In chapter nine of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks,” author Ian Wyatt offers new insights about small-cap stocks.
He began with the observation that investment analysis is no longer about access to information—that has now become available to everyone. Instead, the challenge is finding the right information while filtering out the irrelevant.
Small, unknown companies provide investors with an edge because they are below the radar and ignored by most other investors. When the companies succeed beyond a certain point, they become known entities, demand for their shares goes up and prices rise, sometimes exponentially.
Wyatt wrote that all his best-performing small-cap winners had similar signs of success:
- Growing revenues.
- Expanding profit margins.
- Cash flow from operations.
- Inexpensive valuations.
Ultimately, he said, success always depends on two key metrics:
“But there remains one consistent truth: Companies that grow their revenues and earnings over the long-term will see shares of their stock appreciate considerably."
“No matter what indicators you use to find good values, it invariably comes down to revenues and earnings. These key drivers of a stock’s price over the long-term directly affect share prices. This is a simple and powerful truth about investing.”
To underline his point, Wyatt noted that some of the biggest stock market successes of all time—such as Cisco (CSCO, Financial), Dell (DELL, Financial), Microsoft (MSFT, Financial) and Walmart (WMT, Financial)—grew from their initial public offerings by growing their revenues and earnings at an “incredible pace.” As they kept improving their financial results, their share prices kept rising.
For example, when he recommended BankRate (RATE, Financial) in 2002, revenues were $15 million; six years later they had grown to $166.9 million, an increase of 1,012%. Earnings per share grew from a loss of 7 cents to $1.01 by 2008. Those results were enough to drive the share price up 5,500% in the same period.
The share price of True Religion Apparel (TRLG, Financial) increased 3,100% between 2004 and 2008, driven by revenues that had increased 875% and earnings per share that grew 815%.
In both cases, the share prices increased more quickly than the growth rates of revenue and earnings per share. Wyatt attributed that to valuation multiples, which grew as the companies enhanced their track records. With these enhancements, individual and institutional investors began following these companies and bought shares. Wyatt observed, “This means that instead of a stock trading at 20-times EPS, the valuation multiple may increase to 25 or 30-times EPS or in some cases, much higher.”
He followed up by adding that multiple expansion allowed investors to quickly capture profits, in a simple case of supply and demand.
Those following the herd believe they are getting in on a good thing, yet they are more likely to experience mediocre than outsized profits. The problem is they are buying good or great companies at “outlandish” valuations. Once a stock reaches such valuations, it can see its price driven down dramatically by any suggestion of bad news.
The moral of the story, of course, is that prudent investors will buy these stocks at an early stage—after doing fundamental research and due diligence. He cited Warren Buffett (Trades, Portfolio) as saying, “If you wait for the robins, spring will be over.”
At the same time, Wyatt pointed out that not every promising small cap will become a winner. As a result, portfolio diversification is essential, as he argued in chapter eight. In chapter nine, he offers three strategies for diversifying the small-cap holdings within a portfolio:
- Own between five and 15 individual small caps.
- Own one or several small-cap mutual funds (containing 50 to 200 stocks each).
- Own small-cap exchange-traded funds; the iShares Russell 2000, for example, includes 2,000 individual stocks.
An investor might also use some combination of the three strategies. But be wary of diversifying too much because it may lead to diluted performance. Wyatt wrote that he is satisfied with owning 10 small caps at a time; anything much more would be too hard to follow.
He went on to argue that small caps outperform all equity classes in the long term. And while short-term volatility could be higher with individual small caps, a diversified portfolio of them may be no more risky than mid- or large-cap stocks.
When markets hit the skids, expect small caps to decline faster than the rest of the market, but as the market recovers small caps will recover sooner. Wyatt cited a T. Rowe Price report that found “in the 12-month period following the end of the last nine recessions, small-cap stocks on average gained 24 percent, compared with a 17.6 percent gain for the S&P 500.” A study from Merrill Lynch reached similar conclusions.
Most investors will head to safety when a serious slump occurs, opening even more opportunities for the prepared. At the trough, small caps should be deeply undervalued, even as they are poised to outperform other equities and securities when the market recovers.
Wyatt’s personal manifesto is: “Like most investors, I’ve had my share of winners and losers. My goal is to limit the losses of my investments, while maximizing the upside by holding onto great companies for the longer term.”
Summing up, in this final chapter of “The Small-Cap Investor: Secrets to Winning Big with Small-Cap Stocks,” Wyatt outlined several important considerations for small-cap investors. They include the crucial importance of growing revenues and earnings; how valuation multiples can exponentially expand those gains in revenues and earnings; the importance of finding small caps before they become well known; the importance of diversification within a small-cap portfolio; and the exceptional opportunities available to small-cap investors as markets recover.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
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