5 Small Caps to Buy

Wall Street has always had a fascination with size.

Every market cycle seems to produce a handful of giant companies that dominate headlines, attract endless analyst coverage, and soak up billions of dollars in passive investment flows.

Investors chase the biggest names because they feel safe.

The problem is that safety often comes with a very expensive price tag.

That is one reason I continue to spend a great deal of time looking at companies with market capitalizations below $5 billion.

These are businesses that are often too small for large institutions to own in meaningful size, too obscure for television commentators to discuss, and too illiquid for many large mutual funds.

Those characteristics create exactly the type of market inefficiency investors should be looking for.

Academic research has documented what is commonly called the “small cap premium,” the tendency for smaller companies to outperform larger companies over long periods of time.

While the effect has been inconsistent over shorter periods, the long term evidence remains compelling.

Research from MSCI, Fidelity, and other institutional firms suggests that smaller companies have historically delivered higher returns than large capitalization stocks, albeit with greater volatility.

The reason is not difficult to understand.

A $500 million company only needs to create $500 million of additional value to double in size.

A $2 billion company can become a $4 billion company without changing the world.

A $3 trillion company has to create an astonishing amount of new value just to move the needle.

Small companies simply have a longer runway.

Many of today’s large corporations began their public lives as overlooked small capitalization stocks.

Investors who recognized their potential before the crowd arrived earned extraordinary returns.

Every future industry leader starts out as a small company.

That does not mean every small company becomes a winner.

Many fail.

Some never achieve profitability.

Others dilute shareholders into oblivion.

That is why buying small stocks indiscriminately is a terrible strategy.

Quality matters.

One of the most interesting developments in recent research is that profitability appears to be a critical factor when investing in smaller companies.

The S&P SmallCap 600 Index requires constituent companies to demonstrate profitability before inclusion, and over long periods that index has outperformed broader small cap benchmarks that include large numbers of money losing businesses.

That finding fits perfectly with my own investment philosophy.

I am not interested in buying exciting stories.

I am interested in buying assets, cash flow, and earnings power at discounts to intrinsic value.

My favorite hunting grounds tend to be community banks, REITs, business development companies, small industrial firms, and neglected energy companies.

Many of these businesses have market capitalizations well below $5 billion.

They generate real cash flow, own hard assets, and often trade at discounts to book value or tangible book value.

These are not companies attracting hordes of momentum traders.

They are companies quietly buying back stock, paying dividends, and improving their balance sheets while nobody is paying attention.

The lack of analyst coverage is another advantage.

Apple is followed by dozens of analysts.