Everyone knows Microsoft Corp. (Nasdaq: MSFT).
It’s one of the largest and best-recognized companies in the world.
I’m writing this note in Microsoft Word on a computer running Microsoft Windows.
And if you’re reading this on a computer or smartphone, there’s a good chance it went to a Microsoft Outlook email inbox.
Microsoft is also a leader in cloud computing, second only to Amazon in that space.
It’s hard to imagine a world in which Microsoft doesn’t exist!
The massive software company has also made investors an insane amount of money over the past 10 years leading up to this year’s bear market.
In the decade ending on December 31, 2021, MSFT shares returned an astounding 1,500%!
It’s one of the greatest success stories of our time.
Now let’s look at that same company when it was still just a baby.
In 1981, Microsoft launched MS-DOS, its old-school text-command-based operating system. It followed that up with the first version of Microsoft Windows in 1985 — and then went public in 1986.
In its first 10 years as a public company, Microsoft shares returned 6,980%, more than quadrupling returns in the decade leading up to 2021.
How was MSFT able to generate such massive returns?
It’s all about size.
The Size Factor
Size is one of the six primary investment factors I consider in my Stock Power Ratings system.
All else equal, smaller stocks tend to outperform their larger peers. Countless studies and my own independent research have proven this.
And my trading has shown that it works in the field.
As for the “why,” there are theories.
Some have said that small-cap stocks carry inherent risk, and thus their outperformance is a reward.
Maybe…
But I think it’s more fundamental than that.
A smaller company can grow faster than a larger one.
The minute Starbucks sold its second cup of coffee, it instantly doubled its sales from its first.
Or the day it opened a second coffee shop, its entire operation was twice as big in an instant.
But today?
Starbucks opens eight new stores per day.
Considering the chain has around 34,000 stores around the world, that amounts to about 8.5% store growth in a year.
That’s great, of course, but at the size Starbucks is today, it can’t grow its footprint at the rate it did in the 1990s when it entered the public market.
Apart from business fundamentals, there are also market fundamentals.
Let’s take another look at Microsoft.
Microsoft’s Market Fundamentals
Again, Microsoft’s stock returns over the past decade have been extraordinary.
The amount of wealth created boggles the mind.
But Microsoft today is a $1.7 trillion company by market capitalization (current stock price times number of outstanding shares).
When it went public in 1986, it did so at a market cap of just $61 million.
It takes much less buying pressure to move a $61 million stock than a $1.7 trillion stock.
Maintaining momentum is much harder when the sheer dollar amount needed to generate market movement gets that high.
Investor awareness is also a big issue.
Everyone knows Starbucks and Microsoft.
These are two of the most recognizable companies in the world.
Every investment bank on Wall Street has a team of analysts covering them.
You’re not going to read their annual reports and discover some nugget of information (I call these X-factors) that everyone else missed.
There are too many people picking apart the numbers already.
But Wall Street budgets aren’t unlimited.
They aren’t dedicating the manpower to research smaller companies customers aren’t asking about.
Furthermore, the “big boys” can’t dabble in small caps.
If you manage a portfolio worth tens or hundreds of billions of dollars, you can’t take a meaningful position in a small stock or you’ll end up owning the whole thing!
So in the small-cap universe, there is still potential for you to find stocks that haven’t already been picked clean by Wall Street analysts.
Bottom line: For these reasons, small-cap investing tends to outperform over time.
And those additional risks the academics worry about can be mitigated by having risk management strategies in place and pairing the size factor with other critical factors, such as quality or momentum.
I’ll put this into practice on Monday and show you how smaller stocks can lead to massive gains out of a bear market.
To good profits,
Adam O’Dell
Chief Investment Strategist
