I have a friend in Hong Kong who works for a successful investment fund. His firm manages nearly $6 billion.
To generate a 10% return on their funds under management, they would need to see their portfolio increase in value by approximately $600 million in a year. That’s a tall ask.
In practice, it means there is little point in them looking at investing in any company with a market value of under $4 billion.
Even if they were able to buy 15% of a $4 billion company, investing $600 million, they’d then need the company to DOUBLE in value before it moved the overall needle 10% for their fund ($600 million profit on a $6 billion fund).
For investments in smaller companies, the moves required would be commensurately bigger. Say they took a 20% stake in a $500 million company for $100 million. They would need it to go up 7-fold in value to make $600 million in profit on that investment and see their fund gain 10%. That isn’t very realistic. So, they are forced, by virtue of their own size, to invest only in big companies.
Now, there are still plenty of good large capitalization stocks around. And my friend’s employer has an enviable long-term track record of generating compound annual returns in the low teens for its investors.
But you and I have a massive advantage over these guys. We manage a lot less money. So, it doesn’t take nearly as much to move the needle for us. In turn, the range of possible investment opportunities at our disposal is vastly bigger.
For example, in recent years I have bought about 1% of a Tanzanian investment company. It’s only about a $5 million company at the current share price. I think it’s worth at least three times that, and likely a lot more, based on the investments it owns.
Should my target be met, I’ll have better than tripled my money and made at least $100,000 in profits. For a giant investment firm, a $100,000 profit is a rounding error. For me, it’s a decent chunk of income.
So, rather than have your money invested in a giant investment fund, to me it makes sense to stay small. It makes your choices broader, and your chance of finding great investments much better.
I once described it to a friend this way; take the analogy of a tour group looking for a place to have lunch. Here in Bali there are lots of excellent, but small restaurants and cafes. You and I can have our choice of any of them, if we are just going there alone or with a small family group.
But, if you are a Chinese tour group comprised of two 60-seater coaches, or 120 people, who all need to go to the same sit-down meal at once, you are much more constrained in your choice of restaurants. You can only go to the really big ones that can cater to large groups.
Thus, your selection criteria is no longer simply based on what the best possible meal for your money might be. To me, that seems a dumb constraint to impose on yourself, if you’re looking for a good meal.
Just as it’s easier to find a tasty meal if there are no size constraints on the venue you go to, it’s also a lot easier to find an investment opportunity that has multi-bagger potential when you can fish in the small-company pond. That’s because small companies are generally able to grow into big companies more easily than big companies can grow into huge companies.
But you still need to be very vigilant in your research. Bigger companies tend to have been around longer, and so a degree of survivorship bias applies. The fact they didn’t fail earlier in their lifecycles is often a validation of their business being robust.
In small-company land, the risks are much higher, at least if you take an across-the-board measure of risk. But you can lower the overall risks with careful stock selection.
The key is to screen out those companies with business models, operating environments, or managements, that exhibit excessive risk.
Some of the ways I do this in practice are:
There are no scientific, hard-and-fast rules or hurdle rates. But after a while you will develop a nose for it and come up with rules of thumb.
A company with more debt than equity is usually a no go zone for me. I prefer companies with no debt at all.
A mentor of mine used to say, “Never invest in a company run by anyone with a dubious stock market past.” I try to stick to that. When I break the rule, I usually lose money.
If a company has a return on equity of 15% or more, or a gross profit margin of 50% or more, and dominates its product category or industry, it’s usually worthy of further investigation.
But to be frank, the only way to develop your own rules of thumb, and become a better investor, is to make some mistakes and learn from them. You need to feel your own way and decide how big a margin of safety you need to build into your fundamental research metrics.
The final way to mitigate risk, once you’ve done all the work above, is of course the value investor’s number 1 tool… to pay a low price. You always want to pay less than the value you get.