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 giants who've stumbled to varying degrees over the last year or so -- Ambac Financial (NYSE: ABK  ) , General Electric (NYSE: GE  ) , and Goldman Sachs (NYSE: GS  ) -- 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 Byzantine balance sheets that would make the eyes of even the most scrutinizing investor bleed. 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 Coach (NYSE: COH  ) was spun off by Sara Lee (NYSE: SLE  ) , several years back, that it was really able to show off its wares. Since emerging from the depths of Sara Lee's "kitchen junk drawer," Coach, the purveyor of fine leather goods, has shown impressive growth. Despite recent weakness, this focused, aspiration brand has been a luxurious multibagger since going solo.

Or take a look at the Brink's Company (NYSE: BCO  ) . It has gone the small route, recently simplifying its operating structure and balance sheet by spinning off its home security division, Brink's Home Security (NYSE: CFL  ) . While the spinoff boasts an install base of more than 1 million customers and the remaining parent presides over 50,000 employees with global security operations in more than 50 countries, both companies sport market caps well under $2 billion. Now investors should have an easier job deciphering which publicly traded entity has the most room to run.

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. Coach is a Motley Fool Stock Advisor recommendation. The Motley Fool's disclosure policy is also too small to fail.


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