Editor’s Note: This story was originally published in May 2021, but the underlying research on the size factor of Adam O’Dell’s Stock Power Ratings system is a must-read in any market.
In May 2020, I recommended a biotech company to my Green Zone Fortunes subscribers. Its $1.3 billion market capitalization at the time placed it firmly in the “small-cap” camp of stocks.
Though one year later, the stock has catapulted itself into “mid-cap” territory with a market cap of almost $4.5 billion. And I think it will be a “large-cap” behemoth ($10 billion-plus) within a few years. I’ll touch on that more in a bit.
But first, let’s examine how my proprietary Stock Power Ratings system’s “size factor” played into this stock’s success over the last year.
Size Benefit No. 1: Smaller Companies Fly Under the Radar
When looking for a new company to invest in, it’s natural to search for the largest companies because a huge market cap (current share price times the number of shares outstanding) means the company must be doing something right … right?!
But keep this in mind: A big, headline-grabbing company is not always your best bet, assuming you’re a shrewd investor seeking to maximize your profits.
With a recognizable name can come a cult following and “bandwagon buyers,” who tend to drive up the prices of mega-cap stocks to the point where they’re no longer a good value and at the expense of future returns.
You see, there are risks to buying the biggest companies. In recent years, Big Tech has come under increased scrutiny, triggering concerns over anti-trust laws, heightened regulations and greater taxation.
In short, when a company gets too big, so does the size of the target on its “back.” Increased competition has knocked more than a few big dogs off their pedestals not long after they made it to the top.
Now, I do realize this is a difficult argument to make in the age of the “FAANGs.” Indeed, Facebook, Amazon, Apple, Netflix and Google are huge, “mega-cap” companies, which, love ‘em or hate ‘em, have dominated for many years.
Realize, I’m not saying that the “size factor” is powerful enough to put Amazon out of business, just because the company got too big for its britches.
Size Benefit No. 2: Smaller Companies Outperform
The academic research is clear: Small companies outperform large companies, in aggregate, over the long run.
This means that if an investor consistently buys a portfolio of the smallest half of all stocks in the market and simultaneously short-sells a portfolio of the largest half of all stocks in the market … this investor will over time earn a positive return, thanks to the “size factor.”
The size premium was one of the first factors to be discovered. The famous “three-factor model” I talked about recently included market beta, size and value.
Given a choice between two stocks that rate equally on all other factors, we should prefer buying the smaller one.
Why the Size Factor Works
We can explain each of the six factors that drive market-beating returns by various “risk-based” or “behavioral-based” causes.
With momentum, for example, one behavioral-based explanation is simply that human beings tend to under- and over-react to information flow. These behaviors are persistent … they lead to the temporary mispricing of stocks … which allows momentum traders to make profits.
For the size factor, a number of risk-based reasons explain why investors who are willing to buy smaller companies can earn market-beating profits.
Essentially, the theory is that smaller companies are inherently riskier than larger companies because:
- They tend to employ greater financial leverage.
- They operate with a smaller capital base, restricting their ability to mitigate economic contractions.
- They have lesser access to credit.
- Their earnings tend to be more volatile, even “lumpy.”
- They have greater uncertainty of future cash flows.
- Their business model may be unproven.
- Their management team may be less experienced.
- Their shares are less liquid, making them more expensive to trade.
- Their shares may not qualify as “buyable” for large institutional investors with restrictive mandates.
- They garner less analyst attention and media coverage, decreasing transparency.
These are all fairly intuitive risk factors — if you ask me. It makes sense that smaller companies face challenges that the biggest companies don’t face. As such, buying the shares of smaller companies is not as much a sure bet as buying shares of a well-known blue-chip company.
But here’s the thing…
For one, investors in small companies get paid a “premium” to do so. And in the end, if you hold a diversified portfolio of small companies, you can make more money buying these somewhat riskier small-cap stocks than you can by piling into the big names. The research is crystal-clear on that.
What’s more, you don’t have to buy the tiniest “micro-cap” stock that’s worth only $10 million, for example, to earn market-beating returns from the size factor.
In fact, the company I recommended to my Green Zone Fortunes subscribers a year ago was at something of a “Goldilocks” size when I talked about it initially. It was big enough to gain traction and market share but small enough to still give us the “juice” that small-cap stocks are known for.
That juice led to gains of 91% in just four months for my readers when we closed half the position in September 2020.
This is what we call a partial play. We take some of the profits off the table by closing a portion and letting the rest of the recommendation keep running.
It’s always exciting to be in a stock as it grows from one size category to the next larger one. And with this biotech stock, we watched it double as it quickly moved from the small-cap space to a $4.5 billion “mid-cap” stock.
And the size factor played a part in that run…
To good profits,
Chief Investment Strategist, Money & Markets