Smallcaps learnings from Great Investors: Warren Buffett, Peter Lynch & Michael Burry

by Siddharth Singh Bhaisora

Published On July 14, 2023

In this article

In the early 1990s, Eugene Fama and Ken French brought further understanding to the performance discrepancy between large and smallcap stocks. They confirmed that small caps stocks typically outperform large-cap ones over extended periods. Additionally, they observed that value stocks (those undervalued by the market) often outperform growth stocks (those with potential for significant growth) in the long run.

Metrics such as the price-to-earnings (P/E) and price-to-book ratios are often used to distinguish between value and growth stocks. Stocks with above-average P/E (typically higher than 15) or price-to-book ratios (typically higher than 2.5) are considered growth stocks, while those with below-average ratios are considered value stocks.

Fama and French proposed that the superior performance of small caps and value stocks isn't necessarily a secret strategy, but rather a reflection of higher risks associated with these investments. For instance, these stocks may have a higher bankruptcy risk, thus their potential higher returns.

The findings of Fama and French have been put into practical use by Dimensional Fund Advisors (DFA), an investment firm established in 1981 by two of Fama’s students from the University of Chicago, David Booth and Rex Sinquefield. The firm used these insights to create a variety of products, including many low-cost index funds. Fama and French also serve as board members and consultants for DFA. Today, managing over $400 billion for its clients, DFA demonstrates the practical application and impact of academic findings on the investment industry.

Warren Buffet’s Investment Prowess & Success

Warren Buffett, widely celebrated for his investment acumen, has a notable history with small caps stocks. Though he is now known for his investments in large corporations like Coca-Cola, American Express, and Wells Fargo, he began his career managing smaller amounts of capital and made remarkable profits in the smallcap market.

Buffett has stated on multiple occasions that managing large sums of money can be a performance disadvantage, necessitating investments in 'elephants' or large corporations, to make a meaningful impact on the portfolio's overall performance. He noted that if he were managing only a million dollars instead of billions, he could guarantee a 50% return annually because of the broader range of investment targets available and less worry about market impact when investing.

According to Buffett, smallcap stocks are excellent prospects for individual investors since larger institutions practically can't invest in these smaller markets due to their size constraints. Buffett cites the example of investing in smallcap stocks in South Korea where, at the time, many firms' price-to-earnings ratios were only three times earnings – around 80% cheaper than the values of large U.S stocks.

One of Berkshire's acquisitions, See's Candy in 1972, provides a good case study of Buffett's approach to smallcap investing. See's Candy, a California-based maker of chocolates and other confectionery items, was an excellent business in many respects. It had a great product with a loyal following, recurring revenues due to its consumable nature, a strong brand, the ability to raise prices, and required minimal R&D or capital expenditure. Furthermore, it was relatively immune to competition from large online retailers like Amazon.

While the high-end chocolate business will never be as large as industries such as autos or cell phones, it can still be a profitable and sustainable enterprise. However, these kinds of businesses tend to stay relatively small, making them less attractive to large fund managers. When the family who owned See's decided to sell, Berkshire purchased it for $25 million. At the time, See's had about $30 million in annual revenue and $4.2 million in yearly profits. A few years later, the business was generating roughly $400 million annually in sales and about $100 million per year in profits, demonstrating the potential that can be found in smallcap investments.

Warren Buffett’s Big Investment

Warren Buffett's most renowned smallcap investment is undoubtedly Berkshire Hathaway itself. Today, Berkshire Hathaway stands among the largest corporations globally, boasting a market cap in the hundreds of billions of dollars. However, its origins were humble, beginning as a textile maker in 1839. While textile manufacturing was once a thriving business in America, it gradually lost ground to overseas outsourcing. Moreover, Berkshire was based in the New England area, where operating factories was expensive, especially with the prospering services industry in the Northeast.

Buffett first began purchasing Berkshire shares in 1962 at $7.60 per share for his own investment firm, then named the Buffett Partnership. Despite recognizing the dwindling state of textile manufacturing in the United States, Buffett saw potential value in Berkshire's working capital, real estate, plants, and equipment. He held a glimmer of hope that the company might manage to stabilize its decline, if not entirely turn it around. Buffett took control of Berkshire in 1965, paying $14.86 per share. At that time, Berkshire's net working capital was $19 per share, with the additional value of its property, plant, and equipment. Essentially, Buffett acquired the company for next to nothing.

Even though the textile business was in decline, Berkshire had ample capacity to manage, requiring few new capital expenditures. The business generated a substantial cash flow, which despite its eventual departure from the textile industry, proved to be instrumental. Buffett leveraged this cash flow to acquire many other companies, either in whole or part through their stock. His acquisitions included prominent names like The Washington Post, See's Candy, Coca-Cola, Dairy Queen, Burlington Northern, Wells Fargo, and notably, Geico insurance, a business renowned for its cash generation.

Through a series of judicious capital-allocation decisions, Buffett transformed a smallcap company into one of the world's largest corporations, a testament to the potential inherent in the smallcap market.

Peter Lynch’s Winning Smallcap Strategy

Peter Lynch is another renowned investor celebrated for his successful forays into the smallcap market. Lynch notably steered Fidelity Investments' Magellan Fund to become the world's largest mutual fund by the time he retired. If someone had invested $1,000 into the Magellan fund at the beginning of Lynch's tenure in 1977, their investment would have ballooned to $28,000 by the time he retired 13 years later. A significant part of Lynch's extraordinary performance was attributable to his investments in smallcap firms. Even after the Magellan fund grew considerably large, Lynch didn't entirely turn away from smallcap stocks. Instead, he managed to own more than 1,000 stocks in the fund, heavily populated by smallcap stocks, thereby significantly impacting Magellan's returns. Fidelity's resources aided him in finding and monitoring this vast number of companies.

Lynch coined the term "tenbagger" which refers to a stock whose value grows ten times or more from its initial purchase price. Dunkin Donuts is one of Lynch's most famed tenbaggers. A critical point to note is that it's considerably easier for a smallcap stock to achieve tenbagger status than for a large-cap stock. For example, if a stock initially has a market cap of $1 billion, a tenfold increase would make it a $10 billion stock, amounting to a total return of 900%. By contrast, for a company with a starting market cap of $10 billion to become a tenbagger, it needs to surge to $100 billion, a rarity indeed.

In his books, such as "One Up on Wall Street" and "Beating the Street," Lynch shared his insights on the smallcap market. He advises waiting until small companies turn a profit before investing, a crucial point considering the precariousness of unprofitable small companies. Profitability increases a company's chances of survival and facilitates future growth investments.

Lynch also advises investing in companies with niches. Several large companies today began as niche players. For instance, Microsoft started by developing programs for the BASIC computer language and eventually dominated the operating system market with MS-DOS. Lynch's example illustrates how smallcap companies can initially dominate their niche and subsequently expand into related fields.

Lynch favored stocks off Wall Street’s radar. While companies like Apple, General Electric, or Johnson & Johnson are under the constant gaze of fund managers, many of the 5000-plus stocks in the U.S. and the more than 50,000 globally are too numerous for fund managers to follow in detail. A useful gauge of a stock's "discovery" is the percentage of the stock owned by institutions. Generally, if institutional ownership is less than 50%, the stock is not widely followed by larger investors such as mutual funds, hedge funds, and pension funds.

Another factor Lynch considered is the replicability of a company's concept. A case in point is Starbucks, which went public in 1992 after Lynch had stepped down from running Magellan. Starbucks had a concept—a unique coffee shop experience—that began in Seattle, spread throughout the Northwest region, and eventually rolled out nationwide. If Lynch saw a profitable company with a replicable concept like this, he would be likely to invest in it.

Lynch maintains that the opportunity to find profitable smallcap investments is abundant, particularly for the average person. He suggests, "The average person is exposed to interesting local companies and products years before professionals." This perspective underscores the potential that everyday individuals have in discovering promising smallcap stocks.

Michael Burry’s Smallcap Investments

Michael Burry, who was notably one of the first to foresee and profit from the U.S. housing market bubble in the mid-2000s, also found considerable success investing in smallcap stocks. Known for his trade detailed in The Big Short, Burry was a practicing medical doctor who traded outside of his working hours, driven by his keen interest in the stock market. Diagnosing himself with Asperger Syndrome, Burry's unique personal characteristics and intrinsic value-oriented investing style served him well in his investments.

One of Burry's successful smallcap ventures was his investment in Hyde Athletic Industries in 1997. Much like Buffett's early investment in Berkshire Hathaway, Burry bought Hyde Athletic Industries' stock at a deep discount, with the company selling less than its net working capital, a condition referred to as a "net-net" by Benjamin Graham. Hyde Athletic, a maker of athletic footwear, was growing rapidly at the time. On Silicon Investor website, Burry posted in November 1997 the following:

… that they are growing sales when other shoe companies are floundering is a testament to me of the sublime power of the Saucony brand. To be growing sales at a 24% clip, have a tiny PSR or price-to-sales ratio, and be a net-net, this has to be a stock value investors would love. The only problem is management, but they seem to be doing a better job, and I like the way they are refocusing.

Burry bought the stock at around $5 a share when the company had a market cap of $31 million, although it was worth at least $37 million based on its net working capital alone. The company later rebranded to its most popular brand, Saucony, and Burry made a 50 percent return on this smallcap investment.

Smallcap Learnings & Strategies

Investing in smallcap stocks can provide excellent long-term investment opportunities. For investors looking for exposure to smallcap stocks, index funds are often a viable and straightforward option. These funds offer diversification and typically come with relatively low costs. Alternatively, investors can consider actively managed smallcap mutual or exchange-traded funds. A common strategy employed by investors is to buy a basket of small, young firms in a rapidly growing industry, then reinvest in the firms that emerge as winners as the industry matures.

Strategies employed by successful investors such as Warren Buffett, Peter Lynch, Benjamin Graham, and Michael Burry can also be considered. These investors leveraged different approaches to smallcap investing. Buffett, Graham, and Burry opted for a deep value approach, banking on the belief that the deep value in neglected stocks would eventually be recognized by the market. On the other hand, Peter Lynch focused on profitable small companies with niche offerings that had the potential to replicate their success on a larger scale.

Smallcap investments do carry a certain level of risk, and many end up losing money or going out of business. However, those that succeed can offer significant returns. Just as a cricketer doesn't need to hit a boundary on every ball to have a high batting average, investing in smallcap stocks doesn't require every pick to be a winner in order to generate a winning long-term return. Even if some investments fail, those that succeed can provide substantial returns and boost the overall performance.

Learn more about the trending Wright Smallcaps Portfolio. Be sure to check out the next article in this series: What are the top Small Cap Stocks to Invest in 2023?

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