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Many investors pay a fair (and often inflated) price for companies with high growth potential. On the other hand, value investors seek to pay a discounted price for these opportunities.
Our search for the rare combination of high growth and low valuation often leads us to the small-cap universe. We believe small-cap stocks can offer three distinct advantages:
Small companies grow from a smaller arithmetic base. It is generally much easier for a company to double its sales from $100 million than from $100 billion, for example. Many large companies, while being reasonable investments, have already passed their high-growth phase.
Many small companies are unfamiliar to the general public and attract much less research by the investment community. Therefore, they are more likely to be mispriced compared to their larger peers. Investors who conduct in-depth research on these companies and know what to look for can have a significant advantage.
Although there is no universal definition for small caps, we generally consider them to be those with less than $3 billion of market capitalization. Roughly 75% of all U.S. publicly traded companies fall into this category. Investment managers usually focus on the largest companies, which represents only a small fraction of available opportunities. This leaves us with a large number of underfollowed companies to investigate and find potential winners. Many small companies plod along in relative obscurity, waiting to be recognized by Wall Street. We want to be there before this recognition sets in.
The risk of investing in small-cap stocks is generally considered greater than investing in large cap stocks. Investing with experienced professionals can mitigate, but not eliminate, risk. Investing in stocks can result in a complete loss of principal. Value investors attempt to provide downside protection by buying at an attractive price; however, there can be no assurance that this strategy will be successful.
Small-cap stocks have lower trading liquidity, which means there are fewer buyers and sellers for small-cap stocks than for large-cap stocks. Therefore, small-cap stocks can experience volatile price movements and incur higher transaction costs.
Smaller companies have fewer financial resources and less access to capital compared to their larger peers. Therefore, it can be more difficult to obtain financing to pursue new growth opportunities or to endure economic and industry downturns.
Some small companies do not have long operating histories or proven business models. They can be vulnerable to competition from larger companies.
Less information is publicly available for small companies than for large companies.
Both value and growth investing involve risk and can result in a complete loss of principal. Compared to investors in growth stocks, investors in value stocks attempt to limit downside risk by buying companies trading at relatively low price-to-earnings or price-to-book multiples. However, there can be no assurance that any investment strategy will be successful.
Value investing typically involves buying stocks at low price-to-earnings or low price-to-book ratios with the expectation that the stocks are undervalued and will eventually return to a fair valuation, resulting in an increase in stock price.
First Wilshire has been serving high-net-worth individuals and institutional investors since 1977. Guided by the value investing philosophy, we seek to identify companies with great prospects at an attractive price.
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First Wilshire Securities Management, Inc
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