Here at Penny Sleuth, we always talk about small-cap stocks as the end-all answer for investors, but not often enough do we explain why. Many people wonder why small caps offer better potential. There are many answers, but the Tweedy, Browne Company explains it best.

When I first got interested in stocks, I was handed a copy of Tweedy, Browne’s “What Has Worked in Investing.” This is a wonderful summary of various studies aimed at explaining why certain areas of investing work better than others. It encompasses research dating back to 1926 when record keeping started on these kinds of stats.

In the report, they organize the data into five categories, or characteristics, of investing:

1. Low Price in Relation to Asset Value
2. Low Price in Relation to Earnings
3. A Significant Pattern of Purchases by One of More Insiders (Officers and Directors)
4. A Significant Decline in a Stock’s Price
5. Small Market Capitalization

I want to focus on the third and the last of these characteristics. Now obviously, you believe to at least some degree that small-cap companies offer better gains than their larger contemporaries, or you probably wouldn’t be reading this, but I’m willing to bet that you didn’t know how great the difference is between the two groups.

Take a look at the chart the report provides us on a study of 10 deciles of different market caps between 1963 and 1980:

As you can see, as the size of the companies in each group gets smaller, the returns are greater. There are many reasons for this…

The most obvious is the simple fact that it doesn’t take much price movement to double an investment on a true penny stock ($0.01 to $1) as it would for a true blue chip ($50-plus).

Another fairly obvious explanation for small-cap success is mobility. It’s extremely easy for smaller companies to refocus certain aspects of their business plan. They can also move around in their industry finding the best niche market to exploit. This improves their profit margins compared to larger companies.

The last reason that I’ll give today for why small companies perform better has to deal with the overall cost of owning a portion of the company. We’ve said it before, and I’m sure we’ll say it again… Smart investors look at their investments as pieces of companies instead of just shares. It is far easier for people to buy up larger chunks of small companies, which will raise the stock price.

Here, I want to note that the most successful businesses have this happen all the time by their own insiders (directors and officers). Smaller companies benefit more from this than larger ones because these insiders can actually control more ownership of the company with less money.

Insider buying, as well as share repurchase plans, can drastically move a small company’s share price, which benefits everyone.

There are hundreds of other reasons for why small companies perform better, but the point is they just do. It’s important for investors to take a look from time to time at why they invest the way they do. And for us in the small-cap world, it seems far too easy to confirm why we like these types of companies… The proof is in the past.

Sincerely,
Jim Nelson
August 29, 2007

P.S.: We are always looking for small companies that are buying back shares, or have insiders buying up large chunks of shares, because these are usually the most successful small-caps.

Jim Nelson

Jim Nelson began his investing career during the tech boom at age 14 – with purchases of Starbucks and AOL. Early inspiration came from an old Tweedy Brown whitepaper: “What Works in the Market.” He graduated with a degree in Political Science from Pittsburgh University, Nelson focuses on income investing, including dividends, covered calls, and fixed-income. Additionally, he covers MLPs, ADRs, utilities, consumer staples and tobacco. Nelson is the managing editor of Lifetime Income Report.

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