The Manual of Ideas: The Proven Framework for Finding the Best Value Investments

CHAPTER 7

Small Stocks, Big Returns?

The Opportunity in Underfollowed. Small- and Micro-Caps

All truths are easy to understand once they are discovered; the point is to discover them.

—Galileo Galilei

Small public companies are implicitly discussed in each of the other idea categories in this book, yet we find several reasons to devote a chapter to small caps. First, misconceptions exist about small stocks, with many investors shunning them due to a perception that such securities are more likely to be manipulated or fraudulent. Although various pump-and-dump schemes and revelations such as the high fraud rate of U.S.-listed Chinese small caps have hurt investors, small equities as a group have offered attractive returns over long periods of time. Second, we approach screening for small-cap ideas differently than we might screen for large stocks, as we indeed regard a large percentage of small companies as uninvestable, whether due to infrequent reporting, liquidity considerations, or the speculative nature of the underlying businesses. We apply an investability screen prior to considering individual small-cap opportunities. Finally, we find that the approach to analyzing small companies differs sufficiently from analysis of large-cap equities that it makes sense to outline the distinct process in this chapter.

The Approach: Why It Works

Virtually everyone has heard of Microsoft, and many smart and resourceful people have an opinion as to what it is worth. Neither of these statements ...