In stock market investing, the glittering allure of blue-chip stocks often overshadows the less conspicuous segments of the market. However, there lies a potentially rewarding strategy in venturing into the realm of overlooked and small-cap stocks. This article delves into the compelling advantages of investing in these hidden gems and sheds light on why some of the world’s most acclaimed superinvestors commenced their journeys in these uncharted territories.
By investing in the largest companies available in the market, investors often unknowingly limit the potential returns they can generate. This limitation isn’t necessarily their fault per se, given the substantial industry that revolves around the buying and selling of large-cap stocks. Analysts are constantly updating their forecasts for these kinds of stocks; when you turn on the business channel, these are the stocks they discuss, and most likely, these are also the stocks that investors’ peers talk about when discussing stock market investing. While blue-chip stocks do have their place in a well-thought-out portfolio—for stability, dividend growth, or wealth preservation purposes—they serve a specific function.
However, a truly enterprising investor looking to generate above-average returns knows that seeking exceptional returns from these blue-chip large caps is a fool’s game. Often, the tailwinds that have benefited the firm in reaching large-cap status have already been utilized. This implies that the best days for the firm are usually behind them, and even if a solid return can be obtained by holding these stocks for the very long term, the opportunity cost becomes significant when comparing these kinds of investments to more obscure investments. This is why, although blue-chip stocks do have their place in a portfolio, they are not the most attractive area of the market for generating above-average returns.
The fluctuating landscape of the world’s largest companies from 1989 to 2021 exemplifies the impermanence of corporate preeminence and underscores an important principle for wealth accumulation: the largest companies are not always the best investment for growth.
In 1989, the largest companies by market capitalization were predominantly from the banking and energy sectors. Names like the Industrial Bank of Japan, Sumitomo Bank, and Exxon Mobil represented the pinnacle of economic strength and investment security. These industries were the mainstays of a high-performing portfolio, deemed safe havens for investors across the globe.
Transition to 2021, and the scenario has dramatically transformed. Apple Inc. surged from a position far removed from the top echelons to a market capitalization surpassing $2 trillion, indicative of a broader shift towards technology and innovation. Microsoft and Amazon, once nascent entities or modest contributors to the overall market, emerged as behemoths with valuations in the trillions.
This transformation elucidates a vital point: yesterday’s market leaders are not guaranteed to retain their dominance. The rapid growth of technology and the advent of the digital economy have propelled new entrants to the forefront, often at the expense of established players. Companies adept at leveraging technological advancements, engaging with shifting consumer trends, and expanding into new markets have outpaced their traditional counterparts.
This historical juxtaposition highlights the limitations of a strategy overly reliant on the largest companies. It reminds us that sectors which once seemed unassailable can be overtaken by innovative disruptors. For the investor whose goal is wealth accumulation, this historical perspective advocates for a more nuanced approach than the conventional wisdom of investing only in the biggest firms.
The Allure of Larger Returns
Small and obscure stocks frequently offer the tantalizing prospect of larger returns. The principal reason behind this is their lack of visibility in the market, which can lead to significant undervaluation. For the astute investor, these stocks represent an opportunity to buy in at prices that do not yet reflect their potential future worth. As these companies grow and gain recognition, their stock prices can increase substantially, potentially yielding robust returns on investment.
When it comes to growth and capturing market share, the math gives an undeniable advantage to the smaller market participants. For a stock with a market capitalization of 500 million dollars, doubling its market value to 1 billion still leaves the company within small-cap territory, offering substantial room for growth. In contrast, a company valued at 500 billion dollars must accrue an additional 500 billion dollars to reach a one trillion-dollar valuation and a doubled market cap. The challenge is amplified by the simple fact that the company might not have an addressable market large enough to capture that additional 500 billion dollars in value.
This phenomenon can be thought of as a form of economic gravity. The larger a company becomes, the more challenging it is for that company to double or triple in value. The fact that a company with a 20 million dollar market capitalization only needs to secure an additional 20 million dollars of market value to double is a far more attainable feat than for large caps to attempt the same percentage increase. This is particularly pertinent for investors seeking growth investments, as the smaller arena often presents more favorable conditions for rapid expansion.
The allure of higher returns from more obscure stocks isn’t solely attributed to the company’s ability to grow its market share. Some companies operate in niche markets, which allows them to secure a dominant foothold over the specific clientele they cater to. This advantage becomes evident in their ability to raise prices in line with, or even above, inflation, fend off competition through a strong hold on their market, and the capacity to distribute to shareholders an above-average return due to lower reinvestment demands for generating revenue.
Indeed, the distinctive appeal of higher returns from stocks of companies in niche markets stems from several strategic advantages that go beyond mere expansion of market share. For instance, consider the cement and limestone industry—a sector where companies often exemplify the behavior of leveraging local competitive advantages. These companies have a product that is fundamental to the construction and manufacturing industries, thereby catering to a persistent and reliable demand.
After the initial capital-intensive phase of establishing quarries, these businesses can benefit from economies of scale and reduced reinvestment needs. The geographically bounded nature of their operations creates natural barriers to entry, often resulting in localized monopolies or oligopolies. Such positioning allows these companies to operate with substantial pricing power. As their production costs rise, perhaps due to inflationary pressures or increased regulation, they can typically pass these costs onto consumers, aligning price increases with or even exceeding inflation rates.
Whether an investor is seeking a growth opportunity with the potential to capture market share and increase market value over time, or searching for a unique opportunity where the investment is safeguarded by pricing power, exploring opportunities in the smaller, more obscure areas of the market opens the door to a wide range of possible investments. These opportunities have the ability to generate returns that are often far more attractive than those offered by the largest companies in the market.
The Institutional Oversight
Large institutional investors—such as mutual funds, pension funds, and large asset managers—often eschew smaller stocks. The primary reasons include liquidity constraints and regulatory compliance, which limit their ability to invest heavily in smaller companies without influencing the stock price excessively. This institutional oversight provides individual investors with a unique advantage: the ability to operate under the radar and capitalize on opportunities before they become widely recognized.
Investing is a highly competitive venture, often populated by highly experienced individuals armed with ample resources, all of whom are fervently scouring the market for attractive opportunities. For smaller investors, it becomes increasingly challenging to compete with these large-scale players in the arenas where they excel. One strategy to sidestep this intense competition is to look for areas inaccessible to the largest players. By focusing on obscure market segments too small for large-scale investors to make meaningful investments, a smaller investor can drastically reduce the competition vying for shares.
In these less-traveled parts of the market, buyers and sellers are typically individuals—company insiders, individual investors, or boutique hedge funds—rather than the dominant large asset managers. By concentrating on smaller market areas, an investor not only lessens their competition but also boosts their competitive position. An informed investor can often hold a considerable edge by understanding a company that is not as widely known as some of the bigger names. This could mean a lack of analyst coverage, which allows the investor to develop their own perspective on the company’s narrative instead of being swayed by external influences.
The ascension of passive investing strategies, led by behemoths like BlackRock and Vanguard, has fundamentally altered the investing landscape. The tidal wave of capital that flows into index funds and exchange-traded funds (ETFs) often results in these large institutions owning substantial stakes in a myriad of companies. This form of investment, while efficient and cost-effective for individual investors, carries broader implications for corporate governance and market dynamics.
Passive investment ownership can skew and redirect the decision-making processes within companies through the consolidation of proxy votes. These institutions wield significant influence over corporate policies and board elections due to their sizeable shareholdings, often voting in unison based on predetermined policies or the recommendations of proxy advisory firms. While this can promote some beneficial practices, it can also result in a homogenization of corporate governance, potentially stifling unique strategies and innovation that might arise from a more diverse shareholder base.
To circumvent the pitfalls associated with large passive shareholders, investors may consider turning their attention to smaller companies that are not constituents of major index funds. These companies are less likely to be influenced by the voting power of passive giants, allowing for a more varied and potentially responsive ownership structure. This environment can empower individual shareholders and enable company leadership to pursue strategies tailored to long-term growth and innovation, free from the pressures of passive investors who are often more focused on short-term metrics and benchmark alignment. Moreover, the investment in such companies can provide a haven from market movements that are artificially influenced by the substantial capital shifts within index funds, offering opportunities based more squarely on fundamental performance and less on the prevailing currents of passive investment trends.
Enhanced Relevance of Fundamental Analysis
In the arena of overlooked stocks, fundamental analysis becomes not just useful, but crucial. In the absence of constant media coverage and ubiquitous analyst reports, these stocks offer a fertile ground for investors willing to perform deep, fundamental research. Evaluating financial statements, assessing management quality, and understanding the company’s market position are all paramount. For the discerning investor, this intensive scrutiny can uncover stocks whose intrinsic values are far greater than their current market prices, thereby offering significant investment opportunities.
The reality is that pricing for large-cap stocks is far more efficient. Their financials have been meticulously combed through by numerous analysts, which increases the likelihood that any fundamental advantage is already reflected in the share price. It is far more likely for a small company to harbor hidden value than a large company. This is not to say that large companies cannot experience strong fundamental performance, but rather that this robust performance is typically already factored into the shares, which likely trade at premium valuations.
In the case of smaller companies, especially those that are not as well-promoted, there is a greater chance of uncovering hidden value. This may be due to assets that have not been revalued to reflect their current fair market value, or cash flows that are not fully captured in reported earnings. By meticulously analyzing the financials of companies that are obscure, investors can discover and capitalize on hidden gems, which can lead to particularly attractive returns.
Pathways Pioneered by Superinvestors
Historically, many of the market’s superinvestors—such as Warren Buffett and Peter Lynch—began their illustrious careers by focusing on small, obscure stocks. They hunted for undervalued stocks in overlooked corners of the market, exploiting inefficiencies created by the lack of analyst coverage and general investor interest. Their success stories have illuminated a path for modern investors, suggesting that diligent research and a focus on less popular stocks can lead to exceptional long-term gains.
Warren Buffett has candidly acknowledged that due to Berkshire Hathaway’s massive size, replicating the astronomical success from his early years at the helm is nearly impossible. The principle behind this admission is straightforward: the larger the asset base, the harder it is to achieve high percentage gains. It’s a matter of scalability—Berkshire Hathaway, with its current heft, cannot maneuver with the same agility it once did when it was a smaller entity.
Furthermore, Buffett has posited that if he were managing smaller sums today, he would be confident in his ability to generate approximately 50% compounded annual returns. Although this bold assertion remains untested in today’s market conditions, it underscores his belief in the advantages smaller sums afford in terms of investment flexibility and potential returns.
Buffett’s speculation is rooted in his own historical performance during his partnership years, a time when he famously focused on overlooked sectors of the market to realize substantial gains. By applying a rigorous investment approach to lesser-known and undervalued companies, he was able to uncover opportunities that were not apparent to or accessible for larger investors.
This serves as an inspiration for the small-scale investor today. By emulating Buffett’s early strategies—seeking out the obscure and the overlooked, conducting thorough analysis, and exercising patience—there is potential to significantly outperform the market. While the scale of individual investor operations is far removed from the juggernaut that is Berkshire Hathaway, this difference in scale may, in fact, be a strategic advantage, allowing for more nimble and potentially lucrative investment choices.
Conclusion
Choosing to invest in small and overlooked stocks is not merely a contrarian approach but a strategic one, characterized by the potential for substantial rewards. While these investments do involve higher risks and require more intensive analysis, the payoff can be disproportionately large compared to more mainstream investments. As we navigate through evolving economic landscapes, the ability to identify and capitalize on these opportunities remains a valuable skill for any investor seeking to maximize their investment portfolio’s growth.
This exploration into the overlooked corners of the stock market not only encourages a more meticulous investment strategy but also aligns with the pioneering practices of some of the most successful investors in history. Embracing this path can lead to discovering potent investment opportunities that others may have ignored, paving the way for significant financial gains and enhanced investment acumen.
The information presented in this article is the opinion of Jacobs Investment Management and does not reflect the view of any other person or entity. The information provided is believed to be from reliable sources, but no liability is accepted for any inaccuracies. This is for information purposes and should not be construed as an investment recommendation. Past performance is no guarantee of future performance.