Feb 03 2017
Lawrence Lam

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.