Daddy's been asking a devilish question: "Why do you keep saying that we're going to invest in small caps, but we keep researching $40 stocks?"
I get that all the time. I get it in emails. I get it at the gym. I get it from our customer service reps, who get it over and over on the phone and online from our readers and subscribers. The answer just isn't sinking in. Worst of all, it's our fault.
Blah, blah, blah, blah, blah
This goofy relationship -- between big and small, large cap and small cap, penny stock and $40 stock -- may seem natural to you. Or maybe it was explained to you long ago, pleasantly and with reference to a giant pizza being cut into different numbers of slices. Or maybe it's still a mystery.
And maybe that's not your fault. After all, this particular pizza story takes a nasty turn. Careens is more like it -- through stock splits and market caps, enterprise values (EV), P/E ratios, and heaven knows what else -- before trickling out altogether... blah, blah, blah, blah, blah.
So maybe you are not the problem. Maybe we are. Maybe writers who write about simple topics that sound complex just don't know when to quit -- don't know, frankly, at what point blah is all we're saying. So today I'll keep it simple:
There is no fixed relationship between the price of a stock and the size of the company it represents.
This does not make sense
If you want to read on, that's great. But given the choice of reading on, getting bored, and forgetting what you've heard so far, you are much better off just stopping here and repeating after me:
There is no fixed relationship between the price of a stock and the size of the company it represents.
This is inconvenient to be sure. It's the kind of thing that drives proponents of the metric system bananas. But can it really be so? I assure you it can, but don't take my word for it. Take a look at these examples instead:
| Company | Recent Price | Market Cap | Revenue (ttm) |
|---|---|---|---|
|
Sun Microsystems (NASDAQ:SUNW) | $4.33 | $14.7 B | $11.2 B |
|
Nortel Networks
(NYSE:NT) | $2.87 | $12.9 B | $10.6 B |
Back in the day, both would have been called penny stocks. And yet you can see that both have market caps (more on this later) and annual revenues exceeding $10 billion. You can say what you will about what they are worth to investors, but these are not upstarts.
What's good for the goose
To the contrary, just by virtue of their girth, neither seems likely to grow its businesses by 10 times or more over the next decade or so -- something I at least hope for in a great small cap. It's certainly one of the main reasons we bought Buffalo Wild Wings -- a top pick from Tom Gardner's Motley Fool Hidden Gems -- for Daddy's portfolio.
And here's what prompted the question that prompted this column: We forked over nearly $35 per share for our tiny wing bar. If you're wondering what the heck I'm talking about, check out Daddy's No. 1 Stock Pick. But my point today is that Buffalo Wild Wings really is a small company, despite its "blue-chip" share price.
It's true. With a market cap hovering around $300 million, the dining chain sold about $170 million worth of chicken wings and beer last year. Sounds like a lot, but compare that to the nearly $20 billion taken in by McDonald's (NYSE:MCD) or the $3 billion by Wendy's (NYSE:WEN), both of which have market caps in the billions but also trade in the $30s.
Pennies, nickels, quarters
Trust me, I raise the specter of market cap reluctantly, knowing how it flirts with blah blah blah. But like it or not, it has become a proxy for company size; in fact, investors use it almost exclusively to label a company as large, mid-sized, or small. So we might as well define it:
Market cap is what you would have to pay to buy up every single share of a company's outstanding stock at today's prices.
If that doesn't do it for you, just stick with revenues. We can all agree that a company ringing up $10 billion a year is no lemonade stand. And unlike market cap, which is influenced by investor whimsy, revenues are generated by products and assets and employees and customers.
Let's just say that companies that sell a lot of stuff are big. So how can their share prices be small?
OK, now let's talk pizza
The origins of this problem lie in the fact that the price a company initially asks for a share of its stock is somewhat arbitrary. That's because while the size of the pizza (i.e., the total value of the company) is determined by the market, the company is free to choose the size and number of the slices.
If only this were the end of it. After all, even if the starting price were arbitrary, you would expect some correlation between share price and firm size, especially over time. Consider the following examples:
| Company | IPO Date | IPO Price | Market Cap | Increase in Value |
|---|---|---|---|---|
| Wal-Mart (NYSE:WMT) | Oct. 1970 | $16.50 | $221.6 B | 5,233 times |
| Microsoft (NASDAQ:MSFT) | Mar. 1986 | $21.00 | $267.0 B | 273 times |
| Home Depot (NYSE:HD) | Sep. 1981 | $12.25 | $85.4 B | 1078 times |
Notice that the price of all of these stocks should be high. After all, they are up anywhere from 273 to 5,233 times in value since their IPOs. Even if you replaced those original IPO prices with just $1 per share, these share prices should now be in the hundreds or thousands of dollars. How come they are not?
Split me up, Scotty
The answer is stock splits. Rightly or wrongly, companies are convinced that investors are less likely to buy "high-priced" stocks. To keep their share prices in the sweet spot, they periodically "split" their stocks -- essentially ordering everybody who has any pizza to cut their slices in half.
This leaves you twice as many slices, but each with half the cheese and pepperoni. I know -- blah. Just remember that this process is what guarantees a real disconnect between share price and company size, especially in bull markets where stock prices run up and seem to split on a weekly basis. OK, just one more example.
| Company | Number of Stock Splits | Price Without Splits |
|---|---|---|
| Sun Microsystems | 6 | $275.20 |
| Nortel Networks | 5 | $137.76 |
You remember these, of course, as the "penny stocks" we discussed earlier. Clearly, had these stocks never split, they wouldn't look so cheap. Indeed, had they not split, you might venture to guess at least something about the company's size from their share prices. Alas, it's not to be.
Finally, something you can use
If you forget everything we've discussed today, remember this. When buying a stock, you also determine the size of the pizza -- in this case, your total investment. The size of the slices (the share price of the stock you buy) will have no bearing on the amount of money you will make or lose.
Think about it this way: A thousand bucks is a thousand bucks. It might seem that you stand to make more on a $1 stock, but don't bet on it. Whether you buy one $1,000 share or a thousand $1 shares, all that matters is the size of the pizza. That is, how much -- as a percentage -- your stock goes up or down. At least that's what I told Daddy when we bought a $35 small cap.
What to do now
I have a sinking suspicion that either you have found this discussion ridiculously simplistic or downright baffling. Either way, I have a solution: If you are interested in small-cap investing -- or any-cap investing -- you might want to take a look at Motley Fool Hidden Gems. Tom Gardner is a relentless teacher, and I'm amazed at the educational value of the chatter on the boards.
Finally, I always promise you results. As of March 22, 2005, Hidden Gems are up on average 32.4% vs. just 6.8% for the S&P 500. If you're interested -- either in the picks or the education -- Tom is offering a special 30-day free trial. Click here to learn more.
Fool writer Paul Elliott owns none of the stocks mentioned. The Motley Fool is investors writing for investors and maintains strict trading guidelines for employees.
