Predominantly, What Size Companies Do You Invest In?

[no_free_lunch]

I have spent a bit of time on micro-caps but without much luck.  While they are certainly easier to understand, you really need to buy baskets of them as they have so little diversification.  So this requires researching more stocks and kills the benefit of having a simpler story to understand.  I also prefer the way bigger companies tend to have more reviews, this allows you to quickly learn the basic story and decide if you want to get into the annual reports.

 

I find around the $1B market cap to be the ideal space but with obviously many exceptions.

 

I think it was touched on here but in addition to scams you really need to watch executive compensation on micro-caps (say the under $50M ones).  I have seen companies in this range where exec compensation is in the $1M range, given the size of the company that just takes too much out of margins.

[twacowfca]

"Interestingly, a large part of the "small cap effect" is actually some of these larger companies rebounding after they have been beaten down.  :)"

 

Do you have any concret evidence about this?  :)

 

One evidence is perhaps the O´Higgins strategy: You take the 5 stocks of the "Dogs of the Dow" with the lowest share price and rebalance yearly. I think the annual outperformance to the Dow Jones/DAX is around 5%. This strategy worked for a very long time in the Dow Jones and DAX index.

 

The evidence would be the methodology used in particular studies.  Most studies of the small cap effect take various deciles or quintiles of stocks by market cap, track the performance of each group for a year and then rebalance. Obviously, the smallest cap(s) by decile include a number of beaten down companies, especially after the market has taken a dive. The rebound in that case can be huge.  Select Comfort got beaten down in the last market meltdown to the point that it was a microcap and then bounced 20 or 30 times above it's low.  Same with Crocs and many others.

 

I can't give a citation, but I think there has been at least one study that tracked all the stocks in various market cap deciles, including those that went out of business, in rolling multi year periods. I think there is still a small cap effect in general, although much less than in the studies that rebalance yearly. 

 

Most of the small cap effect appears merely to be regression to the mean.  On another thread, I showed how to get dramatic outperformance in a volatile, but ultimately flat market simply by making purchases and sales and then rebalancing to a 50% cash position as the market rises and falls. Essentially, this means buying when a flat, trendless market has smaller capitalization and selling when the market has higher capitalization.  There have been long periods when the market hasn't been bullish that small caps have under performed.

 

There is a very interesting note in today's Barron's, The Trader column, January, 21, 2013, (no functional link, try google if you don't have a subscription) about an apparent anti mega cap effect.  There aren't enough data points for a reliable statistical analysis, but it appears that when a company advances such that it its market cap approaches about 5% of the total S&P 500 market cap, it faces powerful headwinds, almost a limit.  When that quasi limit is approached, that stock almost hits the wall and declines, no matter how good it's business or prospects or general industry or market bullishness.

 

Is this merely a random correlation?  Or is there something that logically would cause this to happen?

The idea is that this is not a spurious effect because most funds investing in that space have formal or informal rules preventing or discouraging holding a position that constitutes more than 5% of the value of the portfolio, which likely would be composed of S&P 500 stocks.

 

The latest example of this effect is what happened to Apple a few months ago as it approached this apparent limit. 

[Guest deepValue]

Ok.....anybody have any links on articles that tell you how to analyze banks? I really have no idea, never look at the financials sector.

 

You might start with Geoff Gannon: http://www.gurufocus.com/news/88015/geoff-gannon-investor-questions-podcast-9-how-do-you-calculate-a-banks-intrinsic-value

[Packer16]

I think once a firm reaches a certain size the growth slows down along with the growth expectations and the valuation follows.  You also have the trade-off of scale versus effective management.  I think Monish Pabrai observed that the largest firm is not there for too long.

 

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