“The universe I can’t play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in.”
Warren Buffett – July 5, 1999
The investment world has long debated large-cap vs. small-cap equity investing. Quality large-cap companies tend to be strong, dominant, ubiquitous players and, in some cases, have even been incorporated into common language. Go ahead, Google it. Large businesses like these continue to reward long-term shareholders. At Clarkston Capital, however, we have found our forte investing in small-cap businesses in micro-niche markets.
Historically, U.S. small caps, as measured by the Duff & Phelps 2020 SBBI Yearbook, have provided investors with an attractive absolute annualized return of 11.9% since 1926, compared with a 10.2% annualized return for U.S. large caps. Of late, however, the relative investment results of small caps (Russell 2000 Index) have lagged those of large caps (Russell 1000 Index) at an increasingly accelerated pace.
Despite the market’s current disfavor, Clarkston believes that long-term active investors can find tremendous opportunities in small-cap businesses. Over the long term, small caps have delivered excellent absolute returns, and recent performance headwinds have only offered a more enticing entry point. These headwinds will likely give way to tailwinds as the market reverts to the mean and small caps rise in value.
If small-cap investing is as desirable as we claim, why the hesitancy among modern investors? The nearby table lays out the common arguments we hear against small-cap investing, as well as our unique approach to mitigating these negatives:
Clarkston's Unique Approach
Small-cap investors benefit from a large, diverse universe of potential investment targets. These targets fall everywhere on the continuum in terms of business quality: There are those that fail, those that succeed and everything in between. For example, nearly 40% of the companies in the Russell 2000 lost money in 2019. If we use profitability as a simple standard to measure business quality, a significant portion of the index constituents fail to meet this threshold. Our concentrated, rigid, bottom-up research approach is designed to exclude these unprofitable and otherwise low-quality businesses that we anticipate will be more likely to be losers over the long term. At the minimum, we try to win simply by not losing.
Of course, this does not negate the diverse quality of the other approximately 60% of the businesses in the index, which range from wildly successful to just getting by. Through our highly selective approach, we seek to build a concentrated portfolio of high-quality businesses among these thousands. We look for competitively advantaged businesses in micro-niche markets. These businesses must have attractive and defensible business characteristics, such as high returns on capital, recurring revenue and pricing power; must be operated by savvy, capable management teams; and must trade at prices below their intrinsic value, allowing us to purchase at a price that we believe provides a margin of safety.
In many cases, smaller companies are less complex from an operational and financial perspective. They often compete in only one or two business segments, making it easier to gain expertise about the industry, competition and competitive structure. In addition, these companies typically have less complex capital structures, which mitigates the unknown risks associated with financing. Concentrated investors like Clarkston have the opportunity to better understand and get comfortable with simple small-cap companies.
Clarkston also attempts to benefit from the overall inefficiency of the market. We believe the small-cap investable universe is inefficient with regards to disseminating information. The largest 200 names (those in the Russell Top 200 Index) are scrutinized by a median of 22 research firms, whereas small-cap holdings in the Russell 2000 are covered by a median of merely five firms.
Clarkston works hard to exploit this inefficiency. The fact that our investment team competes with fewer rivals examining the same companies provides us with a greater opportunity to gain an information edge using our robust research process. We pore over annual reports and balance sheets of companies in our target market, diving deep into the financials of not just the business in question, but its competitors and the industry as a whole, in order to analyze all factors that drive results. A smaller business means less coverage, less pre-existing research and more information waiting to be discovered and capitalized upon. We don’t have to be the best in the most competitive markets, but we must be able to compete in the market in which we participate. Our research-intensive approach enables us to create a repeatable advantage and remain competitive in this space.
Perhaps the most valuable source of information about a business is the most direct: the management. Smaller market capitalizations enable us to acquire large positions in companies, which grants us better access to management teams. This is critical to Clarkston’s approach. Access to these teams allows us to closely evaluate management and create a better partnership with the stewards of each business. A large stake in a company provides us with an opportunity to communicate directly with management, something that would be capital prohibitive with large-cap companies, where it is unfeasible for us to purchase a significantly large holding.
The Micro-Niche Advantage
A micro-niche business, as Clarkston defines it, is a business that thrives in a smaller, mature market that tends to grow slowly and be more isolated from disruption. These markets are small enough that large corporations can’t justify the cost to entry, and venture capitalists won’t risk the price of innovation when there are more attractive opportunities for blue sky investing elsewhere. Even if these companies were to take the risk of investing in a small market, they could only realize a worthwhile return by stealing market share from existing incumbents – no easy task.
Since the playing field isn’t crowded with hundreds or thousands of competitors fighting for market share at any cost, this leaves a few incumbents ruling the micro-niche market as an oligopoly. Medical/hazardous waste, dealer management systems, healthcare transition processing – all of these are textbook micro-niche markets. They have years, sometimes decades, of operating experience, which leads to wiser choices with pricing, building/taking out capacity and entering new markets and acquisition multiples. Smaller players may try to compete at the perimeters, but they are unable to compete at scale and are often a source for future growth and M&A.
Clarkston’s unique investment approach reflects our fundamental philosophy. We seek out easy-to-understand businesses, exploit the market’s inefficiency to gain an information edge and analyze that information to identify high-quality micro-niche companies. However, all of these factors are predicated on our firm commitment to invest with a long time horizon – at least 10 years or longer.
Longer-term ownership of a business lessens the impact of slight changes in purchase price on the total return of a portfolio holding. As long-term investors, we worry less about slight changes in purchase price and more about the business’s long-term fundamentals. This is paramount for a concentrated investor.
Simply put, a long time horizon rewards our patient temperament. It endows us with strong hands to hold onto high-quality investments during challenging periods when others would be forced to sell and grants us courage to buy when the market is afraid. Add in our robust research approach, the market’s inefficiency and the micro-niche advantage, and we have found our recipe for small-cap investing.
Historical returns are not indicative of future results.
All investing is subject to risk, including the possible loss of the money you invest.
Investing in small or medium sized companies typically exhibit greater risk and higher volatility than larger, more established companies.
The Duff & Phelps Stocks, Bonds, Bills, and Inflation® (SBBI®) Yearbook includes returns, index values, and statistical analyses of U.S. large-company stocks, small company stocks, long-term corporate bonds, long-term government bonds, intermediate-term government bonds, U.S. Treasury bills, and inflation from January 1926 to present. Small-company stocks are represented by stocks making up the ninth and 10th deciles of the New York Stock Exchange (NYSE) from 1926-1981, the DFA U.S. Small Company 9-10 (for ninth and 10th deciles) Portfolio from January 1982-March 2001, and the DFA U.S. Micro Cap Portfolio from April 2001-December 2019.
The Russell 1000® Index is a market capitalization weighted index that measures the performance of the large capitalization sector of the U.S. stock market and includes the 1,000 largest stocks in the Russell 3000® Index. The Russell 2000® Index is a market capitalization weighted index that measures the performance of the small capitalization sector of the U.S. stock market and includes the 2,000 smallest stocks in the Russell 3000® Index. The Russell Top 200® Index includes approximately 200 of the largest securities in the Russell 3000® Index based on a combination of their market cap and current index membership and represents approximately 68% of the US market. The Russell 3000® Index consists of the 3,000 largest U.S. public companies. You cannot invest directly in an index. Although reinvestment of dividend and interest payments is assumed, no expenses are netted against an index’s returns. Frank Russell Company (“Russell”) is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Frank Russell Company. Neither Russell nor its licensors accept any liability for any errors or omissions in the Russell Indexes and/or Russell ratings or underlying data and no party may rely on any Russell Indexes and/or Russell ratings and/or underlying data contained in this communication. No further distribution of Russell Data is permitted without Russell’s express written consent. Russell does not promote, sponsor or endorse the content of this communication.
Warren Buffett quote: Homespun Wisdom From the ‘Oracle Of Omaha’, Business Week (July 5, 1999).
Research and development (R&D) includes activities that companies undertake to innovate and introduce new products and services. Blue sky investments are speculative schemes that have no real value for investors. Mergers and acquisitions (M&A) is a general term used to describe the consolidation of companies or assets through various types of financial transactions, including mergers, acquisitions, consolidations, tender offers, purchase of assets and management acquisitions.
References to specific securities are for illustrative purposes only and should not be considered as investment advice or as recommendations to buy, hold or sell any securities.
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