Choosing Smaller Investment Markets Can Lead to Bigger Returns
If you want to achieve substantial returns in stocks, it’s essential to pick the right market opportunity.
Editor’s Note: On Thursday, I shared the first part of Senior Analyst Brian Hunt’s two-part Easter Egg hunt series. If you missed it, you can read part one here.
In today’s conclusion, Hunt draws a comparison between two egg hunts—one crowded and one less so. If given a choice, you’d likely favor the quieter event, enhancing your chance of success.
As Brian illustrates, this concept mirrors the dynamics of the stock market daily… I’ll let Brian take it from here…
Imagine it’s Easter, and you’re gearing up for the neighborhood Easter egg hunt.
In a small local park, over 100 eggs have been hidden, each containing a treat, and one special egg even holds a cash prize.
If you participate, which scenario would you prefer?
- Alongside you, there are 1,000 other hunters looking for eggs. It’s complete chaos.
- Only 10 other people are hunting for eggs with you.
Like many sensible individuals, you probably chose option B.
You’d prefer the latter setup:
Rather than this crowded scene:
You would prefer having just 10 competitors instead of 1,000 individuals overwhelming the park.
So, how does this relate to investing?
This scenario mirrors the everyday dynamics of the stock market.
In financial markets, millions are hunting for stocks, commodities, currencies, options, bonds, and real estate.
Every investor seeks to buy assets for less than their true value and sell assets for more than their real worth.
Ultimately, each party is trying to outmaneuver the others.
Everyone is on the lookout for hidden opportunities.
Most financial assets are generally priced correctly. However, inefficiencies can occasionally arise—moments when assets can be bought for less or sold for more than their inherent value.
These instances are defined as “market inefficiencies.”
Such opportunities can lead to significant profits.
Yet, as competition increases in a market, the chances of finding these inefficiencies diminish.
The more individuals engaged in the market, the fewer pricing inefficiencies exist, and the narrower the windows of opportunity become.
Institutional investors pose the largest competition in the financial landscape.
This group encompasses mutual funds, pension funds, large hedge funds, and insurance funds, as well as sovereign wealth funds that manage national reserves.
A single significant institutional investor may handle over $10 billion in assets.
In comparison, even a wealthy individual managing $5 million is at a disadvantage in highly competitive markets. This highlights the importance of finding less crowded investment opportunities.
Understanding the Advantages of Small-Cap Investing for Major Funds
Looking at the financial landscape, institutional investors often manage amounts far exceeding $10 billion. Notably, the sovereign wealth fund of Norway, buoyed by its oil revenue, reached over $1 trillion in 2017, which is 100 times the size of an institution with $10 billion to allocate.
Global institutional investors hold enormous sums to invest in stocks, bonds, and other assets.
These large institutions frequently employ numerous analysts, dedicating hundreds of thousands of hours annually to search for investment opportunities worldwide. Their traditional “financial detective” methods include visiting public companies and interviewing industry experts.
In addition to these methods, they utilize advanced computer algorithms and “Big Data” programs to analyze market data. These high-tech tools operate continuously, processing vast amounts of financial data swiftly to identify pricing inefficiencies of all sizes.
This scenario is akin to a highly competitive Easter egg hunt in which the stakes are tremendously high.
The reality is that the financial market is vast and varied, and there are investment opportunities in areas where larger institutions cannot compete.
Challenges of Size in Investing
Professional investors find themselves constantly focused on “liquidity,” which measures the ease or difficulty of buying and selling securities. For instance, consider Amazon stock, valued at over $983 billion in 2022. Given its size and popularity among investors, we classify Amazon stock as “very liquid.” Buyers and sellers actively execute millions of transactions daily, with over 70 million shares traded in a typical day last year.
Conversely, let’s examine a lesser-known small-cap firm with a market capitalization of just $50 million—less than 0.1% of Amazon’s market size. Given that this company’s stock doesn’t attract much attention, liquidity is low, making it challenging for investors to acquire significant shares.
Market cap, defined as the number of outstanding shares multiplied by the share price, explains that small-cap stocks generally have fewer shares available compared to larger counterparts like Amazon, complicating large purchases.
Now, consider managing a $10 billion stock portfolio.
For any stock to make a notable impact on your fund, it usually needs to constitute at least 3% of the portfolio. Many skilled managers prefer to invest between 4% and 8% in a strong stock idea.
Thus, aiming to invest 3% of $10 billion equates to $300 million. That’s six times greater than what a small-cap firm might be worth. Even a modest 1% investment still amounts to $100 million.
Clearly, substantial money managers face obstacles in entering the small-cap market.
Additionally, they find it challenging to participate in other markets with limited liquidity—such as certain options markets, smaller investment funds, individual bonds, small-cap international stocks, and penny stocks.
Competing in these smaller arenas allows investors to avoid the scrutiny of the world’s wealthiest institutions armed with teams of analysts and state-of-the-art computing power.
Instead of facing a crowded marketplace, such investors have fewer competitors to contend with.
Consider it similar to home buying; you would prefer to acquire a property in a neighborhood with limited competition rather than in a location flooded with buyers. As a buyer, having reduced competition is advantageous.
Using another analogy, think of fishing. You would rather cast your line in a tranquil lake without throngs of anglers than among many others vying for the same catch.
Supremely successful investing hinges on tilting the odds in your favor.
The more effectively you can position yourself advantageously, the greater your chances of success become. Diving into niche, less liquid markets—like that of small-cap stocks—often presents the best opportunities to achieve that goal.
Best regards,
Brian Hunt
InvestorPlace Senior Market Analyst
P.S. Eric Fry here.
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