Individual investors, like you and me, don’t have many advantages over large institutions.
But we do have a big one…
How small we are.
I know, that sounds counterintuitive. Institutional investors have deep pockets. They can fund research teams with dozens of Ph.D.s. They can fund lobbyist groups that work to bend regulations in their favor. They can even co-locate their technology with the exchanges’ … ensuring their orders get filled faster and at better prices than ours do.
Just look at Warren Buffett. He’s one of the largest money managers in the game with access to opportunities the “little guys,” like us, could only dream of.
More than a dozen private jets reportedly landed in Omaha as the banking crisis erupted in mid-March. How many landed outside your home?
But the fact that we can’t invest the way Buffett does cuts both ways. Our small size allows us opportunities he could never touch.
The Oracle of Omaha even admitted this himself once, saying:
Anyone who says that size does not hurt investment performance is wrong. The highest rates of return I’ve ever achieved were in the 1950s — but I was investing peanuts then.
It’s a huge structural advantage not to have a lot of money.
See, Buffett manages hundreds of billions of dollars. That means he can’t touch “small” stocks with a 10-foot pole … even when he wants to.
This is a blessing for small investors like us. It means there’s a whole sector of investment opportunity that can make a big impact on your wealth early on … and an even bigger impact once those stocks grow enough to attract institutional attention.
And who do we have to thank but the SEC for affording us the best of these opportunities…
The Stocks Warren Buffett Can’t Touch
Nearly a century ago, the SEC established a frankly ridiculous rule which makes it a real pain for any big investor to buy a certain class of small-cap stocks.
(If you’re already familiar with small caps, feel free to skip down to the next section where I talk about this rule in-depth. Otherwise, read on for a quick primer.)
Stocks are generally categorized by their market capitalizations, or “market cap.” A stock’s market cap is simply its per-share price multiplied by the number of shares it has outstanding.
Stocks with a market cap above $10 billion are considered large-cap stocks. $2 billion to $10 billion makes up the mid-cap category. This is the sandbox where the Big Money plays.
$250 million to $2 billion is the “small-cap” space. And companies with market caps under $250 million are called microcaps.
Effectively, the entire micro- and small-cap categories of stock are off-limits to Buffett and his peers. Even when he sees an attractive opportunity there, he knows the size of his investment would be too small to matter … or that he would move the market if he invested a meaningful amount of capital.
At the end of the day, Buffett knows he can’t touch small stocks. I doubt he bothers to even look at them these days, because even if he does … he has to “pass.”
Of course, Buffett is just the prototypical large institutional investor — he’s far from the only one.
Hundreds of mutual funds, hedge funds, pensions, endowments and insurance companies face the exact same “size penalty.” They’re too big to invest in the best small-cap companies.
Many of those large investors even have rigid rules written into their charters and mandates, absolutely prohibiting them from investing in companies that are too small, either on the basis of market cap or a stock’s per-share price.
In fact, one of the “silliest,” yet highly exploitable anomalies related to the size of a stock is what I call “The $5 Rule.”
Exploit the $5 Rule
The $5 Rule dates back to SEC regulation that was written in the 1930s, creating additional hurdles institutional investors must jump through when buying a stock that’s priced below $5 a share.
The $5 threshold is, as far as I can tell, completely arbitrary. There is no meaningful difference between a stock that’s priced at $4.99 and one priced at $5.01.
- Yet, in the eyes of the SEC, and the institutional investors subject to the $5 Rule, there is a difference: $5.01 and above, stocks are “fair game.”
- $4.99 and below, stocks are effectively “off-limits.”
And that’s why I’m saying the little guys like us have a meaningful advantage over the big boys. When we find a high-quality company whose stock trades for less than $5 … we can buy it just as easily as a stock that trades for $50.
While the stock trades below that threshold, we have little competition from the Wall Street machine and its biggest players.
Most institutions won’t touch a stock while it’s under $5. Many analysts don’t even bother covering it.
And that leaves a trove of high-quality companies that go overlooked, undiscovered or untouched … simply because they’re “too small,” according to that arbitrary $5 Rule.
And here’s the most beautiful part of it all…
Once a stock that was previously below $5 crosses above that threshold … Wall Street’s handcuffs are off. Analysts, portfolio managers and allocators can all jump back in.
And when they do, sometimes all at once, it can send prices dramatically higher.
At this point, the investor who’s read one too many Berkshire Hathaway annual letters may be reading this and thumbing their nose at the risks associated with small-cap stocks.
Well, you’re right. Those risks exist.
But when you invest the way I do, you know how to mitigate those risks … and find only the small-cap stocks with the highest odds of success.
The Right Way to Find Great Small Caps
If you’ve been following along in Stock Power Daily over the last week, you know I just released a 298-ticker master list of stocks that are priced under $5 per share — too low for any major institution to get their hands on … for now.
This list is my ultimate hunting ground. Smart buys in this space today will pay off huge dividends in the years to come.
But if you ask me, we won’t have to wait that long.
Because somewhere in this haystack of names are a handful of golden needles that I believe will return 500% or more before the end of 2023.
I’ve been doing a ton of research over the past week to uncover those names. And this week, I’ll strike around 160 stocks from the list that won’t make the cut.
If you haven’t already, be sure to click here and put down your email to access the list of stocks and follow along. And be sure to check out this Thursday’s Stock Power Daily, where I’ll release the newest version of the list and show you how we’re separating the wheat from the chaff.
Chief Investment Strategist, Money & Markets