How Big Can a Small-Cap Stock Be? And Other Topics

The growth of retail investing over the past year has been incredible and is poised to increase from here. In this episode of MarketFoolery, Chief Investment Officer Andy Cross discusses that phenomenon, why we may need to rethink the definition of "small caps," and Airbnb's need for a strong second half of the year.

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This video was recorded on July 13, 2021.

Chris Hill: It's Tuesday, July 13, welcome to MarketFoolery. I'm Chris Hill, with me today, the Chief Investment Officer, Andy Cross. Thanks for being here.

Andy Cross: Hey, Chris, thanks for having me, I always love being on your shows and talking stocks and talking businesses.

Hill: Earlier this month on Motley Fool Money, Jason Moser, Emily Flippen, and I did a look ahead to the second half of the year. I wanted to get your thoughts on this because I've said before that I think that cybersecurity best in industry has now moved its way into what I think of as the must-have in a portfolio. Like if you have a diversified portfolio, you've got 20, 25 stocks. You look in your portfolio and you don't have any exposure to cybersecurity, you need to rethink that because I just think the future is so promising for that industry. That's one of the things I'm going to be watching in the second half of 2021, but what about you?

Cross: Well, Chris, I didn't know you were going to mention cybersecurity. I think that is definitely one. I'll mention something differently but I think looking at cybersecurity in the market, companies like Zscaler, like CrowdStrike, which we've talked about before and recommended, The Motley Fool. I think exceptional companies are both founder-led, both businesses with really high growth rates, adding to their revenue profile, expanding their products. I think you're dead-on with cybersecurity. That's a great one to watch. I am really just fascinated by the whole move on the retail investor understanding and the looking at what they are doing in the market, how much they are putting into stocks. You and I are individual investors and we love our retail investors. We really have seen this exceptional growth. I mean, this year, JMP Securities had estimated that 10 million accounts were opened at brokerage houses just this year alone, matching all of 2020. You look at the amount of money going into equity funds, they're at record levels, $28 billion put into stocks in just June alone and that was the highest since 2014, $580 billion, almost $600 billion went into global stocks funds during the first half of this year. That was a record by a long shot and if that pace just continued, Bank of America estimates that for the year that pace continued for the year, that would match the amount of money that retail investors put into equity funds and global stock funds of all the past 20 years. 

You're seeing a lot of exceptional activity going into the retail investors. We know what's going on with Robinhood. We know what's going on with the meme stocks. So much wealth is tied into the financial assets today at record levels, according to the Federal Reserves. So I'm just really interested to see how that trend continues. We basically lapsed a year when we first started seeing the COVID impacts, Chris, and we started seeing a lot of money flow into our savings accounts from the federal government and from lots of other stimulus that is still out there, that is still happening to some degree, and there's still a lot of money saved. The savings rates have really spiked over the last few months and over the last year or so. How that money gets deployed as we start to change our spending and buying habits. Whether that starts to not be as interesting to put into stocks and invest or trade into stocks. Especially if markets start to go through a little bit of a low I'll say, they don't always just go up from the lows of 2020. I'm really interested, just continue to watch this explosion of retail investing in trading and in one way, I'm super excited because I love to see more people getting invested and getting involved in what we think is the greatest legal way essentially to create wealth for regular people out there. So, I love seeing that. I hope it continues in a healthy way. When I see some activity out there as we've talked about it over the years. It does start to look just a little bit frothy to me.

Hill: I know that one of the categories of stocks that you look at are small caps. I'm wondering if you think we as investors need to recalibrate what we consider to be small caps as a category. Just because we're now living in a world where there are companies with market caps north of $1 trillion. When you and I were starting out, there were professionals in the financial industry who would tell you, if a company has a market cap north of $1 billion to $2 billion, it's no longer a small-cap. I'm wondering if now we need to ramp up what we think of small caps as anything under $10 billion or maybe even on anything under $20 billion?

Cross: Yeah, maybe they do vary, Chris, and I think certainly sometimes we don't index ourselves to inflation there. When Tom, Bill, and I were running Hidden Gems and we're looking at small cap companies, we're looking at less than $2 billion and we've now steadily raised that ourselves as we think about our small-cap investing strategy up to as high as $7 billion, maybe even higher. I think you're right, you do have to start to understand how the markets and the impact of these large caps and the successful, these massively successful companies like Apple, Microsoft and Google [Alphabet] and Facebook and the rest and so many global companies as well too. Just markets grow over time and so we have to catalog, we have to recognize that. We do have to adjust our expectations. Just one quick anecdote. I was talking to one of our investor analysts recently and he mentioned the term "unicorn." I haven't really heard the term "unicorn," which is a company that becomes public and north of $1 billion in market cap. I hadn't really heard that term in a long time, at least a year. That's because if you're not coming in at a $1 billion market cap, you're like an afterthought. It's like why even bother? Because these companies are becoming public at such huge valuations now. So I think we do have to recognize and catalog and think about how we think about market capitalizations. 

There are so many large companies out there that if you are looking more at the small cap market. Looking at the really micro side level, you have to be careful with that because you might be looking at a lot more speculative mini penny-stock companies that probably deserved to be down that level.

Hill: Yeah. The idea that a unicorn in the private markets, its valuation is over $1 billion. If we're going to keep the term unicorn, we're going to have to raise the ceiling on that to $100 billion.

Cross: Exactly. I was like what number do we go to and what funny name can we think about. Maybe listeners can email you in with some fun name to think about the valuations of some of the companies that come public because we're just seeing really over the past two years, we've seen these outrageous valuations for some of these IPO companies.

Hill: When I asked Jason and Emily about, look, the market's up more than 14% the first half of the year, that's great. There's no reason to think it can't continue in the second half, but not everybody had a great first half. When I asked them who needs a strong second half of the year, they mentioned Peloton and Quidel. I'm curious when you look at the universe of stocks out there, what's a business that you look at and you think they really need a strong second half?

Cross: Well, it's one of the businesses I like and it's well-known and speaking of unicorns that just came out at a very lofty valuation, as Airbnb (ABNB -0.46%). But the past few months have been a little bit rougher for Airbnb now. They had a really challenging period from late 2019 through 2020 when they saw their gross bookings fall somewhere in the 40% range when they saw just travel, just slowed to a crawl, if not go in reverse. But now we're going to start to see that on lock. I think the stock activity of the past year is as we think about this new economy post COVID, how do we think about our travel? How do we utilize Airbnb? What services are they providing that consumers really need and really want? What is the regulatory risk for those hosts out there in different cities as we start to see more and more regulation creep up around different municipalities in different cities toward Airbnb hosts and providers? Consumers start to see other options now. Hotels are reopened; they're doing a really very nice job on all the COVID protocols. 

I look at Airbnb, and see a stock that's down. We have a market cap that's, gosh, now probably $85 billion, a few months ago it was north of $100 billion-$115 billion, so you've seen the market react. Well, how is Airbnb going to benefit over the next year? I think it is truly short-term. However, the long-term advantages and the competitive advantage to Airbnb, I think, continues to get stronger and stronger over time. They made some changes to their website, and enhanced their business. I think they have a leading brand position. I really like the spirit of how they support their host, it's a very diverse host clientele, and I like that. It really supports entrepreneurs in that way. So Airbnb is one that I'm really interested to watch, and I think long term over the next three to five years, it can do quite well, but I do see this year being a little bit of an inflection point as people start to normalize their expectation for Airbnb, the stock, tied to the business as we start to reopen.

Hill: Look, obviously, Airbnb is competing with the hotels and vice versa. But I'm wondering if you think there is a degree to which they each have a little bit of a moat against the other with respect to who are the people who are doing the booking. Because I look at Airbnb and for all of the attractiveness of the business, I don't see it as being particularly compelling for business travelers. That's both great in some ways that they don't have the risk because business travel is returning, but it's returning slowly and it's going to be a while before it gets back to the levels that it was at in 2019. By the same token, they don't really have the opportunity that the hotels have in terms of the way that they cater to the business market and even things like rewards programs.

Cross: I think that's right, Chris. They really are tailored to experiences and travel, consumer travel, holidays, getting away, getting out, whether local or distant which I think is an advantage for Airbnb. That is for hotels too. Hotels certainly cater to the business clientele like airlines. They make a lot of money from the business clientele. I think that is going to be disrupted more permanently. Businesses will still travel. We know Jamie Dimon is very eager to get his people back at JPMorgan, get the people back into the office and on the roads again, and I know a lot of business people are excited to get on the roads again to make those face-to-face relationships, so it's not going away. I just think it is going to be changed from the past year-and-a-half experiences. 

What we've learned, the value of not having to travel from a personnel perspective and from an efficiency perspective, and certainly from a cost perspective. Chris, we've seen a lot of companies talk about this in their conference calls, the fact that the value of not having to spend travel when it comes to their profitability is not going to be the case going forward as it was the past year or so. They are guiding analysts to expect that. There is value from not having to travel as much as a business, but there's value to the business. I think that does impact hotels, more so than Airbnb. Airbnb does have some other challenges, regulatory challenges, consumer challenges, and a very competitive market. There are a lot of options out there, so you do have that dynamic. It is a little bit of like you said, a little bit of protection from each other but really in the end in so many ways you're still competing. I could stay at a Marriott. We stayed downtown for the fireworks this Fourth of July. We thought about an Airbnb just because of the convenience with the hotel and we knew it all and was all locked into our credit card points and mileage and we just set it on autopilot and they set it up for us. Airbnb is a little bit of a different story because they don't have that advantage but they do offer a much more diverse set of experiences, which is what consumers want.

Hill: It is nice that the fireworks in D.C., it wasn't cloudy. It wasn't rainy, it was like the first time in years I was like, ''Oh no, it actually worked this year, the weather Gods were in our favor."

Cross: It was amazing. Actually, July 4 is my wife, Jaime's, birthday and she was just so thrilled that it's like the nicest weather for her birthday in, like, 20 years and we are very excited. Yeah, it was a great way to spend the July fourth on a reopening weekend.

Hill: Andy Cross, great talking to you. Thanks for being here.

Cross: Yes, thanks, Chris.

Hill: As always, people on the program have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against stocks mentioned, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of MarketFoolery. The show is mixed by Dan Boyd. I'm Chris Hill, thanks for listening. We'll see you tomorrow.