I recently came across an article by Nate Tobik on Oddballstocks.com about why he focuses on small-cap stocks. It is a great article (as is most of Nate’s writing) and I encourage you to read it because, by and large, I agree with Nate. He lists several reasons why he concentrates on researching and investing in smaller companies, including the higher likelihood of finding underfollowed or unknown stocks, more accessible management and, often times, simpler and easier to understand businesses. These are all great reasons for investing in small-cap stocks.
When I first began investing, I had the same dream I think every investor has had. It is the dream of being a young Warren Buffett (Trades, Portfolio), ferreting out small, undiscovered hidden gem stocks. When I started the Drexel Dragon Fund while getting my Master of Business Administration at Drexel University, many club members wanted to focus on small-cap stocks. However, the undergraduates had already claimed that domain, leaving us with mid- to large-cap companies. The stock pitches that find their way into my inbox are usually always small companies as well. It seems we all dream of finding that pot of gold that no one else could. However, are large-cap stocks really that bad?
We own a portfolio of mostly large- and mid-cap companies (we own and have owned some small-cap companies as well). Why? Well, in our opinion, larger companies have several advantages over smaller companies.
Trend toward oligopolies
One of the biggest reasons to consider, and perhaps start, a search for attractive investments in the large-cap stock space is the evolution of corporate America.
Over the last few decades, the business landscape has become increasingly dominated by monopolistic or oligopolistic companies. Many market segments are dominated by just a few companies and corporate profits have increasingly flowed toward the top few players.
The following data and charts are from a scholarly article published in the Monthly Review in 2011. While the Monthly Review is a very left-leaning publication, the data is predominately from U.S. government sources such as the IRS, the U.S. Census Bureau or reputable third-party sources such as Compustat.
The following chart shows the number and percentage of U.S. manufacturing industries where the largest four companies controlled at least 50% of the market.
Starting in the late 1980s, the manufacturing industry became increasingly concentrated (on a percentage basis). Other segments, such as retail, tell the same story.
In many cases, the percentage of sales by the four largest companies has doubled or even tripled during the 15-year period shown.
Examining the economy as a whole shows the same story. The share of revenue accruing to the largest companies has been on a steady uptrend since the 1950s.
This means if an investor is searching for companies with strong economic moats that are earning outsize returns on capital, they are likely to find those companies in the large-cap space. As industries consolidate, there are likely to be more monopolies and duopolies. As the pool of profits from a sector gets divided up among fewer players, those players are naturally going to increase in market cap and are likely to be found in large-cap indexes.
For example, the credit and debit card industry has just three major players in Visa (V, Financial) and MasterCard (MA, Financial), with American Express (AXP) a distant third. Other industries, such as mobile operating systems, are basically duopolies. In this case, Google’s Android platform and Apple iOS.
More bargains?
While the trend toward industry consolidation has taken place over several decades and shows no signs of slowing down, the following advantage of large-caps is likely transitory in nature. Right now, large-cap stocks are trading very cheaply compared to small-cap stocks.
The Vanguard Small-Cap Index ETF (VB, Financial) currently has a price-earnings (P/E) ratio of 30 compared to just 23 for the Vanguard Large-Cap Index ETF (VV, Financial). Investors who are searching for cheap stocks are likely to have more options to choose from in the large-cap space than in the small-cap space. Of course, the small-cap index contains about triple the number of stocks, so perhaps there could be just as many bargains there as well due to the larger number of constituents. In any case, relative cheapness is an advantage that can be tentatively ascribed to large-cap stocks for the time being.
Large-cap stocks can be misunderstood
Even though large-cap stocks are widely followed, it is possible for people to misunderstand a company or price it incorrectly. While it is unlikely to find a multi-billion dollar mid- or large-cap stock or some type of hidden asset on the balance sheet, easily mispriced stocks can be found.
Between 2010-2011, defense contractors were trading extremely cheaply. Both Lockheed Martin (LMT, Financial) and Northrop Grumman (NOC, Financial) (we bought and still own both) were trading at prices that implied free cash flow declines of around 5% per year for the next 10 years, which were based on fears that the budget sequester would severely curtail defense spending. Yet anyone familiar with defense spending and the culture at the Pentagon and in Congress could be reasonably certain that while the headline budget may indeed be cut, the Overseas Contingency Operations budget, nominally for the wars in Iraq and Afghanistan, would be used as a sort of slush fund to mitigate some headline cuts. Public Department of Defense documents also showed that the DOD’s budget cuts would largely fall on staff and administrative costs while savings would be plowed back into weapons spending. Finally, anyone following the defense industry would know that defense contractors have mostly variable cost structures with the ratio of variable costs to fixed costs somewhere around 95%.
Another example is H&R Block (HRB, Financial), which we owned for a multi-year period. The stock traded cheaply based on fears of a shift to digital tax prep as well a fall in the number of taxpayers due to the economy. The IRS makes data about tax return preparation publicly available and the U.S. Treasury also makes data about tax refunds (a good proxy for real-time in season tax return data) publicly available. We were able to examine the data on tax return prep and buy H&R Block when it was clear the market’s fears were unfounded. Likewise, we were able to make a timely sale a few years later when we saw the actual shift to digital tax prep really begin to gain traction.
Summary
There are advantages and disadvantages to investing in small-caps and large-caps. The takeaway sould not be that one is better than the other. It is likely that investors can find great opportunities in either space. The argument for focusing on one area or the other should come down to what you are interested in personally as an investor. If you enjoy buying larger well-known stocks and can sleep better at night with a portfolio full of companies you have heard of before, then it makes sense to concentrate your research on large-cap companies. If you enjoy finding unknown stocks and adventuring off the beaten path, then a portfolio of nano-, micro- and small-cap stocks might be right. Or better yet, do not limit yourself to any specific size company and invest in great companies at great prices no matter what size they are!
Disclosure: Long LMT, NOC and V.
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