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 giants who have either stumbled or fallen recently -- Bank of America (NYSE: BAC ) , General Motors (NYSE: GM ) , and Lehman Brothers, for example -- they all have had one thing in common: overly complex and encumbered balance sheets and business models.
I'm not saying that analyzing multinational organizations should be easy, but some of these companies have balance sheets so frightening as to make even the bravest investor run for cover. 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, Ticketmaster (Nasdaq: TKTM ) spinning free of IAC/InterActive (Nasdaq: IACI ) allowed the market to openly evaluate the true value of this entertainment-ticketing giant. Since emerging from the backstage of IACI's "multi-brand concert," the value of Ticketmaster's dominant processing franchise was quickly recognized, as live-event promoter Live Nation (NYSE: LYV ) engineered a deal that, basically, rocks.
Or take a look at FMC Technologies, Inc. (NYSE: FTI ) . This conglomerate has seen the wisdom of small, recently simplifying a portion of its operating structure by spinning off its FoodTech and Airport Systems division, John Bean Technologies Corporation (NYSE: JBT ) . This niche equipment maker boasts a solid position in both the industrial food processing and airport-ground-support industry. This relatively tiny, sub-$300M company has revenues in excess of $1B, employs approximately 3,400 people worldwide, has operations in over 25 countries, and sports a 4-star CAPS rating.
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:
- Clean, understandable balance sheets
- Small, niche-market dominance
- Great, sustainable businesses
- 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 owns a tiny, fractional interest in Bank of America through an old synthetic DRIP account, giving the term "it's cheaper to keep her" a whole new meaning. The Motley Fool's disclosure policy is also too small to fail.