He’s been called the best investor of all time. In multiplying every dollar invested in 1964 by a massive 490,409 times over a 46 year period, Buffett has left every investor aside in the investing game.
However, despite such an enviable track record and so much wealth, there is one reason Buffett envies you – the small investor – a lot!
Yes, that’s true…and Buffett has himself claimed this time and again.
You still don’t believe me?
Well, here is what Buffett said in a Business Week interview in 1999…
If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then.
It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.
The universe I can’t play in i.e., small companies has become more attractive than the universe I can play in, that of large companies. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.
In short, what Buffett indicated in the above statements is that he wished he had less money to invest!
He said, “It’s a huge structural advantage not to have a lot of money,” because when you invest small, you have a far greater chance to earn far greater returns than someone (like your fund manager) who is investing millions of rupees.
Also, as Buffett said, the small investor has an advantage over the big investor because he can invest in small companies, or the mosquitoes that are much attractive than the elephants (the large companies).
What is more, Buffett defended his 1999 statements in a 2005 interview, when he said…
Yes, I would still say the same thing today…You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map – way off the map. You may find local companies that have nothing wrong with them at all…
So there you are. As a small investor, you don’t have to sit on the sidelines when most large caps – or the ‘market darlings’ as they are said – are trading at overpriced valuations.
Instead, identifying unknown and mispriced small-cap opportunities is a great way for you to grow your wealth when others around you are running after the known and overpriced names.
Small caps! Aren’t they risky?
First, we have discussed this time and again on Safal Niveshak that ‘risk’ comes from not knowing what you are doing.
So if you are ignorant about the business models of known names like Suzlon or SKS Microfinance, even these are like dynamites waiting to burst in your hands (sorry, these have already burst!).
However, if you have studied and are comfortable with an ‘unknown’ name like Graphite India, go get it (wait, I’m not recommending this stock but just using this as an example!).
So remember this – risk comes from not knowing what you are doing.
But, as Buffett says, if you can identify “local companies that have nothing wrong with them at all”, buy them.
Of course, the proportion of small companies that can go out of business is much bigger than the large companies that can face such a fate, but this shouldn’t deter you from looking at this pack – the small caps – with interest.
Small companies – the good ones – have a lot of advantages to offer you that large caps don’t. Advantages like…
- Small caps are the ‘ignored kids’ of the market, and thus often mispriced in relation to their intrinsic values.
- It’s easier to double the sales, and thus profits, and thus market capitalization of a small company than a large company.
- Small caps are mostly illiquid (few shares traded daily) so while you can buy them, the big investors like mutual funds can’t, as they have restrictions on buying illiquid stocks.
- Small caps often get re-rated – P/E ratios rise faster – when more and more investors come to known about the ‘story’, so the earlier you get in the more you can make during the re-rating.
- Small-companies are nimbler than large companies (remember the unsinkable Titanic?) and thus can change direction when disaster strikes.
The biggest advantage you have while investing small caps is that if you are an expert in some businesses, or have a good knowledge about small, local companies, your insights can give you an edge over other investors.
But look before you leap!
Remember what I said above – the proportion of small companies that can go out of business is much bigger than the proportion of large companies that can face such a fate.
In simple words, if 1 out of every 10 large companies can go bust, 5 out of every 10 small companies can face this fate.
This makes small caps investing more risky.
Plus, small caps are more volatile and thus can give your heartaches if you aren’t prepared.
Also, as I said above, they’re much less liquid – if bad news hits the company, you may not be able to sell your holding quickly, or only at a very low price.
And finally, they are arguably more prone to get impacted by the rapid variations in human behaviour – the hypes and investment manias you see.
So, for all the great prospects that good small caps can get you over the long term, you need to be very watchful on the kind of company you are laying your hands on.
As Buffett reminded everyone, just because he would love to invest in smaller companies doesn’t mean he would change his underlying strategy.
He still wouldn’t speculate in companies he didn’t understand. And even you shouldn’t.
Vishalji, though it looks good on paper, it is a humongous task to find a good small cap stock, atleast here in Indian market where companies go kaput including some big names. One of Buffett’s favorite thing to do is go through couple of thousands of financial statements every year. I did a much smaller exercise of going through the small cap list of NSE and could only come up with, may be 1 or 2 stocks at the max, that was just ok to invest. The business dynamics are changing, morals have gone out in the wind, the very reason to be listed in the index for a company is because they think their business could become a good investment for the shareholders – 80-90% of the listed companies don’t have this underlying concept for being listed. It’s a difficult world :(. I know I am cribbing too much of small cap, my ignorance could be a reason for it. Happy Republic Day.
Vishal Khandelwal says
Indeed you are right that a majority of of the companies out there don’t have the underlying concept for being listed, but you can still find the ones that worth investing for the long term. Pulling out good small caps is also a tough task, but then if you can identify even a few of them over your investing career, you’ll create a lot of wealth for yourself. The idea however must be to not go overboard with small-caps and keep a small portion of your money in them.