In honor of the two-year anniversary of Cabot Small-Cap Confidential, I’ve been bringing you a multi-part series with Editor Thomas Garrity. Tom has explained how he got interested in small-cap stocks and where he thinks the market is going. Today he’ll discuss the Law of Large Numbers. I hope you enjoy it!
(You can read the previous issues here, here, here and here.)
Question: Why do you prefer to invest in small-cap stocks? What benefits do they offer investors?
Answer: The obvious reason for investment in small- and micro-cap stocks would be that they have a proven and long history of outperforming all other asset classes. The last statistics I saw on the performance of small-cap stocks showed that during a 79-year period, small-cap and micro-cap stocks have outperformed large-cap stocks by 165% and 437% respectively.
The second reason may sound a little silly, but I’ll tell you anyway. When I was a kid my dad used to take me with him to the dump to unload unwanted junk from our station wagon. On returning from the dump, we’d have more stuff in the car than we started with! I like finding the true value of something that others have neglected and failed to correctly appraise. Small-cap stocks fit into that perfectly.
As the U.S. enters a new chapter, I believe that investments in small-cap stocks will be better positioned to deal with the economic uncertainty that lies ahead. We know now that bigger doesn’t necessarily mean better. The best investment choice is the nimble one that can adapt to change, and for this reason I feel that small-cap stocks have a distinct advantage.
Question: What sectors are you interested in right now? Why?
Answer: My models are currently favoring alternative energy, technology and health care stocks. In times like this, asset managers want to invest in trends that won’t be hot one minute and cold the next. Investors want to put their money into stocks of companies whose operations are sustainable and whose destinies aren’t going to be hung out to dry by the economy or next product cycle. Investors are looking at enterprises that are creating the new economy instead of chipping away at the old one.
I’m focusing my time and money on Green companies whose products contribute to the welfare of both people and the economy. Let’s consider an investment in a hypothetical company that manufactures process control equipment to produce cleaner forms of energy. Right out of the gate in the stock selection process, we’ll know whether the company approaches investment worthiness–the business has strong fundamentals that can be easily quantified. For instance, we know that X amount of petrol is used by vehicles of all types on the road, each of those vehicles contributes Y amount of pollutants, causing Z amount in health care costs and so on.
Here I’m only addressing a single market, alternative energy, but my approach includes many more peripheral variables that strengthen the merits of the investment theme. Call it a three for one investment approach: this company that makes the environmentally friendly fuel does a lot more than produce an ultra clean fuel product. It reduces our dependence on expensive. Diminishing resources and indirectly reduces the cost of health care and so on. So I guess you could say I’m looking at dramatic shifts in how we live our daily lives and the products and perceptions that go along with those changes. Expensive oil is taboo, as are pollution and costly health care, and the United States’ desire to remove these encumbrances is already in motion.
Similar parameters for identifying stocks are applicable to companies that produce wireless components/software, produce vaccines or manufacture medical devices. We have data that suggests there is an existing large pool of users for these products and services, that these audiences are growing based on demographics and that the products or services are making their way into our everyday lives.
In short, I’m abiding by the Law of Large Numbers and sticking with large addressable markets. I’m currently applying much of my investment analysis to the alternative energy, technology and health care sectors.