Stocks Too Small to Fail

There will always be days in the stock market that make Chicken Little's claim that "the sky is falling" look like an overly optimistic weather forecast.

During the worst of times, we endure the seemingly endless drops in the major stock market indexes that make us all wonder how low stocks can go. Everyone is stunned by the dramatic collapse of the corporate colossus of the day. Finally, it ends with some form of government intervention, as these tin titans are quickly declared "too big to fail." The sudden disappearance of once-solvent organizations should make us all reexamine our portfolios and ask if bigger really is better.

The bigger they are, the harder they fall
This adage may be better put as “the bigger they are, the harder they are to follow.” When we look at some of the largest distressed companies of 2008 -- Fannie Mae (NYSE: FNM  ) , AIG (NYSE: AIG  ) , and Citigroup (NYSE: C  ) -- they all have one thing in common: They operated as virtual black boxes.

I'm not saying that they don't provide all the disclosures required by law, but these organizations have portfolios and balance sheets that would make the head of even the most sophisticated investor explode. In October 2004, our own Bill Mann presciently and appropriately declared Fannie Mae "unanalyzable."

When Warren Buffett references his "too-hard pile," he isn't merely offering platitudes, but applicable advice for all intelligent investors. When he says he only invests in companies he understands, and looks for hurdles that he can step -- versus jump over -- he is giving sound advice on humility and on recognizing your own competency in a given area. So how do investors increase the probability that they find stocks they can truly value? Go small.

Little things mean a lot
The average investor has a much better chance of interpreting the balance sheet of small companies with market caps under $2 billion. These companies have what I term "human-scale" operations that are reasonably interpretable. In addition, they tend to have relatively simple business models and management teams that are more interested in day-to-day execution than corporate empire-building.

For example, it wasn't until Middleby (Nasdaq: MIDD  ) jettisoned its refrigerators, freezers, and deli cases -- all in all, more than half the company's products -- and turned its focus intensely toward commercial ovens that this former turnaround story begin to heat up. In contrast, a company like United Technologies (NYSE: UTX  ) , which is classified into six divergent business segments, makes everything from food-service equipment to elevators to military technology. Investors may find it a bit difficult to accurately value a company like this, with revenues originating from such unrelated industries.

Or take a look at Buffalo Wild Wings (Nasdaq: BWLD  ) , a wings-and-a-beer concept with about 550 restaurants in 38 states. This Minneapolis-based restaurant chain has quite a bit more room to run than Darden (NYSE: DRI  ) , which juggles more than 1,700 Olive Garden, Red Lobster, Bahama Breeze, Smokey Bones, and Seasons 52 restaurants.

There are only so many hours in the day, and the best companies focus on what they are best at during those precious 24.

Small companies can mean huge payoffs
So, why should investors sweat the small stuff? Research by the likes of Aswath Damodaran, Nagel and Quigley, and Ibbotson Associates examines more than 80 years of stock market history and confirms the long-term outperformance of small-cap companies. In addition, Dimson and Marsh found that small companies outperformed larger ones by 7% annually over a 29-year period in England, while Bergstrom, Frashure, and Chisholm found similar effects in France and Germany. But even without the studies, it is clear that smaller companies simply have a larger pool of both customers and markets to explore.

Of course, small companies come with their own dangers. The possibility of large returns sometimes goes hand-in-hand with a higher level of volatility and a risk of total capital loss on the worst-performing small caps. Therefore, stock selection is paramount when adding them to your portfolio. That's why the Motley Fool Hidden Gems team scours the market for only the best small companies that offer:

  1. Clean, understandable balance sheets.
  2. Small, niche market dominance.
  3. Great, sustainable businesses.
  4. Dedicated, vested management.

Good things can come in small packages
Even in the worst of times, there are sound, small companies that firmly stand their ground in the midst of market turmoil. These remarkable companies are often led by dedicated management teams that actually grow stronger during the "bust" times as their competitors fall by the wayside.

If you need a little help finding great small companies with clean balance sheets and excellent growth prospects, click here to try Hidden Gems. You can check out our top two new stock ideas, plus all of our past issues, free for 30 days.

Fool contributor Andy Louis-Charles does not own shares of any company mentioned in this article. Middleby and Buffalo Wild Wings are Motley Fool Hidden Gems picks. The Fool owns shares of Buffalo Wild Wings. The Motley Fool has a disclosure policy.

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  • Report this Comment On December 12, 2008, at 5:41 PM, bardwa wrote:

    Be wary of small stocks. One that you recommended this spring is Birch Mountain Resources. It had every reason to be profitable - market - product - location but it still went bankrupt. As one who was formerly in the gravel/rock business, I thought I could understand their business plan, but apparantly not well enough.

  • Report this Comment On December 12, 2008, at 9:47 PM, jamesgambrell wrote:

    Always know the EXACT reason you bought the stock.

    When that reason no longer exists, sell it. Don't look for new reasons to hold it.

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