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 re-examine 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 -- Freddie Mac (NYSE: FRE  ) , MBIA (NYSE: MBI  ) , and Morgan Stanley (NYSE: MS  ) -- they all have one thing in common: They had portions of their organizations that 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 and Freddie "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 Chipotle (NYSE: CMG-B  ) was jettisoned by McDonald's that it was really able to stand out. Since emerging from the depths of the burger behemoth's balance sheet, the "fast-casual" Mexican concept has grown from less than 500 stores to just under 800 restaurants in about 33 states. Chipotle could comfortably double its footprint -- twice, perhaps -- before saturating the market, while McDonald's, with more than 30,000 restaurants worldwide, would be hard-pressed to follow suit.

Or take a look at Grand Canyon Education (Nasdaq: LOPE  ) . This recent for-profit university IPO boasts a respectable enrollment base of approximately 15,000 students and revenues that have doubled since 2005. Given its size, this Phoenix-based educational upstart has quite a bit more room to run than its hometown competitor, Apollo Group (Nasdaq: APOL  ) , which juggles more than 350,000 students and seven different university brands.

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, ones 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.

This article was first published Dec. 6, 2008. It has been updated.

Fool contributor Andy Louis-Charles does not own shares of any company mentioned in this article, but does order a bowl of cilantro-lime rice with a side of guacamole quite frequently. Chipotle Mexican Grill is both a Motley Fool Hidden Gems and a Rule Breakers pick; the Fool owns B shares of Chipotle. The Motley Fool has a disclosure policy.


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