Investing in the Future

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Dear SmallCap Network Members:

Micro and small cap investing has historically been left to those with strong stomachs and a flair for adventure.  In the early years, information on these companies was often difficult to obtain. Investing sometimes turned out to be no more than a "shell" game, separating investors from their hard earned money.  However, small caps have performed extremely well despite these shortcomings.

According to Ibbotson Associates, for the 20 year period ending in 1994, the real return of the S&P was about threefold while the small cap sector soared to a tenfold return! It is unfortunate that a small percentage of disreputable companies have cast a negative cloud around micro and small caps.  The SmallCap Network's objective is to provide sound investment ideas to Members to help produce better investment results over the long-term.

Diversification

Most successful long-term investors understand the importance of diversifying.  It is a common creed among the best investors and rightfully so. What isn't as widely known is diversifying across different industries and companies is simply not enough.  Allocating investment dollars to companies in different industries as well as those with varying market caps increases the odds of success.

What many investors fail to realize is there are companies that are in the process of becoming the next big global enterprise TODAY. Time is needed for these companies to develop into the next Microsoft, Wal-Mart, Coca-Cola, or Intel.  The companies listed in the Fortune 500 change each year with new companies being added and incumbents being ousted. A few shareholders are fortunate enough to ride the wave by buying and holding these companies as they achieve amazing growth rates and increase shareholder value over time.

Economies of Scale

The micro and small cap stages of development are passed through by every one of these big winners at some point in their history.  It is difficult and challenging to grow revenues from $5 million to $50 million and then from $50 million to $350 million. As a company grows, it is able to achieve certain economies of scale that ultimately enable it to grow from $1 billion to $5 billion, or more.

There is frequently a defined market for the services and products a company provides.  At some point, a company's business peaks and the high growth rates level off to more moderate levels. Often the market for a company's products or services becomes saturated.  

Over 90% of the world's PCs run on some version of Microsoft Windows. How much more market share can they reasonably be expected to obtain?  Companies like Microsoft must move into new lines of business or launch new products to sustain their growth. In essence, they are forced to deviate from their original business model.

Just because a company achieves overwhelming success in one area does not mean entering a new area guarantees similar success. As an example, Intel recently announced plans to close its' consumer products division because their products failed to "catch on." Conversely, small cap companies are free to operate with a more well defined and narrow focus. The rewards to the company and its shareholders can be enormous if the company executes its business plan.

It is not always an easy task for small cap companies to produce positive results, but they do benefit by being able to operate outside the "eye" of the Wall Street "storm."  Because many small cap companies do not meet the capital needs criteria of the large investment banks, they get no analyst coverage from them. Companies that DO perform but don't obtain analyst coverage often find their stocks priced inefficiently in the marketplace.

Does this lack of institutional coverage inhibit returns for investors?  According to Kacy Gott of wealth management firm Kotchis Fitz, $1 invested in the S&P 500 index in 1926 would have yielded $2,320 in 1998.  The same $1 invested in small caps would've grown to $4,460! A level playing field for individual investors exists in micro and small caps, providing a tremendous advantage for well informed individuals over big institutions in this arena.

Because they are thinly traded it is often difficult for large institutional investors to establish meaningful positions in small cap stocks. Investors can wait for these stocks to get big enough to attract institutional investors or get in before the business takes off in earnest.

Access to Management

Can an individual investor pick up the phone and talk to Microsoft's Bill Gates or Oracles Larry Ellison? No. However, it is often possible to talk with senior management teams at micro and small cap companies.  They are more willing to talk to investors because they are still trying to generate exposure and build a base of support among the investment community at-large.  

Successful small cap company management teams realize the importance of the individual investor to their long-term success.  

Foreign Exposure

The decline of the global economy has caused problems for many leading U.S. companies and rightfully so.  Many depend on international growth to sustain their company's higher valuations.  However, in a weakening environment foreign exposure forces many companies to write off or divest billions in international investments. Many small companies avoid this pitfall.

Fortunately, small companies are usually the first to recover when the economy is coming out of recession.  As we've observed, small company stocks tend to be one group most likely to be priced inefficiently. This spells opportunity for the savvy investor willing to go where Wall Street and most institutional investors can't or won't go.

Rate Cuts

Earlier this month, the Fed cut the discount rate to 2 percent from 2.5 percent.  This was the ninth reduction this year and the second half point cut since Sept. 11. As we've mentioned in earlier issues, the discount rate now stands at the lowest level since 1962. The Fed is expected to cut interest rates for the tenth time at its next meeting, November 6.  

The biggest beneficiaries of this activity are quality micro and small cap companies.

Small Cap Investing

This is the best time to be investing for the future.  Small cap companies represent the future leaders of the American business scene.  The current economic environment has made it more conducive for small caps to thrive.  Finding the right small cap is not an easy task.  Small caps are not widely followed so it may be difficult to locate information about these companies if investors are not equipped with the right resources.

The SmallCap Network is designed to be a resource to assist micro and small cap investors in identifying quality opportunities. We evaluate thousands of small caps in search of those companies with the potential to become top performers.  Please keep in mind small caps are risky, but they also have the ability to produce the greatest rewards. 

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