“Investment is essentially the arbitrage of ignorance.” Jim Slater

In my opinion, the share market’s valuation of investments is usually correct – ‘usually’ being the key word here. In terms of the whole market, there will be occasions when shares will become overvalued and undervalued to a wide degree. By having a differing opinion on the valuation of a certain asset to the current share price, and backing that opinion by investing in the asset, you can make money. Outside the realm of technical trading, it does not matter if you are a day trader or long-term investor, a value or growth trader, a “big-picture” or a “trend” investor; you are essentially aiming to profit from value discrepancy. The subject of this article is small caps and micro caps, two groups of stocks which are more likely to be mispriced.

I first got interested in small caps and micro caps companies due to the opportunities they offer. It was during my reading of the Zulu Principle, by Jim Slater, that I was exposed to their advantages, and also their disadvantages. Zulu Principle was one of the first books that I had ever read on investment strategies, and it was one which yielded me an idea that has been quite profitable (to date it is my most profitable idea yet, on a rate of return basis).

The terms ‘small caps’ and ‘micro caps’ are used to categorize shares by market value (or market capitalisation). Market capitalisation is calculated as share price times the number of shares outstanding. ‘Micro cap’ stocks are between $50 million and $100 million[1] while small caps are usually between $50 million and $400 million (in my opinion).

The basic advantage of small and micro cap stocks was referred to in my introductory paragraph. Small and micro cap stocks are less likely to be well researched by professional stock analysts and followed by the big funds. Contrary to the large cap stocks, which usually have an entourage of stock analysts and are owned by a lot of the major funds, Slater says “you are therefore more likely to find a bargain in this relatively under-exploited area of the stock market.” This is the core strategy of the Zulu Principle, that is, to find and develop an edge and focus on it. The principle is similar to Warren Buffet’s margin of safety.

These groups of shares are also well-suited to university student investors because of their generally smaller share prices. The advantages are two-fold. Firstly, because share prices may be lower, you can buy more shares with a small amount of money (let’s say $2000), and mathematically your brokerage costs per share will be less cost per share compared to buying expensive shares. For university students with less capital to invest, stocks will relatively lower share prices offer a good opportunity to buy relatively more shares. Secondly, because smaller cap stocks are often new companies or start-ups, their price growth can be amazing, if they hit a success story. Fortescue Metal Group (ASX code: FMG) which I will later discuss, achieved a price increase from $0.05 to currently be $6.15, with a high of $13.15 (that is a 123 fold increase if you invested at $0.05. N.B. That is a BIG if. A more realistic situation is if you invested when it was $1, which is still a 6 fold increase)

However, disadvantages are also present for these two groups of stocks. Always remember that behind each stock is a business entity. As with any companies on the start-ups stage (which is usually the stage on which micro and small cap stocks are on), there are high failure rates. Only a handful of these companies will make it large enough to be included in the benchmark index of Australian shares, the ASX 200. This is why diversification is particularly useful in a portfolio consisting of small companies. Moreover, since small companies are usually covered by fewer stock analysts, there will often be a lack of information on the companies regarding the history of its management amongst other things. This is one of the main (and ironic) impediments in picking smaller cap stocks – it is more imperative to research these stocks well due to a higher probability of failure, yet it is also more difficult to obtain this information.

In Taming the Lion, an excellent book by Richard Farleigh, Farleigh outlines the basic five-point checklist for small companies. Firstly, the quality of the company’s management is the most crucial factor in determining its success. Bad management can turn great potential into a disaster, while brilliant management can turn average ideas into a success story. ABC Learning Centre’s collapse exemplifies the result of bad management, whilst Facebook’s success symbolizes the latter (MySpace and Friendster were forerunners). Secondly, is the valuation based on some ridiculous potential? The tech bubble of late 90s is perhaps the most vivid example of this. Companies consisting of a group of teenagers in a room of computers were getting obscene P/E ratios. Thirdly, what is the company’s comparative advantage? JB Hi-Fi (ASX code: JBH) has a unique comparative advantage, which is that their inventories are stored on the shop floors, therefore saving on inventory costs, while simultaneously allowing them to open stores in more shopping centres than their competitors. Fourthly, determine if the business is sustainable, that is, will the business last? Finally, research if the product is actually being adopted by the market and if it has the ability to handle growth.

Fortescue Metal Group is one of the success stories which ticked all the boxes. Fortescue was a small mining company, which was previously named Allied Mining & Processing. However, in five years it rose to become the one of the major iron ore producers in the world. The arrival of Andrew Forrest as CEO for Fortescue marked a turning point for the company, demonstrating the importance of good management. Forrest had a vision for the company, which was to become the “third infrastructure force” behind BHP and Rio Tinto in Pilbara and eventually to become the “lowest cost, most profitable and safest iron ore producer.” His track record was stained by his previous post at Anaconda Nickel, however, his ability to raise capital and his ‘never say die’ attitude in troubled circumstances provided glimpses of the brilliance that would prove to be vital in Fortescue’s success. The circumstances surrounding the rise of Fortescue must not be overlooked; the mining boom provided the room necessary to sustain Forrest’s vision. If not for the rising iron ore prices and its subsequent boom for mining companies, Fortescue would not have been sustainable. Whilst its valuation might have been ridiculous, it is a case of opportunism for Fortescue. They used their high valuation to build something concrete. This was made only possible by the competency of their management[2].

This is the price chart of FMG:

Small and micro cap stocks can provide great opportunities. Despite their high failure rate, they can provide the best risk-reward ratio, particularly if diversification is used. One or two stocks which hit it big time can compensate for the part of your portfolio which tanked. Personally, I would not allocate my entire portfolio entirely to small stocks, however it can be a viable strategy if done correctly. Australia’s small market means that a large proportion of the small and micro cap stocks will be located in the commodities sector. Therefore, if you do venture out into small companies investing, it is recommended that you familiarise yourself with commodities and their nature. This includes the rollercoaster ride in share prices resulting from news of mining discoveries and the basis of a particular commodity’s demand.

[2] For a brief overview of the Fortescue story, visit http://www.fmgl.com.au/IRM/content/invest_corporateoverview.htm