Small Cap Foolish 8 Eight Reasons to Love Small Caps

For those who do their homework, there are several reasons why investing in smaller companies can be a much more profitable and rewarding experience than investing in the giants. Below are eight of those reasons.

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By Paul Larson (TMF Parlay)
October 23, 2001

[Starting next week, the Small Cap Foolish 8 column will run on Monday instead of Tuesday. Stop by then for more great insights on small-cap investing!]

Researching and investing in small capitalization companies is a totally different ballgame than doing the same with the behemoths that make up the S&P 500. My experience has been that the due diligence legwork is easier and the investing experience more rewarding with smaller companies, businesses such as those put forth by the Foolish 8 screen. In general terms, here are eight reasons why sometimes smaller is better.

1) Simpler to understand
By their very nature, smaller companies are, well, smaller. This generally means that a company will have a shorter list of products and markets to serve, which means that investors have fewer things they need to research. For example, it's much easier to research the competitive positioning and market potential of a one-drug biotech company than it is to investigate a pharmaceutical giant that may have dozens of therapies on the market. Smaller companies have fewer moving parts, and that means fewer parts to scrutinize.

2) Ability to do primary research
My second reason for liking small caps is related to the first. When a company is smaller and has only a handful of products, it's much easier to actually go out and test the products for yourself. Moreover, visiting a single factory is much easier than racking up the frequent flier miles to check out all the operations of a larger company. Want an example? Reread the Motley Fool Investment Guide to find out what the early investors in Iomega (NYSE: IOM) did when Zip drives were first hitting the street.

3) Growth comes easier
The third factor for liking smaller companies comes from a simple mathematical relationship. When working off a smaller base, it takes a smaller amount of incremental revenue to create a certain amount of percentage growth. A company with $100 million in revenue adding a new product and creating an additional $100 million worth of business can double its size, while a $2 billion company adding the same $100 million product barely grows 5%.

4) Motivated management
Top management at small companies tends to be made up of folks that actually founded the company, and founders generally have a much larger equity stake in the firms they run. The larger the equity stake, the more motivated a manager will operate. I much prefer having top management's personal dreams and fortunes on the same line as my investment than having managers who are merely filling a position and collecting a salary.

5) Easier access to top management
It's also easier to actually get hold of Presidents, CEOs, and CFOs at smaller companies than at the corporate goliaths. Not that management is any less busy at smaller firms; there just tend to be fewer layers of red tape between investors and managers, and fewer investors and analysts vying for management's time. It's much more preferable to get information and insights straight from the horse's mouth instead of through a press representative.

6) Shareholder control
On a similar note, active shareholders interested in helping their companies tend to be noticed more and their ideas taken more seriously with smaller companies than those investors in the giants, and this is especially true when one can get the ear of top management. Moreover, really active shareholders can even find themselves elected to the Board of Directors of smaller companies if they own a large enough stake. Example -- small-cap gaming company Shuffle Master (Nasdaq: SHFL) today has a former Fool community member sitting on its board.

7) Potential for higher returns
Though small-cap companies may be riskier than larger companies that have longer track records and a wider variety of business lines, that higher risk comes with the potential for much higher rewards. Still, investors who truly do their homework and watch their companies like hawks can greatly decrease their downside exposure while maintaining the potential for an enormous amount of upside return on their investments. It's much easier for a small-cap company to see its stock increase 10-fold inside two years than it is for a giant already carrying an 11-digit market capitalization.

8) Flying under the radar
I think I've saved the best reason for liking small caps for last. Smaller companies tend to be less widely followed on Wall Street, and many institutional investors simply don't bother to research investment opportunities presented by smaller companies. The smaller the pool of investors watching a particular company increases the likelihood of market inefficiencies, and market inefficiencies create golden investment opportunities for those who do their research.

Of course, with all eight of these reasons I'm talking in general terms and painting with a very wide brush, and every company and situation is unique. That said, for those who do their homework, there are reasons why investing in smaller companies can be a much more profitable experience than investing in the giants.

Paul Larson owns several small-cap stocks as well as many large-cap ones. You can see which ones online thanks to The Motley Fool's progressive disclosure policy.