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 worldwide, making us all wonder how low stocks can go. Everyone is stunned by the dramatic collapse of the corporate colossus of the day. Finally, governments intervene, and 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 global giants who have either stumbled or fallen recently -- Royal Bank of Scotland (NYSE: RBS  ) , ING Group (NYSE: ING  ) , and Mitsubishi UFJ Financial (NYSE: MTU  ) , 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 a grown CPA cry.

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 
I believe 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, look at the simple but clever business model of discount broker thinkorswim (Nasdaq: SWIM  ) . The company has used its financial education division, Investools, as both a revenue source and a customer acquisition engine. This has helped it out-stroke industry peers optionsXpress (Nasdaq: OXPS  ) and TradeStation (Nasdaq: TRAD  ) . thinkorswim's value has not gone unnoticed, as TD AMERITRADE seeks to complete a swimmingly handsome acquisition of the online broker.

Or observe pawnshop operator and payday lender First Cash Financial (Nasdaq: FCFS  ) . At first glance, this "financial services" company may seem to you nothing more than a subprime bottom-feeder. However, in a tight credit world, banks have become increasingly stingy. These companies provide a much-needed, albeit costly, source of liquidity to those who can't or don't use banks. Beliefs aside, First Cash, operator of 320 pawn stores and 205 short-term loan centers, has delivered a real payday to investors. Over the past 10 years, the company has returned close to 19% annualized returns to shareholders.

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 posses a nimbleness that can lead them to 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, looking for:

  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.

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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. optionsXpress Holdings is a Motley Fool Stock Advisor recommendation. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool's disclosure policy is also too small to fail.

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  • Report this Comment On April 21, 2009, at 3:19 AM, rajeevsingh111 wrote:

    Well there are compelling reasons for investing in both large and small caps, just because few of the large companeis failed doesnot mean that all large companies are going to follow suit.. while I agree that

    1. Smaller companeis do offer greater chance of capital appreiation over long term . This also because they carry higher risk than large cap companies. SO higher the risk , higher the return.

    2. I also feel understanding a small company is easier than a large company, but , that is no guarantee for a superior returns on smaller companies.

    My take is that both large and small caps have their inherent strengths.

    Small caps can get your richer faster but not sure they will do so always, while large caps will mostly get you decent returns . Chenches of them failing you is much lesser than small caps.

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