How You Can Find an Edge in Small-Caps

“Having an edge will help you make money in stocks”
– Peter Lynch

What is Your Edge?

As an investor, your “edge” is what sets you apart from the competition.

It helps you beat the standard market return.

In other words, it’s your competitive advantage.

Every retail investor is capable of outperforming the experts and seeing greater returns, but the competition is going to be tough. You’ll be up against wealth managers, hedge funds, high frequency and quant traders, institutional investors and other retail investors.

As a retail investor, “What’s my edge?” is a critical question you should continuously be asking yourself, whether you’re a beginner or a seasoned pro.

Think Small to Gain Big

If you ask your family, friends, and colleagues what their investment strategy is, the majority that invest will tell you they allocate a portion of their savings to an investment advisor; or to mutual funds, ETFs, or bonds. They may even do a combination of all of these strategies. They probably won’t tell you they invest in small-cap stocks because they are considered “high risk”, or “highly volatile.”

However, if you want to make life-changing money, small-caps are exactly where you should be looking.

Why?

It’s highly unlikely that you’ll find the next 100-bagger looking only at large-cap stocks. These kinds of companies are already valued at billions—if not trillions of dollar. They are not likely to double or triple their market cap any time soon – their upside is considered limited.

In fact, taking a decent-sized position in a large-cap company is a lot more expensive than it is in a small-cap company. For example, buying 1,000 shares of Amazon today is going to cost you north of $3 million.

Asymmetric Upside

Small-caps, on the other hand, are far more likely to have unlimited or significant upside potential relative to a limited downside potential. This is called “asymmetric upside” or “asymmetric opportunity.” It’s the reason so many legendary value investors, such as Warren Buffett, Charlie Munger, and Peter Lynch, made their early fortunes in small-cap stocks.

If you had invested US$1,000 in Amazon’s IPO stock in 1997, it would be worth more than US$1.35 million today (accounting for stock splits, as of Sept 10, 2020).

That’s the power of asymmetric upside.

Amazon’s upside back in 1997, when it was a small-cap stock, was virtually unlimited, while its downside was relatively limited.

Today?

The inverse is true.

Greater Risk, Greater Reward

As a large-cap stock, Amazon may now have limited upside, but, it’s considered “low-risk.”

Small-caps on the other hand are considered “high-risk.” After all, beating the market often means taking on extra risk – as they say, “greater risk, greater reward.” As a retail investor, you can mitigate these risks and develop an investment strategy leveraging certain advantages. These advantages are your investment “edge.

Finding an Edge in Small-Cap Investing

Generally speaking, there are 3 main market “edges” or advantages:

  • Informational Advantage
  • Analytical Advantage
  • Time-Horizon Advantage

1.) Informational Advantage

“Investors operate with limited funds and limited intelligence; they do not need to know everything. As long as they understand something better than others, they have an edge.”
– George Soros

It used to be a lot harder for the retail investor to gain an informational advantage. Before the internet became a household staple, only professional investors really had access to the kind of company information available for anyone to research today.

Now, anyone can type a stock ticker into their browser to see its stock price, share structure, company website, press releases, financials – a trove of information that’s yours to absorb.

But while household-name large caps are the stocks that are frequently searched, it’s the undiscovered small-caps that are the true gems of the market. They are the companies that most other investors aren’t talking about or studying, let alone scrutinizing. They largely fly under the radar, which is good news for the retail investor – it means you can gain an informational advantage over others.

Once a small-cap stock is on your radar, you are free to research its history, financials, management team, and sector it is part of. Many others won’t bother to put in the work you do, and this will work to your (informational) advantage.

Additionally, most large institutional investors don’t spend their time researching small-cap stocks because they are generally restricted from buying them. This alone eliminates some of your heaviest competition.

Another informational advantage specific to small-caps is access to management.

It’s pretty unlikely you’re going to be able to call Tesla’s IR department and get put through to Elon Musk, but generally speaking, management teams of small-cap companies are more accessible to investors. It’s possible as a retail investor to contact a member of management in a small-cap company — possibly even the CEO — and talk to them to gain extra insight, or tour their facilities.

2.) Analytical Advantage

Gaining an analytical advantage is harder for most retail investors to achieve.

Unless you have access to a team of professional analysts, as most institutional investors do, you’re going to be doing your own research and drawing your own conclusions about companies and industries.

Gaining an analytical advantage could mean anything from poring over a company’s entire financial history to determine whether or not they will be profitable, to reading detailed market reports to gain insight on an industry or sector’s forecasted growth. This kind of edge is much easier to obtain if you are willing to invest a little bit of money and time into quality research reports, high quality newsletters, market reports, and even analyst reports.

3.) Time-Horizon Advantage

The Time-Horizon Advantage is the biggest conundrum of the three.

In terms of effort, it’s actually the easiest kind of edge you can gain: all it requires is patience.

However, patience is something many investors don’t have.

Everyone wants to “buy low, sell high,” but if it were that easy, everyone would be doing it. The urge to trade and flip stocks over the short-term is strong, and mostly driven by fear and greed.

If you are someone who can put money into a stock and just let it sit there to compound over the years, you already have an edge over many other investors.

During 1997, Amazon’s IPO price was $1.50 per share.

Then, it dipped to $1.3125 in the months after listing.

In late 1999, the dot-com bubble brought it up to a peak of $113 per share.

Soon after, the bubble burst and Amazon lost 95% of its value, falling to $5.51 per share in late 2001.

Through all those ups and downs, those who held their stock patiently for the last 23 years are reaping the rewards – they are now millionaires, if not billionaires.

Ask any successful value investor — the majority of multi-bagger stocks are not created overnight. Quality companies are built over years and decades, not months and days.

One of the most effective and easiest strategies for successful investing is simply patience. Do your research, choose high-quality companies, give them time to grow, and then it will be possible to beat the market.

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