps.

The post considered the idea that there is more opportunity in small caps. Upon reflection, perhaps it would have been better to make the distinction between micro-caps and large-caps, as micro-caps – stocks with market capitalizations less than $250-300 million – are more the area of the market I was writing about.

I have a few more thoughts on this thread.

I don’t think there is as much opportunity in this area as there was when Buffett was operating his partnership. There were no value-oriented hedge funds scouring the market with computer screens, so the market was less efficient. In 1963, there were 284 candidates for the CFA. In 2007 there were nearly 100,000 CFA charter holders.

Munger has made the point that the Great Depression so shell shocked equity investors that it caused a lasting multiple compression that created a period of opportunity for early value investors. Using Munger’s metaphor, now, when you run your Geiger counter looking for mispriced micro-caps, it may not click. The practical implication here is that to operate in this sector – given the potential paucity of candidates – you may find yourself reaching for companies of questionable quality.

A point that was made in the prior post – but that deserves re-emphasis – is that Buffett was an exceptionally gifted investor. He was the only student to get an A+ in Ben Graham’s investment class and is widely acknowledged as the best investor of his generation, if not all time. The point is that investing in micro-caps can be tricky. These companies don’t typically have the resilience of large caps and the lack of information that contributes to their mispricing may make it difficult to determine their intrinsic value.

For what it’s worth – and it may say more about me as an investor than the risks of micro-cap investing – I have lost more money in this area than in investing in large caps. Perhaps it would be prudent to “cut your teeth” in large or mid caps and prove to yourself that you know what you’re doing before seeking opportunity in micro-caps.

A case in point of the challenges of micro-cap investing is the example of Paul Sonkin. Sonkin is a hedge fund manager who specializes in micro and nano-cap investing (market caps under $50 million). Bruce Greenwald has looked at Sonkin’s trades and concluded that his initial positions were only minimally profitable and that the majority of Sonkin’s returns came from buying more stock as the price declined below his original purchase price. This means that Sonkin had to have a high degree of confidence in his valuations to be able to buy more stock as the priced declined. This could be a recipe for disaster if you didn’t know what you were doing.

Finally, a couple thoughts regarding Buffett.

First, Buffett points out in his partnership letters that he had a built-in hedge when investing in under-valued micro-caps. If he established a position and the stock went up, he made money. If the stock price stayed low, or declined further, Buffett could keep buying and eventually acquire a controlling interest in the business. He could then unlock the value in the business by changing management. Very few investors are in a position to utilize this hedge.

Second, Buffett did not put all his eggs in one basket. He made three types of investment in the partnership: 1) undervalued securities (what he called “generals”), 2) workouts, and 3) control situations.

I am not trying to discourage investing in micro-caps, but rather trying to point out some of the challenges so that, if you decide to do so, you will maximize your odds of success.