Small Cap Investing: Profiting from Repeated Failure

One of our readers wrote in recently, asking if it wasn't contradictory to suggest investing in small cap growth shares and resource shares while having a fundamentally bearish outlook for global stocks. Of course not!

The best time for small cap investing is in a bull market. Bull markets make everyone look smart. Or, if you prefer a fancier description, the majority of your return in any given investment comes from being in the right asset class, and not from the wisdom of your stock selection. If you buy stocks in a bull market, you'll generally do pretty well.

The trouble is, it's not a universal bull market anymore. Investors have to be more selective now, instead of riding broad indexes inexorably up. Index tracking investors in Australia are actually much better off than their peers in North America right now. The weightings of the resource companies in Australia mean the All Ordinaries has more or less broken free of its slavish correlation with the S&P 500, at least since 2003 (see below)

But if you're not in broad bull market in which you can sit back comfortably and passively enjoy the ride, what do you do?

You have to look at sectors that have broken away from the general trend. In the last few years, that's been energy and resources, which also favours Australia. This also explains, in part, the popularity of the Aussie dollar with global investors seeking both yield and capital appreciation.

We know it's not polite to say in financial company, but it doesn't appear to us that looking for big growth in bullish sectors has much in the way to do with careful balance sheet analysis. Balance sheets and income statements reveal what's already known about a company - which is great if you're looking for long-term blue chip growth or steady income. By all means, review the financial record in detail.

Small cap investors are careful security analysts. They comb balance sheets, hoping to spot a mistake. They look for mis-priced assets, discounts to book value, and a margin of safety, to use Warren Buffett and Benjamin Graham's terminology.

And god bless the small cap value investors. They can have good years when the market itself goes from bear to bull and the small caps as an asset class go from laggards to leaders. It's like a giant piece of elastic snaps and moves the small caps with balance sheet value from the back of the queue to the front.

The real challenge with this approach is that you have to find the market's mistakes. In liquid markets, where there are a lot of analysts and traders, this is nearly impossible. You have more of an advantage in places like Australia, where not all companies are followed by analyst. But for that advantage you take on liquidity risk. It's hard to buy and sell these little gems, provided you can find them. You must be prepared to hold them for a long time. How long?

That's another problem. You have to wait for the mis-priced assets to be revalued. If you have a lot of time and are patient, this won't be a problem. But don't expect a quick bang for your buck.

But even assuming you're right about the mistake and have the patience to wait out the market's mistake, your return is effective capped inasmuch as value stocks rarely trade at huge premiums to book value or earnings. And if you're a faithful value investor, you sell them when they become expensive anyway.

We prefer to look off the balance sheet when it comes to small cap investing. That is, what you're really looking for is what hasn't happened yet, that discrete event that can't be priced into the stock because it isn't known yet.

Small cap growth happens when a company's product finally hits it big. Or when intellectual property is suddenly - for some reason - worth a lot more than the balance sheet value. Or, with a mining company, it could be the discovery of a vast new ore body.

Whatever it is, good small cap speculations are like long-dated call options on growth that don't expire. There's time decay in the sense that your capital is tied up while you wait. But what you're basically buying exposure to a high-magnitude, low probability event. Your risk is that the event never happens.

However, the frequency of your losers shouldn't matter in this respect, if you cut your losses or invest in small amounts you can afford to lose. An investor could lose nine out of ten times and still come out aheadif he's cutting his losses... AND his one winner is a ten bagger.

Please note, what we've described above is certainly not what you'd call "safe". So what's the benefit?

Well, right now there are a lot of investors looking for beaten down value in the financial stocks. Reading this yesterday, we were reminded of what author Nassim Taleb said in July at the Agora Wealth Symposium in Vancouver.

He said that investors have too much respect for the wrong businesses. This is especially true of value investors search for value in banks and bankers right now. As Taleb said, "Banks are businesses made for dull people who talk slowly and don't seem very bright. But it's the riskiest business you could think of because it's prone to big explosions."

Throw in some non-dull bankers, and you get even bigger explosions. So why go fishing in that ocean? You're more likely to catch a hand grenade than a good dinner.

"We should have more respect for businesses that are prone to positive black swans... like biotechnology... big pharma... technology... and mineral exploration stocks," Taleb said.

By positive black swans, he meant businesses in which failure is a regular part of the business plan, but in which the winners are so big...the business is still worth being in (and investing in).

The best way to get these positive black swans is to build a portfolio of speculative experiments in high growth industries where there is a large dollop of the unknown... like alternative energy. No one knows which technology will work at a commercial level. Most will fail. But not all.

You also want to invest in good people when you can. Good management is especially important in small firms. And you want to avoid debt.

But mostly - if you're asking us how we got about finding stocks that make money (as opposed to chronicling financial Armageddon), we believe you invest in the types of stocks that can go up a lot really quickly...not the sort of stuff that's under priced and might correct or be mean reverting. You want stuff that will have to be repriced because of some massive change... that's not already reflected the balance sheet or the income statement.

Dan Denning
The Daily Reckoning Australia

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