Small is Good

Why do people tend to invest in  blue chip companies with huge market capitalization? The reasons might vary - because it is stable? Gives out good dividends? Not as volatile? Too big to fail? Government backed?

Blue Chips

Blue chips, like in poker and other card games, are the most expensive chips. Similarly, blue chip stocks are worth the most and come from larger companies.Blue chip stocks are the most valuable stocks on Wall Street and are usually from companies that are household names, such as AT&T, McDonald's, and Starbucks and tend to be large or mid-cap stocks. Blue chips have a long operating history, steady earnings, and a good reputation. They also have high liquidity, or the ability to trade large amounts of a stock without any problems. Blue chips are considered safe bets, especially if the market is falling. However, some blue chips do not always perform well.


I feel that blue chips are suitable for investors who are planning for retirement/retired or very risk adverse group of people who cannot stand to see volatile and wild swings in their portfolios. Blue chips in today's market are relatively fully or over priced and hence there is no need to even buy into any of them now. They are the best to invest once a bear market comes into play and panicky investors/fund houses are selling them off.

Small Cap Stocks

Personally I do like to pick small cap companies over larger ones as they are in the midst of creating a piece of history and are in the infant stage of their business. Most of these companies are volatile, does not pay a dividend, has low liquidity and earnings are sporadic. However they offer more upside potential than the blue chip companies. These sort of companies are not for the faint hearted and you have to be prepared to lose most/all of your invested capital in the worst case scenario/black swan event.

 

Advantages of Investing in Small Cap Stocks



Over the past 80 years, small cap stocks have outperformed larger cap stocks and this trend looks set to continue as the growth rates of smaller cap companies tend to develop at a much faster rate.

 

 

Huge growth potential - Big corporations like Wal-Mart, Microsoft, Apple Inc, Home Depot, P&G were once small cap companies too. I prefer to uncover diamonds in the rough and see them being polished - foresight is needed and crucial to uncovering the next Microsoft which possesses such potential. The difference in growth is that you're unlikely to see a large cap company with a market cap of $10bn doubling to $20bn within a few years but a company with a $500m market cap to double to $1bn seems possible if the circumstances are right and with prudent management teams in place.

 

Mutual Funds do not invest in them - Mutual funds are not allowed to invest in small cap companies as mutual funds have larger fund sizes to invest hence investing a $50m stake could potentially end up with them buying 20% of the company. This causes imbalance in the markets and increases market manipulation. Therefore as a retail investor, not having mutual funds invested in them could be a blessing in disguise.

 

Lack of Analyst Coverage - Fund houses or banks have analysts to cover large cap companies but smaller cap companies are often neglected as they are deemed as volatile and often unprofitable. However I feel this creates an opportunity as the most undervalued and neglected stocks with high profit margins are often overlooked just because they are smaller in size. (size matters apparently to the big boys). You can buy them at discounts and when your smaller cap stocks grow big enough to garner the attention of the big boys, you'll be laughing all the way to the bank. In investing, it doesn't matter where you start, its the end that matters. Some friends I've spoken to had scoffed at my idea of wanting to buy/watchlist/read up on smaller cap companies but on hindsight now, who's having the last laugh - bitches!

  

 

Risks

As always, I will end with the risks involved as some might be thinking about just going into any smaller cap stocks and buying them like candy. They are cheap for a reason and often riskier than blue chips simply because they require lesser volume to move prices. Those with smaller floats tend to fluctuate 3%-5% in a single day. Unless you can stomach the volatility, you are better off putting your money somewhere else and always risk what you can afford to lose in small cap investing. I wouldn't bet my farm on a single or multiple small cap companies right? At the end of the day, we got to be rational and understand the downside risk in the event of something unexpected. Total annihilation can occur in small cap investing.

 

The issue of finding these type of small cap companies with a compelling growth story is hard work - be prepared to read, research and question irregularities. If you are thinking that it'll be a walk in the park, it isn't. To even find one that is even worth looking at, I have spent and read and dumped more than a few hundred stocks that were really crap. But when you do see one, you know its the one - like how you guys met your wife/girl friend/gay buddy or whatever man. Bottom-line is, hard work is required but the rewards are often very appealing and it can be an addiction to find diamonds in the rough.