When investing in small to mid cap companies, there are many potential pitfalls. Companies this size can be quite alluring as they may offer better than average growth potential, but the aforementioned risks can be substantial.
Generally speaking, we are aware of the obvious downside to small and mid cap size companies. Risks such as limited operating history, concentrated customer bases, or economic impact all have a major impact. However, one consideration that I have experienced is misjudging the market potential. This was a difficult lesson to learn because it seemed so counterintuitive.
Most novice investors have a misconception of what successful small cap investing should be. We all dream of finding that 10+ bagger that start out as a tiny business and grow into a large, thriving business (making us rich along the way). While this is indeed a nice dream, I believe it is the wrong way to think about investing in small caps. For example, Oracle Corp (ORCL) dominates the $21 billion database market. $21 billion is a huge market opportunity. It may be tempting to take a chance on a company with $50million in revenue which participates in the market. If the company could only grab 1% of the market, their top line would quadruple – or so the logic goes. This sounds great on paper, but unfortunately it rarely turns out as planned. Not to imply this is impossible, but the odds are against you relative to the potential payoff.
Rather, seek out companies that are market share leaders is small/niche markets – a big fish in a small pond. Simpson Manufacturing (SSD, Financial) is a good example of this type of opportunity. Granted it may not be as exciting as a $21 billion opportunity, but the risk reward is much more favorable. Simpson Manufacturing Co., Inc. designs, engineers and manufactures wood-to-wood, wood-to-concrete and wood-to-masonry connectors. The Company’s subsidiary, Simpson Dura-Vent Company, Inc. (SDV), designs, engineers and manufactures venting systems for gas, wood, oil, pellet and other alternative fuel burning appliances. SDV is the Company’s venting products segment.
Although Simpson Manufacturing has been hit by the housing market downturn, this is a company that has a market share leading position in the connector market. The Simpson Strong-Tie has very strong brand recognition within the building industry. Connectors may not sound very exciting, but it is a profitable niche for the company. Prior to the downturn, the company had averaged over 18% EBIT margins and sustained returns on capital north of 15%. Revenues hit only $860 million at the peak – so it’s not a huge market. The company’s niche dominance has rewarded shareholders with a stock price that has grown almost 10X over the past 15 years. That’s a gain of over 700% compared to the 150% return for the S&P 500.
