Small-cap Companies; Home of Great Management and Rapid Growth

For convenience purposes, the publicly traded companies have been categorized with respect to size and industry. This allows us to focus our search even more specifically. Stocks are sized by capitalization, which is often abbreviated “cap.” Capitalization is equal to the number of outstanding shares multiplied by the stock price. Here is a cap classification:

This classification is more or less a guideline. Don’t get all worked up if you come across another classification that does not mirror this one exactly. What is important is that you realize long-term growth stocks are normally found in the small-cap and mid-cap categories. There are a number of reasons why the smaller companies grow faster. First, as alluded to earlier, small companies usually maintain a highly motivated management team that probably consists of the founder(s). Second, smaller companies are easier to manage. Compare organizing a wedding for 2 as opposed to 400. Third, small young companies can naturally progress up the cap ladder as they grow. All great stock performers have started out as small cap companies. This is illustrated in the following table:

*Cap given in million

These companies managed to maintain outstanding growth for at least 15 consecutive years as they climbed the cap ladder. Cap is a function of age. Large caps are older than small caps. Did Microsoft start off as a large cap? No, it did not. Is it still considered a growth stock? This point could be argued with merit from both sides; however, it will never climb the cap ladder again. In addition, it will never be young again. The small growing company will split existing stock to keep the price per share around $50.

For example, you buy 100 shares of XYZ at $10 and in five years the price has risen to $100 per share. To keep the price down XYZ splits the outstanding shares by a ratio of 2 for 1, so now you have 200 shares and the price is $50. There are other split ratios like 3 for 2, which would increase your shares to 150 and reduce the price to $75. You want to own shares of companies before they start splitting stock. Stock price usually responds well to a split; in other words, the stock price will appreciate quickly after a split. This is likely because of a sale mentality on the street. People are conditioned to buy something that has been marked down by 50 percent. Splits can be thought of as the growth rings in a tree. The older the company the more splits it will have. You want to grab onto shares of small-growing companies that have a bright future in a growing industry before they start splitting. So, where are Dell, Medtronic, Wal-Mart, and Microsoft headed? That is a good question. Remember:

Earnings grow fastest among small young companies and earnings growth drives stock price appreciation.

Large caps probably will not be able to support 20 percent annual earnings growth over a long period because of exponential growth expectations. This can be explained with basic mathematics. Applying a fixed percentage to any number large or small leads to compounding or exponential growth. This is illustrated in the following graph.

The crazy compounding beast is back. This beast will help us retire with a cool million, but the beast will also push your favorite company to grow exponentially, which is not sustainable. Notice at the onset (side A) there is not a lot of compounding taking place, which manifests itself in a relatively flat line. That is why young companies can meet expectations. However, as time progresses (side B) and the company ages, the compounding kicks in and really accelerates earnings expectations (line heads north).

This coupled with a finite market leads to contracting earnings. In other words, the company will grow exponentially until expectations (earnings) exceed the company’s growth capacity. Earnings cannot grow at a fixed percentage indefinitely. Eventually, earnings will contract. The estimated 3-5 year annual earnings grow rate for WMT, DELL, MSFT, and MND are expected to decelerate, please refer to the graph below.

Wal-Mart and Medtronic, the slower older growers, are expected to decelerate a bit in the future. However, Dell and Microsoft, the fast growers, are expected to slow considerably in the next 3-5 years—probably because of market saturation and competition. The point I am trying to make is that they all slowdown from the pressure of geometric growth which accumulates with time. What is the moral of the story? Buy young, rapidly growing small cap companies and hang on to them until their earnings eventually contract.

Company size should not be estimated solely on market cap. Consider buying stocks that have the following size criteria:

1. The company’s annual sales: less than $200 million. History has shown that companies of this size are the most likely to double and triple in size in a couple of years. Don’t second-guess history; it repeats itself.

2. Daily dollar volume: $1 to $3 million. This is a useful size indicator easily estimated by multiplying the average shares traded per day times the share price. Most financial journals will report the volume and stock price as well as Internet financial websites. Large institutions cannot invest in small companies with daily dollar volume of $1 to $3 million. We want to beat them to the punch so to speak. Once we are in and the daily dollar volume increases, the mutual funds will step in and buy large blocks of shares, which will drive the price up. We want to be in before them.

All this sounds too good to be true. What is the catch? There are several issues with small cap companies that must be understood.