How Small-Cap Companies Can Help You Beat the Market

In this podcast, Motley Fool producer Ricky Mulvey, Motley Fool analyst Dylan Lewis, and Bill Mann, director of small-cap research at The Motley Fool, kick off their series on small-cap investing. They discuss topics including:

• Why small-cap investors have an opportunity to beat the market.
• The metrics that really matter for small caps.
• One small-cap trend catching Bill's attention.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on August 13, 2022.

Bill Mann: Some of the most profitable investments you will ever make are companies that don't seem like they're growing very fast but they are growing very consistently. The lower the raw growth rate, the more I would want to see a company that if it disappeared tomorrow, would be painful to the consumers that buy it.

Dylan Lewis: I'm Dylan Lewis and that's The Motley Fool's Bill Mann. Today we're kicking off our series on small-cap investing, it's the secret sauce of what we do here. Producer Ricky Mulvey caught up with Bill to talk about why small-caps can help investors beat the market, the traits of great leaders in this space, and why it's even more important to watch these CEOs and one investing trend that has some serious staying power. Today we're kicking off a series on small-cap investing. Joining us now is Bill Mann. We don't normally do the full titles at the Fool, but you are the director of small sap research here, so it does seem appropriate to establish that. Thanks for doing this.

Bill Mann: It's no problem. You're right, we don't do titles and I'm glad we don't but in this case, hopefully I've got something to say.

Ricky Mulvey: Well, we got about a half-hour and if you have nothing to say, it's going to be a very difficult podcast. [laughs]

Bill Mann: That's right. Hey Ricky, what do you got?

Ricky Mulvey: If you're new to this, why do you like small-cap investing? Why is this stuff more fun than the other kind?

Bill Mann: I love the fact that you've described it as fun and it really is. Small-cap investing is where you get to go treasure hunting. The reality of small-cap investing is that when you bring up these companies at cocktail parties, at softball games, wherever it is that you go and interact with other people, a lot of times you are not going to get the same level of a response people than if you say, oh, yeah, I own Apple or I own Berkshire Hathaway. These tend to be companies that very few people have heard of. It is fun to me because it is also an area where you can truly go on a treasure hunt and there are fewer people and less money fishing in these waters. One of the things we're going to talk about in a little bit is why individual investors actually have a structural advantage when it comes to smaller companies.

Ricky Mulvey: Let's do that now. Look, we've got to do a daily show here at Motley Fool Money. We got to talk about a lot of things. [laughs] This is the secret sauce. Find a small company, if they've products, customers if they got the right numbers on them and you buy enough for those companies, you can possibly beat the market over a long stretch of time.

Bill Mann: I'd say probably. Can I say probably? We're not going to get the podcast please, it's going to come down on us if we say probably. It is in order to invest in small caps and to make it a large component of your portfolio. You do have to have the right mindset, you are going to be wrong more often. That's just full-stop. There is less information on them. You are not going to be able to find much in the way of institutional research on these companies. It doesn't make any sense for the big banks to go out and research them because it doesn't make any sense for them to go out and buy them, the money is not there for them. If you are committed to owning a larger number of companies, and if you are committed to recognizing the fact that you're going to be wrong a lot and just embrace it. You're going to be wrong a lot, even more often with small caps. Then there is a path there to making a tremendous return over time. Small caps have historically constituted the lion's share of the returns for The Motley Fool from our recommendations, by which I say, for example, one of the companies that we have done best on is Netflix. I know Netflix has had a hard stretch in 2022 but we invested in it as a small cap. We invested in a company called Marvel that became Disney, and it was a small cap. David Gardner recommended a little tiny company called Amazon in 1998 and never wavered and it was a small cap when he picked it and I understand, Ricky, that that's a little bit of gilding the Lilly pointing out those three companies right away. But the great thing about small-cap investing is that you can be wrong often but if you're right once and you have that tenacity to hold on, it will make all the difference.

Ricky Mulvey: Let's go to the flip side because we can play the hits but you talk about how you have to be comfortable losing and that's probably even more so the case with this than the large caps. But can you think of a time that maybe you got burned with a small cap company with big promises?

Bill Mann: Oh, God. There are a bunch. The one that was probably most embarrassing for me. I used the term embarrassing because I do have to tell a little bit of a story behind it but in 2001, I was invited as an expert witness to testify before the US Senate Banking Committee after the collapse of Enron as an expert and I sat there before these senators and explain to them exactly why it was that some investors were able to see what was happening with Enron. I felt like a million bucks. This was at the point in time, the greatest honor that I had had as an investor and as a follower of the markets. That same day I returned to our offices, we were down on Pit Street in Alexandria, Virginia and I came in and a company that I had not just invest it myself, I had recommended and it was called ACLN and it was a small cap company that was a car carrier company based in Belgium. Its stated business was that these car carriers would come from Korea or they would come from Japan and drop cars off in Europe and the US and they would go back empty. ACLN said, hey yeah, what we're going to do is fill these car carriers with used cars and we're going to take them to Africa, which is a huge used car market. This all sounds awesome and it also sounds the thing that one really needs to happen and too is actually happening. All of those things were true except for the is actually happening part. It was a complete and utter fraud. The same day that I was being held up as an expert in finding fraud, I fell into one absolutely directly and very publicly. You know what they say, [laughs] if you want to be laid low first be made proud. [laughs] That happened awfully fast. It happens in this segment and you've got to be able to recognize the fact that, that thing is, maybe not that, that was somewhat spectacular but companies disappointing you in this segment is a reality.

Ricky Mulvey: Yeah. That's one reason that's more challenging. You have to get ready to lose more often, you have thinner information, you're dealing with younger companies. I'm trying to think any general reasons that this is, let's say harder than picking who I like, Microsoft and Ford.

Bill Mann: Well, I have a friend named Ian Cassel who runs a site called the MicroCapClub and he put out a book called the Intelligent Fanatics Project. I love the framing of the term Intelligent Fanatics and it actually was coined by Charlie Munger, who is the vice chairman of Berkshire Hathaway. It talks about the types of business leaders that they want to see running companies. One of the most important things and why small-cap investing offers so much promise and so much challenge is that unlike the American Expresses of the world or the MasterCard's or the Apples of the world, small caps are almost by definition, driven by great management. The quality of the management means so much in this segment, it is a much more important factor in smaller companies than it is in larger companies. Larger companies, they've got staffs of hundreds, if not thousands doing all the things and in some ways the people at the top of the business don't have any idea what's going on in large parts of the business. If that's happening at most small cap companies, the company is probably on its way into the rocks.

Ricky Mulvey: Let's focus on leadership in a sec. I feel like I'm doing an ad break now but I do think we got to knockout some of the allocations stuff.

Bill Mann: Okay. [laughs] Fair enough. Let's take our spinach.

Ricky Mulvey: Let's do the quick allocation. We always say at the Motley Fool, you've got to own 25-30 stocks. Do you think that number increases if you're playing the small cap game?

Bill Mann: Well, it depends on how you do it and specifically, I would say this, if you're going to buy small cap companies, you need to be fairly sure that your companies are internally diverse. It's easy enough to say 25-30 but if you own 25 SaaS companies and then a biotech company for diversity, you're not actually diverse and I don't care what the number of companies that you own. Yes. I would absolutely positively encourage to own on the high side of smaller cap companies in terms of the number. But at the same time, you do also have to make sure I always think about my portfolios. You have a risk on a company basis, but you also have a risk on a thematic basis. If you own all Chinese companies, that you are exposed 100 percent to China. It doesn't matter that you own two companies or 50, you still are absolutely positively exposed to something exogenous to any of the individual companies. Yes I would suggest that you own more smaller cap companies. I would suggest that you give yourself the grace to know that in any case, owning more companies means that you will be able to study them less. We all have the same number of hours in the day. Therefore, you are likely to be wrong more often and in smaller cap companies, even if you have the best source of knowledge that there is, sometimes these companies are going to disappoint you.

Ricky Mulvey: It's not the number of slices on the pie chart, not just that it's the colors on the pie chart.

Bill Mann: Exactly, like like, hey I've got 17 shades of green. Is this a rainbow? No, it's not a rainbow.

Ricky Mulvey: I've heard this from Jason Moser. I've heard it from John Rotonti. The ideas when you're playing the speculative game, make sure you essentially buy for each speculative company, you buy one that's not going to keep you up at night.

Bill Mann: Right, exactly and we've been talking about small caps as if they are some like monolithic beast. Maybe put it a little bit of definition around what a small cap. What's that?

Ricky Mulvey: I said that would have been helpful if I did that episode.

Bill Mann: Yeah exactly [laughs] so what are we talking about here? We're talking about essentially at this point in time, companies that are $8 billion and below, so $8 billion it turns out, if you are the only owner of a company worth $8 billion, you have a billion-dollars. Which is a lot of money, but from a company perspective an $8 billion company barely moves the needle for the S&P 500, for example, for the index that it's in. Anything sub $8 billion, I would consider to be a smaller cap company. Now, you can definitionally go smaller than that and say between 300 million and two billion as a small cap company, which is absolutely fine. I wouldn't get too wrapped up around the definitions, but I really, to me, the ceiling is about eight billion.

Ricky Mulvey: Okay.

Bill Mann: The way I come up with that number, Ricky, is that that is the market cap of the 490th sized company in the S&P 500.

Ricky Mulvey: We picked 490 for what reason?

Bill Mann: Because there's always companies that are within the S&P 500 that are so deeply impacted that they're going to be pulled out.

Ricky Mulvey: Got you.

Bill Mann: Right there are companies at all times that are in the S&P 500 that are on their way out because they are something deeply wrong. Again, don't get too spun on this. That's not a scientific number. It just seems like a good rough cut. When you're talking about small cap companies, you have to recognize a couple of things. One is there are small cap banks. There are 30 tiny banks in the state of Indiana that are publicly traded companies. There are also revenue-less biotech companies that are small cap companies. There are SaaS companies that are biotech companies, there are manufacturing companies that are small cap companies. It is a segment that is defined by being smaller, but you need to be careful about taking too much in the way of rules like small-cap means this because some of these companies are small caps, have been public, have been small caps for 50 years, and to the extent that they will survive will always be small-caps. There are other companies, like when we were talking earlier about Amazon. At a trillion plus and market cap, it's obviously no longer a small cap. A lot of small cap companies are on their way to being something else. Hopefully that's something else is a much bigger company. That's an extra minute before I get to answering the question that you asked, which was Jason Moser's point and John Rotonti's point about buying something that speculative and matching it against something that is much more dependable. Like for example, a biotech company at a bank. I think in some ways you have to know yourself. Like you need to make sure that to the best of your ability, that you are buying risks that are compensated for. You don't want uncompensated risks in any single company. That doesn't mean that things aren't going to go wrong, but if you are someone who is not comfortable with your portfolio going down 30 or 40 percent, you absolutely need to make sure that you are much more loaded with companies that aren't going to do that. I know 2022 has been painful for a lot of people but in even in years like 2020, small-cap companies, you just look at their 52-week low and their 52 week high, and they're usually 70 or 80 percent apart from each other. These companies move a lot. To the extent that you're comfortable with that, you can take a little bit more risk with the companies that you are putting into your portfolio, to the extent that you're not, you should be a little bit more conservative.

Ricky Mulvey: I want to go back on a point you made about how yes this is a market cap. This is a definition of market cap and there is an impossibly large number of sectors within that. When we had a conversation earlier, you said essentially a good beginning point. If you're looking at small caps is, what problem does this company solve? Do they have the resources to do so and then also, how's their leadership?

Bill Mann: Yeah it's a good way of thinking about it and just to put a little bit of meat around this concept. In the US stock market, small caps, and I mean, companies that are smaller than mid and large caps make up 90 percent of the number of companies in the market. That goes all the way down to micro caps. But it only makes up about seven percent of the total market cap of US stock market of the three of the major exchanges. You are talking about a large number of companies, but a smaller component of the market.

Ricky Mulvey: Let's get even smaller. How about some leadership as small cap companies? Among these small-caps who are some leaders that you particularly admire right now?

Bill Mann: We talk a lot at The Motley Fool about Arista Networks, which is a company that is incredibly important to the development of Cloud computing. They are a network company and their CEO is a woman named Jayshree Ullal, who when she and Andy Bechtolsheim founded Arista, they took no money. They didn't buy, they took no money. They obviously got paid as human beings, but they didn't go out and do huge amounts of capital raises once they became a public company. They have grown in a very intelligent way. They've never reached out and it's interesting because a lot of times you look at these companies that are based in Silicon Valley and it really seems like they're being run like a fraternity house. She has made sure that the culture at Arista is incredibly accommodative. To the extent that she's just said that what she wants from herself and her employees is that she just knows that human beings all crave appreciation and they want to be recognized for having done a good job.

Ricky Mulvey: I've heard that in a few interviews, which is at a conversation with Bill George on last week's show. He had this theme of look for the we leaders and hear that in Jayshree is interviews where she's very quick to point out like the members of her team and who's doing what well, and it's taken the spotlight away from her and that's something you'd like to see.

Bill Mann: She is actually interacted a quite a bit with the Motley Fool. She's been wonderfully giving over time, but she actually really doesn't like for herself to be in the spotlight. It's funny you can pick this up and this just takes a few minutes to do with any company that you're interested in. I mean, especially with small caps, one thing that you can do and it doesn't take more than five minutes, is read the letter from the CEO or the Chairman in the last annual report, and you will see that in spades. Now first of all, one thing you have to make sure of is you know how you can tell when something's been written by a committee or it's been written by a professional.

Ricky Mulvey: They're good statements.

Bill Mann: Yeah, exactly but you can tell. But one of the real tip-offs for me is that exact thing you're looking for. We CEO and you are also looking for someone who in the course of the single most read document that they will produce that they both give credit for things that have gone well, but then they also take blame for and don't make excuses for things that have gone poorly. Ricky, every company in some ways is dysfunctional but some companies dysfunction in a positive direction. Every single company faces challenges, every company has things happen both internal and external that impact their operations, impacts their trajectory. How do they respond to them and how do they communicate them? It's so important.

Ricky Mulvey: You look at a lot of small cap companies, and I would also say that in our interactions, you seem to have a pretty good BS radar. Let's talk about some of the BS among leadership. What does your radar spike when you're reading those letters, you're listening to a quarterly call and just maybe a yellow flag goes up?

Bill Mann: Like so, for example. Gosh, we're about to get in trouble, are you ready?

Ricky Mulvey: Let's go.

Bill Mann: Get your hand on the button. I am not saying that a lot of companies have not been impacted by supply chain issues and in particular by the Russian invasion of Ukraine, but if you are a small cap bank in Indiana and you make the excuse that the invasion of Ukraine has somehow impacted your operations. You should always have your detector up and understand that even the great communicators, they're trying to put their best foot forward. If the best foot is always, "Hey, we've got complete control," that to me is a red flag. Again, I'm going to give just a tiny bit more homework because one of the ways that you can find this. There's a CEO of a company that's really struggled this year, but I think the world of him, Glenn Kelman at Redfin. If you go back and you read three years of his letters to shareholders, just three years, so we've gone now from five minutes of homework to 15 minutes of homework, you will see that he is talking about the same exact goals. He's not saying on this year, we've done great because of the number of houses we've sold, and the next year, we've done great because the revenues, and the next year, we've done great because our price to phone number is really low. He's absolutely consistent. He's responsive to things that are happening, but he's not changing what he wants you to look at to show, hey, this is a super successful company. Companies just don't succeed all the time, and it's fine. It's really OK and the CEOs at small cap companies who embrace that are the ones that you can trust them more.

Ricky Mulvey: If you're looking to dig into some small cap companies, four metrics to watch. Is you're looking through to see if the company is healthy, if it's sustainably profitable. Number one is company sales, is that one that you have a cut off for? It ranges based on are you looking at a consumer goods company or a biotech company? But is there a general level in which you're just like, you know what? This is a biotech company with no sales falls outside of my circle of competence. No, thank you.

Bill Mann: You hit on the exact right term. For me, you don't want to listen to me about biotech companies. You just don't. For me, I own one biotech company in my portfolio and it's because my daughter does this, and she was the one who recommended it to me, but it's not an area where I'm going to be reaching out over my skis. Some of the most profitable investments you will ever make, our companies that don't seem like they're growing very fast, but they are growing very consistently. The lower the raw growth rate, the more I would want to see a company that if it disappeared tomorrow, would be painful to the consumers that buy it. Like for example, in 2001, I actually had the opportunity to have a conversation with Warren Buffett, and I pitched a company called Church & Dwight Tim. Church & Dwight is ARM & HAMMER Baking Soda. It does a number of other things. It bought other companies along the way. It didn't grow very fast, but it had an unbelievable franchise. If you go to the market and ARM & HAMMER Baking Soda is 79 cents and off-brand baking soda is 59 cents, you're paying that 20 cents. Full stop. That's how it goes. With no real expectation that it's going to perform better, but you just do. Company sales to me, I do like to own profitable companies. I do like to own companies that are currently showing growing sales, but I don't really need to see that big of a number if I believe that the company's franchise and its moat is big enough.

Ricky Mulvey: It's a question beyond just the sales and net profit margin.

Bill Mann: I think a lot of investors get wrapped up a little too much of saying, "I want a company that's growing at 25 percent." Then so suddenly, if a company is growing 23 percent like, is that good enough? I made the mistake of selling Starbucks in 1999 and it's grown 23 percent a year since then. Would that have been OK? I think that would have been just fine.

Ricky Mulvey: Then minimum share price, daily dollar volume, are you checking boxes on those or is that a skim over?

Bill Mann: No, I think that that's a really interesting point and it doesn't exist so much anymore, but generally speaking, the target price range for a US company used to be about $10 to about $100. When companies got above $100, they would split. That all had to do with the mechanics of trading, and I don't really know that we need to get into that, but it is still the case. It's still the case that companies that are trading below $10 a share have something that has gone wrong or has something that the market has perceived as having gone wrong. When you get into the lower, and Ricky, I know there are a lot of people who say, "Well, if the shares are priced lower, I can get more of them." But it's not really the way it works. For me if a company is trading below $10 a share and you said seven, and I actually think that's actually a great number that I'm now going to embrace wholeheartedly as being scientific, you need to understand that something has probably gone wrong or is going wrong at the company, and you should sort out what it is. Doesn't mean you should stay away from the company, but knowing what the risks are is super-important, and ignoring risks doesn't mean that the risks go away.

Ricky Mulvey: You've been listening for a while. We've been talking a lot about how to do this. Let's get to some meat and potatoes. What's the trend in small-cap investing you're excited about right now? Something you're watching out for is the director of small cap research.

Bill Mann: One of the great things is that we're starting to see every once in a while, there is a turnover in brands and brands happen. They happen in waves. It is not for nothing that Chipotle and Buffalo Wild Wings and a number of other restaurants styles exploded onto the scene in the mid 2000. I think that we're seeing that now as well in other areas. Like for example, one of the big trends that happened during COVID, but it was already happening was that people in this country were going out and buying RVs. They're down with camping, not getting on planes as much as they have in the past. I stopped and thought about this and said, well, who are the best operators in this business? Perhaps, the best operator is Marcus Lemonis and Camping World Holdings, which owns dozens of gigantic sales sites for RVs all around the country. I think that we're beginning to see a changeover in habits, and maybe some of it's been driven by the pandemic. I think some of it probably been just changed by, as we're moving into the dominance of the millennials and the fade-out of vast Gen Xs. I think that, that is a huge area of exploration. The new brands that are coming along.

Ricky Mulvey: Bill Mann, thank you for your time. Hey, maybe we will see you for part two.

Bill Mann: If I did OK, I hope you have me back.

Dylan Lewis: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis, thanks for listening. We'll see you tomorrow.