Why small to medium sized companies may not be as risky as larger stocks

Risk is dependent on each individual business and its activities, not whether the company is large or small.

Great small to medium sized companies are more likely to be overlooked by large institutional investors, and have more potential for growth.


The risk of investing in a company is determined by the strength of its business model and how well the business is run. Not by its size.

We are often asked for our opinion on whether investing in smaller stocks is riskier than investing in larger ‘blue chip’ stocks. To us, risk is the potential of losing the capital you have invested and from our experience, this is not dependent on the size of a company. Rather, risk is a result of its inherent business model, the competitive industry in which it operates, and how well the managers run the company. We can recall many examples of large ‘blue chip’ stocks which have gone bankrupt. Large Australian companies such as Ansett, HIH and One-Tel were once thought of as safe blue chip stocks. Lehman Brothers and Enron were amongst the world’s largest companies but failed due to excessive financial risk and mismanagement. These examples demonstrate that the riskiness of an investment cannot be generalised by the size of the business. In fact, our best investments have been in small to medium sized businesses that we have analysed with detail. The detail of the financial statements tells us the story of the business, its strengths and possible weaknesses. Only the detail can give us an objective measure of an investments’ true risk.

Pleasant outcomes of searching for small to medium sized businesses

Our definition of small to medium sized companies are those with a market capitalisation of less than $1 billion. Provided we have examined the detail, we favour small to medium sized companies. We have found several pleasant outcomes of doing so.

First, these companies have more potential for growth. These small to medium sized companies are usually younger businesses that have found a competitive advantage in a new industry niche. Compared to large, established businesses (think Telstra (TLS:ASX), big 4 Australian banks) which are established and grow slowly, smaller companies haven’t plateaued yet. They aren’t as heavily regulated and have more potential for upside.

Second, these companies are more likely to have strong founder ownership. The founder may still be involved in the day-to-day operations of the business and has not yet sold off their stake in the business. They are still hungry to see the success of their business. Conversely, large companies have complicated ownership structures and have many conflicting stakeholders to align and manage.

Third, these companies are more likely to be overlooked by institutional investors. Large institutional funds focus on larger companies because they have a lot of funds to deploy and smaller companies are too small for the size of investment they are after.

Provided that we are satisfied with the quality and risk of the business, our experience of investing in smaller companies has been a positive one and we continue to favour them in our search for quality long term investments.

Performance of the overall economy – why it’s irrelevant to most investors

Macro predictions about the performance of the economy or specific industries have limited value to us – we invest in specific businesses, not economies.

Lower risk and higher returns can be made from finding quality businesses in out-of-favour industries.


We invest in businesses, not specific industries or economies. Broad economic predictions have limited value to us

With the start of the new year, experts have put forward a bunch of financial predictions for the next 12 months. Where will the ASX 200 be at the end of the year? How will the property market behave? Will the Australian dollar be much lower than its current levels? Which sectors will outperform this year? Will small caps beat large caps again this year? To us, these are difficult questions that we don’t have the answer to. We have found the expert analysis an interesting read, but not something we are prepared to invest our money in. The poor track-record from the experts demonstrates exactly how difficult it is to correctly predict both the magnitude and timing of financial markets. For instance, ABC’s The Business has an annual review of economic predictions, pitting experts against students – more often than not, students come out on top: http://www.abc.net.au/news/2015-12-04/student-economic-predictions-humble-professionals/7002196.

Not only are the predictive arts extremely difficult and unreliable, we question its usefulness. We invest in stocks, not the overall economy or specific industry sectors. A prediction on the Australian economy, even if it is correct, only informs us of the overall average performance of all stocks, not a particular stock. In sporting terms, a correct prediction for the average time for all swimmers in a race still doesn’t help us predict which swimmer will win that race. We believe in studying the merits of each business objectively without the influence of market sentiment. We have found it useful to have this independent, unbiased foundation to our analysis.

Broad economic predictions inform us of market sentiment – we can use this to our advantage.

Broad economic predictions inform us where the market’s attention will likely be. Quality businesses at fair prices are less likely to be found in industries predicted to boom. Conversely, the market does not focus on out-of-favour industries – this is an ideal environment to find quality businesses at fair prices. We have found that the likelihood of finding a diamond in the rough is greater in these out-of-favour industries. For example, some of our best investments have been in finance businesses following the GFC.

As the pundits continue to issue economic forecasts (and subsequent revision updates that will inevitably follow) we will continue to focus on the main game – the merits of each individual business.

Further reading which may be of interest:

http://www.abc.net.au/radionational/programs/futuretense/why-pundits-and-experts-are-so-bad-at-predicting-the-future/6483666