In this podcast, Motley Fool host Ricky Mulvey caught up with Bill Mann, director of small-cap research at The Motley Fool, for a primer on small-cap investing.
They check in on a handful of different small caps and discuss:
- If the disappearance of "the small-cap premium" is a win for investors.
- How to navigate environments with limited feedback.
- The value (or lack thereof) of book value.
To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.
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This video was recorded on March 02, 2024.
Bill Mann: What you're really looking for in a small-cap company is the opportunity to invest in a Home Depot, whether it is a couple of shops in Atlanta or at Chipotle when it is 400 stores, most of which seemed to be concentrated around Denver. There is absolutely something to be said for identifying companies that have a chance of growing large and understanding that in a lot of those situations, the company is going to disappoint you.
Mary Long: I'm Mary Long, and that's Bill Mann, Director of Small-Cap Research at The Motley Fool. Ricky Mulvey caught up with Bill to check in on, you guessed it, small-cap stocks. They also discuss the advantages of being able to play below the $1 billion barrier, truths and horse racing, and investing, whether institutional attention is a positive or a negative, and a company that pays dividends in dollars and snacks.
Ricky Mulvey: It's the small-cap show. Let's talk about small-caps with The Motley Fool's Director of Small Cap Investing, it's Bill Mann. Thanks for doing this again with me.
Bill Mann: How're you doing, pal?
Ricky Mulvey: Doing pretty well. Every so often we get together where I have a list of very specific questions about very specific companies that we normally don't talk about on the show.
Bill Mann: I invent very specific answers, that's perfect for everyone.
Ricky Mulvey: I want to get there, but also investing in the smaller companies, the small-caps, this is sort of the Black Diamond skiing, if you will, of stock investing. I want to set the table a little bit with some macro stuff just so someone who's newer to investing can get their expectations right. We got to be honest, it's been a rough stretch for the small-cap class. The Russell 2000 is up about 30% over the past five years, which is well under the return for the S&P in the Nasdaq, so I will start with an easy question, what gives?
Bill Mann: I'm going to start with a trivia question for you.
Ricky Mulvey: Yes.
Bill Mann: How many of the seven largest companies in America are in the Russell 2000?
Ricky Mulvey: Zero.
Bill Mann: You did it, you got it right. It was a trick question. None of the companies that have corresponded with the overwhelming percentage of gains and the S&P 500 and the Nasdaq are in the Russell 2000. Most of the companies that are in the S&P 500 in 2023 actually trailed the performance of the S&P 500. The same exact companies that are in the index failed to beat the index. We have to recognize the fact that it's been a very unique stretch where the largest companies are now a huge part of the biggest indices, and they have been among the biggest gainers.
Ricky Mulvey: It's tough to make a broad judgment based on looking at the returns of a couple of indexes, just a little. Bill is pointing his fingers together in a small way for the listeners. One of the appeals of small-caps, we've talked about it on a previous show is that, it's like the institutional money can't fish in these waters. The thing I want to follow up about though, is that there's also a lot of fish staying out of the water because it's a real pain to be a public company and there's a lot of private equity firms keeping these smaller companies private. We're going to look at some specific examples, but you've been following this stuff for a while, do you think there's a bigger quality problem with the small-caps that are out there today than a decade or so ago?
Bill Mann: You described this as Black Diamond skiing earlier, and I think that that's exactly right. More to the point, there's been very little payoff on average to go skiing on the Black Diamonds over the last 15 years. It's been one of the longest stretches of under-performance of small-cap companies to large-cap companies ever as long as we've been measuring. I think it's really important to note that when we're talking about small-cap companies, that these are companies not just that institutional investors can't invest in, but ever since the mid-noughties, it doesn't make any sense for Wall Street analysts to really cover them. There isn't enough institutional trading, there's not enough money to be made, and now that we're in a commission-free environment for a lot of companies spending their time saying, here's a really interesting $800 million company, it's not worth it to the bags. There is in a time in which there's an endless amount of data available on the internet. Because of the internet, there is very little in the way of attention being paid to these companies. I think that there really is something there.
Ricky Mulvey: From what I've heard from institutional type investors, there seems to be this $1 billion barrier which is, we really can't focus on companies that don't hit that common mark that we'd like to see.
Bill Mann: Isn't it great that, that's something that we have as an advantage? If you think about an institutional investor, they say like, well, if it trades less than $20 million a day, it's not worth it for me to do. Guess what, Ricky? That's fine for you and me. It's just a matter of identifying what the good companies are.
Ricky Mulvey: I would say I'm not as arrogant enough to say that, like $800 million is not a lot of money. [laughs] There's also something with the macro stuff I want to follow up on, and this is you had a conversation with Aswath Damodaran that we put on the show, and you revisited the idea of the small-cap premium, and I actually can't figure out if the lack of it is a good or bad thing for investors. Part of the conversation with Aswath Damodaran I want to follow up on is he basically said, ''I can't think of a good reason why small-cap stocks should earn a higher return than large-cap stocks by themselves''. The idea being, is that if you're a small company, you have more room to grow, so investors were paying a premium for that. That seems to have disappeared. Is that a good or bad thing for people looking at its small-cap companies?
Bill Mann: The point that he was making is that in aggregate, this is the case, that there's no real reason that there would be a premium for small-cap companies. In some ways, if you think about it, a small-cap company that has come public, they are taking on a pretty high cost in terms of regulations, in terms of the attention that is being paid to them. What we are looking for are the extraordinary small-cap companies, and I think that I disagree with him in that regard. Actually, it's not even just say that I disagree with him because he made this point as well. There are companies within small-caps that have those characteristics where they can grow for a really long time. But that's not the average small-cap company.
Ricky Mulvey: The point was, essentially if you have an aggregate number of small-cap companies, you won't get that premium because of the law of large numbers basically.
Bill Mann: Yeah, basically that.
Ricky Mulvey: I feel like we've had a little bit of a negativity corner here about it being, it's really difficult to be a public company, especially if you're small. Maybe it's not even classy to be a public company under a billion-dollars to the eyes of the institutional investors, so hard to find these companies. You're talking to a newer investor right now. Why are small-caps interesting to look at? Why even play this game if you're someone who's interested in picking stocks.
Bill Mann: I think first of all, you have to get your mindset right when you're going into small-cap because as a group, they're going to be more volatile, there's going to be less information about them, and you're not going to have the same level of confidence. When you drive down the street, you see Exxons everywhere. You walk into Whole Foods, it's owned by Amazon and everyone is carrying Apple phones. That is not the case with the average small-cap company. You don't get that feedback loop, and so you need to be prepared for a real lack of information, you need to be prepared for a lack of the feedbacks, but everybody else has that same lack of information and then that same lack of feedbacks. And it is certainly, definitely the case that in a parimutuel market, like the stock market, similar to odds rates, one of the ways that you can gain an advantage is going to where nobody else is looking before they might come looking there. It's simply a fact in it, and it's inexorable, it is true and it will continue to pay off over time. But the mindset that's required to do it is something that not every investor has or should have.
Ricky Mulvey: Creating that mindset, how do you set your expectations? Is this something where you want to follow a few companies very closely and then maybe occasionally make investments make or despite the law of large numbers, do you want to essentially use that lack of information to your advantage, pick a bunch of companies, make it a small part of your portfolio and hope one of them really takes off?
Bill Mann: I think it's a little bit of both. One of the things that you can do in small-caps is you can become very smart about a sector. You have to be comfortable with not only being wrong at a lot of times, but seeming to be wrong, which is the market is moving against you. You can't really use that as your signal as to whether you're correct or not over the short-term? There is something definitely to be said in small-cap investing, in getting to know an industry or a trend, or some sort of factor of the economy in making that something that you study very intently.
Ricky Mulvey: This might be heretical to The Motley Fool style of investing. Being careful saying it and I'm saying it's an urge, it's not something I actually practice, but among the small cap companies that I followed for a few years, they moved so drastically on just a little piece of news. I find myself wanting to trade more with small cap companies because I think this was one analyst downgrade. Maybe the stock shouldn't be down by a third. Is this something you deal with? How do you deal with that sort of urge in wanting to be more active when these companies move on just small bits of information?
Bill Mann: You find yourself all the time saying, "This can't be right."
Ricky Mulvey: Yeah.
Bill Mann: You know what I mean? There's no way that they've gotten this correct. This can't be right. Why is this stock up 27% today? Because it beat by a penny. This is just a reality of investing in companies that there's not a whole lot of information on when new information is dropped onto the pile, it's analyzed very quickly. I think the thing to do is to recognize the fact that if you are investing in a company that requires a very small change in reality, for a very large change in market returns, that probably you're cutting it a little bit too close to the line. What you're really looking for in a small cap company is the opportunity to invest in a Home Depot when it is a couple of shops in Atlanta or at Chipotle when it is 400 stores, most of which seemed to be concentrated around Denver. So there is absolutely something to be said for identifying companies that have a chance of growing large, and understanding that in a lot of those situations, the company is going to disappoint you.
Ricky Mulvey: Sometimes during this podcast, Bill is going to be talking to the listener, but I appreciate you talking to me for that one.
Bill Mann: [laughs]
Ricky Mulvey: There's also a corner of these companies where it's tough to do the outreach. Sometimes you don't want too much focus from institutional investors because they're not exactly helpful all of the time. Just because you're getting attention from institutional investors doesn't mean they're helpful, so they don't communicate a ton. They're not doing a ton of flashy press releases, but there's still great companies. I think one that we both agree on is Winmark, it's a resale company. I think something interesting happened to the company this year, which is that it crossed the billion-dollar mark and then the stock surged.
Bill Mann: Yeah.
Ricky Mulvey: I love the company, I don't think it fundamentally changed over the past few years though.
Bill Mann: There is absolutely truth to the fact that institutional investors have mandates and those mandates are written down there canonic law. They say things like, "Our investing universe is every company larger than a billion dollars" so when a company gets above a billion-dollars, there are institutional investors out there who basically have whether they liked the company as a $990 million market cap company or not, they couldn't buy it without violating their policy. So there is absolutely something to be said to that. Now, the flip side of that is, is this a good thing or is it a relative thing? On the one hand, we'd love our stocks to go up. You don't buy a stock going, "Hey, I'm just here for the snacks.".
Ricky Mulvey: I'm here for the divvy.
Bill Mann: Right. Well, some people do that.
Ricky Mulvey: [laughs]
Bill Mann: Is there a company that pays dividends in snacks? That would be great.
Ricky Mulvey: I'm going to think.
Bill Mann: All of this to say, Ricky, is that institutional attention is really neither a good thing nor a bad thing, but it can be a catalyst if you were in fact right about the company to get it revalued higher simply because it moves onto the radar screen of more institutions and more money that can buy it.
Ricky Mulvey: I think the Costco hotdog counts as a snack dividend because it's something you're absolutely you have access to below cost. You get it as part of the membership. I'm counting that as the snack dividend. I'm going to stay on Winmark for a second, because it likes to fly under the radar. We've actually, had the CEO, Brett Heffes on the show, but he doesn't do earnings calls. The commentary for the latest annual report, I will read all of it now, "A 2023 result reflected positive performance by our franchise partners. However, growth was lower in the second half of the year."
Bill Mann: Should we pause for a second just to see if there's more?
Ricky Mulvey: You can, but there's not, that that was it.
Bill Mann: That was it?
Ricky Mulvey: Yeah. Part of it is we'll let our business performance do the talking, and I appreciate that. There's some other small-cap examples that I think do this. Dillards, which I've talked about on the show. I don't want to get into too many details here. They do that as well. They're not particularly interested in engaging with analysts because the business performance can do the talking. Are there any smaller cap companies that do that, that avoid the spotlight deliberately but maybe deserve some attention?
Bill Mann: I feel like a lot of them do and I'm not sure that I would put a whole lot of meaning into how companies interact with the investing public in terms of their communication style. But there is something that's really important about what what Brett Heffes was saying. He was not quoting non generally accepted accounting numbers. He was like, "These are our earnings, these are our cash flows. These are not our cash flows. When you take X, Y, and Z, and X, Y and Z are all things that make the company look better." If there is a longer explanation, that's really OK with me, but the explanation should not be in my mind, "Hey, I'm trying to sell you a story and I've tried to sell you a stock."
Ricky Mulvey: Well, there are companies though I'm going to disagree, I think communication style is important. But I'm also in that business, so I'm incredibly biased in making that statement. I think there is a company that's a small cap company that's followed by the Fool. It's Boston Omaha. It's a mini conglomerate that welcomes comparisons to Berkshire Hathaway. This is one where I think maybe it should have a little bit more of a clear communication plan, explaining to analysts in the investing public what they're doing. Because I can have a theory right now, it might be trading at it a "conglomerate discount" because it's such a small company with so many tentacles, and it's incredibly easy if you're an investing analysts to say, "I'm putting this in the too hard bucket because it's it's too small and also there's a lot going on with what they're doing."
Bill Mann: Ricky, wouldn't you say that welcoming comparisons to Berkshire Hathaway is in some ways a communication strategy?
Ricky Mulvey: Yes. I would say that is a communication strategy.
Bill Mann: Yeah. Which is to say that what they are doing, and I don't disagree with you with all of those other things. I think that's right. But what they are doing in this case is they're shortcutting a whole of communications that they don't need to have. They basically are saying, what Buffett said, we believe the same thing. What other questions do you have? I think it is a better strategy across the board to say less than more. Generally speaking, I think that that's in fact true. I'm always nervous when I'm being sold a stock. It doesn't seem to me like it is an advantageous environment for me to be buying when I'm being sold something but at the same time, in general, I would say less is more. But sometimes companies really do, in the case of Boston Omaha, I would think would be one of them. They could explain more so that you've got a fuller picture of what it is that they are trying to do beyond, we want to be like Buffett.
Ricky Mulvey: Yeah, we're doing billboards, we're doing broadband internet that they've gotten investment with Sky Harbor. Right now it's also going for less, as we talk it's going for less than book value and I know speaking of Buffett, he's had different opinions on the book value. Do you think that's important right now for Boston Omaha or for someone looking at the company?
Bill Mann: In our conversation with Aswath Damodaran, he had some real things to say about how book value does not matter as much as it used to because we are in an information economy. How do you value a bit in book value? It could be anything. It could be one part of a color blue. It could be part of a code that is the core to Amazon's ecosystem, so it does matter in the case of Boston Omaha but it is not something that I would say is going to be a real signpost as to whether a company is going to provide value for you long term or not.
Ricky Mulvey: I want to check in now on a small cap that you follow closely. We got a great question from Sam Estoria, New York. It's about Fiverr, which is a marketplace for services like logo design, voice-overs, you can have someone edit your book, they do content creation. It's basically a marketplace for digital services and he wrote to us, quote, "Hey Motley Fool Money team. Is the future bleak for companies like Fiverr and Upwork? I bought shares of Fiverr in early 2020 in an unfortunate peak with the thesis that the increase of remote work and the ease of contract enrolls like developers and designers that this would be a tailwind for Fiverr. But with the rise of generative AI, is this one of those companies that's becoming irrelevant? There's an episode last January where Dan Pink discussed how generative AI is a boom to the bottom tier of workers and the knowledge economy. But does that mean it would be cheaper and easier to use AI in these programs rather than contract someone from Fiverr? We'd love to hear the team's thoughts and Fool on."
Bill Mann: AI doesn't program itself first and foremost. While Fiverr and Upwork have had a fairly sharp dislocation with certain types of jobs disappearing or becoming less needed in a world of AI, the thing that has happened definitively at Fiverr is that some very sophisticated buyers of gig work are posting thousands of jobs where AI is at the center of the job itself. What you're having right now is a bit of a dislocation. There are some things that are disappearing at Fiverr and Upwork and then there are some things that are reappearing. I don't think that it's an accident at all that we are seeing a large amount of layoffs at a bunch of tech companies, simply because they went into the pandemic in the midst of a hiring binge in the thoughts that things might not change the way that they have changed. I never want to point to layoffs as being anything other than a human tragedy for the people who are being laid off but a lot of these jobs are going to be taken over by short-term work in the best platforms that exist at Fiverr and Upwork.
Ricky Mulvey: I do think there's a narrative problem around Fiverr though, because they're getting more enterprise customers to do these big projects. But when I look at the website, it's like, do you want to hire someone with a mid-journey subscription to create a logo? I don't know, what does Fiverr need to do to turn that narrative around about how AI affects the company? Is it doing a good job?
Bill Mann: I don't know if it's doing a good job or it's doing an optimized job. You might even start looking at the name of the company which came along as, five bucks and someone will do a task for you.
Ricky Mulvey: Yeah.
Bill Mann: I think that they could do better, but I do think that they have done a very good job in terms of shifting their business to the realities of what are some very promising developments in the market today.
Ricky Mulvey: This is on the complete opposite end of the spectrum of Fiverr.
Bill Mann: Okay.
Ricky Mulvey: It is Grupo Aeroportuario del Sureste. It is the complete opposite end of the spectrum of small caps. We've talked about companies where they're maybe in a couple of restaurants in one city then they can greatly expand. There's also a small caps that have a niche and a moat, and they have the ability to protect it. This is a group of privatized Mexican airports where most of the traffic comes through Cancun and I know you follow this company. This is what I've been looking at. But the question I'm struggling with is basically, why is this more attractive than a regular American utility stock? Pays a high dividend, fairly low earnings multiple, and it has a lot of the commonalities where it has a moat but it's not going to necessarily scale quite like the companies we've just talked about.
Bill Mann: The question is, why is it more attractive than a utility stock? That's a fascinating way of framing it up because in some ways you're talking about the same exact type of economic model, a really high fixed cost, and then basically a guaranteed rate of pay that comes from negotiating with the government. I think that the overall difference here is the fact that we're talking about Mexican airports. There is a growth curve there that is much sharper than utilities and there are ancillary services that they can add that utilities can't necessarily do. Things like cold storage, things like logistics, things like additional parking. There are so many different areas where the concession gives them some optionality that utilities don't necessarily have.
Ricky Mulvey: This podcast was for listeners and it was also for me. Bill, thank you so much for joining me on this and hope we can do it again in a few months.
Bill Mann: Thanks, Ricky.
Mary Long: As always, people on the program may have interest in the stocks we talk about and the Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. I'm Mary Long. Thanks for listening. We'll see you tomorrow.
John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Bill Mann has positions in Berkshire Hathaway and Costco Wholesale. Mary Long has no position in any of the stocks mentioned. Ricky Mulvey has positions in Boston Omaha, Home Depot, and Winmark. The Motley Fool has positions in and recommends Amazon, Apple, Berkshire Hathaway, Boston Omaha, Chipotle Mexican Grill, Costco Wholesale, Fiverr International, Grupo Aeroportuario del Sureste, Home Depot, and Winmark. The Motley Fool recommends Upwork. The Motley Fool has a disclosure policy.
