In a previous post, I discussed how individual investors have a significant advantage over professional money managers: they don’t face the pressure of outside capital being redeemed. This allows them to adopt a long-term investment strategy, regardless of short-term market fluctuations. In contrast, professional fund managers must consider short-term performance to retain investors and assets under management. But there’s another equally powerful edge that often goes overlooked: the benefit of managing a smaller capital base.
Why Small Capital is a Big Advantage
Publicly traded stocks can be broadly categorized by market capitalization (“market cap”). Market cap is calculated by multiplying a company’s current stock price by the number of outstanding shares. For instance, a company with 20 million shares and a $30 stock price has a market cap of $600 million. Among listed companies, market caps range from a few million dollars to several trillion dollars, creating a vast and diverse investment universe.
However, institutional investors and large investment funds operate within constraints that significantly narrow this universe. Consider a fund with $1 billion in capital (a modest sum in the institutional world). If the fund follows basic investment constraints such as (a) holding at least 25 different stocks and (b) owning less than 5% of any one company’s shares, then it can only invest in companies with a market cap of at least $800 million.
Theoretically, the fund could expand its universe by holding more stocks, but greater diversification often dilutes potential returns. As the old adage goes, there’s no such thing as a free lunch.
The Freedom of Small-Cap Investing
Now, contrast this with a private investor investing a few million dollars. This investor is free from size constraints and can invest in virtually any listed company, regardless of market capitalization. That includes micro-cap and small-cap stocks, which are often overlooked by large funds.
So, why invest in smaller companies?
The primary reason is that there’s far less competition. Fewer analysts and institutional investors are scrutinizing these stocks, which increases the likelihood of mispriced opportunities. For value-oriented investors like myself, this inefficiency can lead to highly attractive returns.
Small-Cap Stocks: High Risk, High Reward
In my own experience, many of my most successful investments have been in companies with market capitalization under $200 million. These businesses typically had no sell-side analyst coverage and limited institutional ownership (a sweet spot for independent investors doing their own research).
Of course, small-cap investing comes with its own risks:
- Financial Vulnerability: Smaller companies often have less access to capital and weaker balance sheets than their larger peers. During events like the COVID-19 pandemic, many of these businesses struggled to survive.
- Liquidity Risk: With fewer buyers and sellers in the market, it’s harder to quickly enter or exit positions in small-cap stocks. This can create volatility and execution challenges, especially in times of market stress.
Final Thoughts: Where Research Pays Off
Despite these risks, I believe there is no segment of the market where careful, fundamental research can produce greater returns than in small-cap stocks. For the patient, disciplined investor, managing a small pool of capital is a major advantage.
