Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice chairman Charlie Munger (Trades, Portfolio) is not known as a small-cap investor. Indeed, most of Berkshire’s current major holdings are extremely large businesses that have long track records of delivering sustained profit growth.
However, Munger has previously highlighted the appeal of buying smaller companies. As he once said:
“How do you get into these great companies? One method is what I'd call the method of finding them small get them when they're little. For example, buy Wal-Mart when Sam Walton first goes public and so forth. And a lot of people try to do just that. And it's a very beguiling idea. If I were a young man, I might actually go into it.”
Small-cap rewards
In my view, investing in smaller companies can provide higher rewards. Often, small-caps are less widely covered by analysts. This can mean their share prices are less efficient, in terms of reflecting their intrinsic value to a lesser degree than larger companies. As such, there may be more scope to purchase smaller companies at a wide discount to their intrinsic value.
Furthermore, smaller companies can offer higher growth rates than their larger peers. By definition, a smaller business operating in a specific industry is likely to have greater scope to grow compared a larger rival. For example, it can enter new market segments and expand into new geographies that large-cap stocks have already entered.
Small-cap risks
However, in my opinion, small-cap investing can be significantly riskier than purchasing larger companies. Often, small-cap stocks are less liquid than their larger peers. Clearly, this may not be an obvious concern for many investors in the current bull market. However, selling shares in smaller companies can be a far more challenging process during periods of greater market volatility.
In addition, smaller companies may have relatively weak financial positions and could even have narrower economic moats. For example, they may be more reliant on a small number of customers to generate their sales, or on a specific geographical region. Their financial performance may suffer to a greater extent than a more diversified larger business should there be an unfavorable event in their core customer base or markets.
Risk tolerance
Clearly, Charlie Munger (Trades, Portfolio) is in a fortunate position in terms of having vast amounts of cash and experience that mean he is likely able to overcome significant losses over the long run. Investors with more limited capital and experience could find that task more challenging. As such, small-cap investing may be less appropriate for them.
Overall, the appeal of smaller companies may come down to an investor’s risk tolerance. In my opinion, some investors may be better suited to investing in larger companies due to the diversification and financial strength they may offer. However, investors seeking the prospect of higher returns, and who can overcome the inherent higher risks of smaller businesses, may be better off purchasing small-caps.
As for Munger, while he recognizes the return potential of small-caps, he is unlikely to become an avid buyer of small-cap stocks due to Berkshire’s size and the vast amount of cash it holds. As he once said:
Also check out:“It (small-cap investing) doesn't work for Berkshire Hathaway because we've got too much money. We can't find anything that fits our size parameter that way. Besides, we're set in our ways. But I regard finding them small as a perfectly intelligent approach for somebody to try with discipline. It's just not something that I've done.”
