Micro Caps vs. Large Caps: An Easy Choice

Competing with smart money to try and find the best large caps is a game on an uneven playing field. Change the rules by looking at micro caps.

magnifying glass on stock board

When I started my career with Eaton Vance I was fortunate enough to work with insanely smart people, many of whom had the Chartered Financial Analyst designation and MBAs from some of the best graduate schools in the world.

The firm’s great culture meant everyone was friendly and welcoming and I was fortunate that my department was small relative to the assets under management. As a result, even as an entry level research associate, I had the opportunity to interview senior management teams.

Shortly after I started my career, the senior pharma analyst under whom I had worked left for another job, and I was the only “pharma expert” left.

Before they hired another senior analyst, I was tasked with interviewing the management teams that visited our offices when conducting the Boston portion of their periodic roadshows.

I still distinctly remember interviewing Johnson and Johnson Chairman and CEO Bill Weldon, who must have been quite surprised to be sitting across from a 22-year-old recent college graduate.

While my experience at Eaton Vance was wonderful, my experience there seared one key lesson into my mind: to outperform the market, you need to find a niche.

Let me explain.

The Problem with Large Caps
At Eaton Vance, the primary focus was on managing portfolios of large-cap stocks.

As a result, the senior analysts and portfolio managers worked incredibly hard to find an edge that would give them insights as to which large-cap stocks were poised to outperform.

Why?

Because the slightest edge would enable the firm’s large-cap funds to outperform their index and would drive billions of dollars of equity inflows.

Every billion dollars of new assets under management would generate an additional ~$7.5 million of high-margin, sticky revenue. At the time, the firm managed over $100 billion dollars.

To gain an edge, the firm’s portfolio managers, analysts and lowly associates (me!) poured over financial results, traveled the globe attending industry conferences, and spent countless hours performing due diligence while the firm paid millions of dollars for specialized research and access to data.

All of this work was done to create an edge. The financial stakes were enormous.

At the same time, there were hundreds of other portfolio managers and senior analysts in Boston trying to do the same thing. Many were backed by firms (like Wellington Management, Fidelity Investments or Putnam Investments) that had even greater financial resources than Eaton Vance.

On a global basis, there were tens of thousands of portfolio managers and senior analysts trying to do the same thing.

Competition was fierce because the stakes were so high.

As a result, nobody really won.

Eaton Vance funds were not able to consistently outperform their benchmarks despite the best efforts of the firm’s incredibly talented team.

This was not unique to Eaton Vance.

S&P Global recently found that the majority of large-cap funds (89%) had underperformed the index over the past decade.

As a result, the outflows from active equity funds into passive funds has been unrelenting.

Now let’s get back to the key lesson that was seared into my mind: to outperform the market, you need to find a niche.

You can outperform and make money buying large-cap stocks. But it’s a really hard game to win consistently because there are so many intelligent and highly trained analysts trying to do the same thing. The financial incentives are massive.

To consistently outperform, you need to find a niche.

My favorite niche? Micro-cap stocks. Why? It starts with outperformance.

From 1927 to 2016, the smallest decile of stocks in the U.S. generated a 17.5% compound annual return, versus 9.2% for the largest decile of stocks.

Like any good fisherman knows, you want to go to where the fish are.

3 Reasons to Invest in Micro-Cap Stocks
But beyond excellent historical returns, there are several other reasons you should invest in micro-cap stocks.

Less competition
Almost all professional investors are prohibited from investing in micro-caps because they are too small. Therefore, there is less competition.

Simple business models
Micro-caps typically only have one line of business, and so they are easy to understand and analyze.

Management access
If you want to talk to Apple’s CEO, Tim Cook, good luck getting him on the phone.

But most micro-cap management teams are eager to spend time on the phone with prospective investors.

Just pick up the phone and give them a call!

My work focuses exclusively on identifying high potential micro-caps.

It’s a lot of fun and historically has been very lucrative. In fact the average return among the 15 micro-cap stocks currently in my portfolio is 73%!

Have you considered micro-cap investing to boost your returns?

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