There is something alluring about the small company. For an investor, small companies offer opportunities, since small things, if well cared for, have the potential to get bigger. That's basically what investing in small companies is all about. The hope is not to catch the next Microsoft in the earliest stages of its stock market life. Instead, the aim is to invest in something small in the hopes that it will get bigger, whether measured by the number annual sales dollars it collects, the number of widgets it sells, or its capitalization in the marketplace.
(As an aside -- perhaps useful, perhaps not -- it's true that Microsoft (Nasdaq: MSFT) was a small company at one time, but it was never much of a small-cap per se. On the day of the firm's IPO in 1986, Microsoft's valuation was on the order of $525 million or so. That's indeed puny compared to the company's market cap today, but it was by no means small by 1986 standards.)
Some investors have a tendency to turn their noses up at small companies for a number of reasons, most of which are undeserved. Obviously, finding good small companies entails a decent amount of legwork on the part of the investor, which is an instant turn-off for some.
Also, the glossy financial magazines, while quite often fun to read and of general use to investors, don't run cover stories very often on small companies. By and large, it is the largest companies that get the most media coverage, since they tend to be the ones most familiar to the widest reading audience. There may be an issue or two a year devoted to small companies -- typically a "best of" list of some sort -- but that's about it.
A look at Business Week's archives over the past five years shows 19 cover stories devoted to just six different companies -- Microsoft, IBM, Apple, AT&T, General Electric, and Sun Microsystems. The number of cover stories on small companies over that span? Three. (To boot, all three small company issues were promoted with the same flashy "Hot Growth Companies" title. Go figure.)
This lack of coverage extends to sell-side analysts as well, who for all intents and purposes are Wall Street's version of the Fourth Estate. Small businesses are not viewed as the type of customers who will bring in big investment banking fees, so they are often ignored as matter of course by the big research firms. Likewise, a large investment firm's major institutional clients are usually so large themselves that adding a few small companies to their billion dollar stock funds would be like adding a few twigs to a bonfire. So demand from both sides of the Wall Street aisle -- from the buy-side as well as the sell-side -- is weak as far as small companies are concerned.
This lack of coverage by both the media and by the professional analyst community opens up potential opportunities for investors willing to devote time and energy to studying small companies. But this does not mean that all small companies are good small companies and thus worthy of an analyst's time. In fact, it is generally tougher to find great businesses among the small shrubs than amid the tall trees.
Large firms as a group tend to generate better returns on equity and capital than smaller companies, which is one reason why large companies command bigger relative valuations than small companies. In fact, the relationship between large business size and large business returns has been a major theme of corporate America over the past few decades. According to the stock screener at Quicken.com, better than one out of four companies with annual revenues of $500 million or more has also generated at least a 15% return on equity over the past year. For companies with less than $500 million in annual revenues, the number claiming a greater than 15% return on equity is closer to one out of fourteen.
A long-term strategy devoted to large, exceptional businesses is an appealing option for an investor, and can make a great deal of sense if executed properly. Little wonder, then, that there is an entire investing strategy devoted to such large, exceptional businesses (we call them Rule Makers) right here at the Fool.
On the other hand, a good small company does not need to be bent on changing the world in order to generate respectable business returns for its owners. Innovation or latching onto the new way of doing things can generate tremendous returns for shareholders, especially for the leader in an emerging business area.
However, a company does not necessarily need to be the leader of the trend in order to benefit from the trend. As noted small company investor Ralph Wanger has pointed out with a dusty example from the past, railroads were the major business trend of the mid- to late-1800s. But plenty of money -- in fact, more in some instances -- was made in areas that were tangential to the railroads' development, such as in real estate in important rail cities such as Chicago and San Francisco.
Likewise, it's possible for a small company to make good business returns by operating successfully in just a small niche, rather than in leading the way in a large emerging trend. Surely, owning companies fitting the latter criteria can be quite rewarding as well, and that's what the Rule Breaker strategy is all about. But for investors who are not averse to owning companies that operate beyond the reach of the bright spotlight, small company investing outside -- or downstream -- from the major trend offers a different yet still potentially profitable alternative.
The key question now is how to find the good, small companies that are out there. A list of possible firms, based on a certain mix of business and market criteria, would be a good starting point. In future columns, we will be discussing just such a system for finding potentially good small companies. We call it the Foolish 8. Starting with this small idea, it is our hope that big things will develop for the small company-oriented investor.
