Let me share with you an interesting snippet from the book ‘One up on Wall Street’ by the legendary investor Peter Lynch.
He says that during his time in the market he noticed that fund managers usually refrained from investing in unknown stocks. The key reason he identified for this was that when a fund manager wanted to invest in a computer business and he/she chose a name unheard of and the stock did not work well, then the entire blame would fall on him.
However, if the fund manager chose a well known name that every other fund manager was also investing in like IBM and the stock did not perform well then the blame would fall on either IBM or the markets.
Frankly speaking, it is not so much about small-mid caps or large caps, it is about putting in countless hours of research, due diligence, discussions, etc. that helps create wealth. It is about trying to understand what one is investing in than simply giving tags.
In this email, let me share with you why we largely invest in small/mid cap stocks.
Easier to Understand – We only invest in companies that we can understand easily. From the business model to the product, we try our best to study every inch and nook of the company that we are about to recommend to our clients. For that level of detailed research to be possible we have to choose companies from our circle of competence.
Lesser Moving Variables – Once we invest in a company, we track the developments regularly and also notify our subscribers as and when we notice any substantial change. These changes can be both internal (like a CAPEX plan) or external (like shortage of raw material supply). With small/mid cap companies such moving variables are few and hence much easier to keep track of.
Undiscovered – Most institutions do not invest in companies below a certain market cap; this makes it relatively easier to find growth cum value opportunities in the mid/small cap space. Since these companies are undiscovered, they are often available at decent bargains.
Prefer Owner Operated Businesses – Unlike most large cap companies, most mid/small cap companies are owner operated and the people taking key decisions have a much higher skin in the game. The owner is also personally and emotionally attached to the growth of the business. This is something that we like and prefer having in our portfolio companies.
Potential for Greater Returns – We like companies that have the potential for both earnings expansion and PE re-rating. Imagine a stock delivers an earnings growth of 300% in 5 years. Now, if at the same time the stock gets re-rated from a PE of 8 to a PE of 25, then your return on the stock jumps from 4x to a massive 12.5x. Such scope of PE re-rating is generally higher in undiscovered small/mid cap opportunities.
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