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Size, Mispricing, and Buffett


jawn619
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I had this thought when thinking about how much a bottle of water costs while at a Broadway show. When at a club/event/show, Water can cost up to $8.00/bottle. I've seen prices for a bottle of water range from $1-8/bottle. How much does it cost to buy if you get it at Costco in bulk? Around .25/bottle. If Costco is selling it for .25/bottle, their cost is probably closer to .20/bottle.

 

How does this relate to investing?

 

I, like many others, view investing as valuing something, often times a business, and then buying at a discount leaving a margin for error. Then I thought, as the absolute value of anything goes up, there are less likely to be inefficiencies. For example, it's not uncommon or impossible for you to buy water at .25/bottle and sell it for $2/bottle, an 800% markup. How likely or possible is it that you are able to buy GM cars for 1/8th of their price and sell it for 8 times more? What about the company that makes GM cars? What about billion dollar wonderful companies with competitive advantages and sustainable margins? How likely is it that you are able to find that at a discount?

 

My point is that we should all be closer to the water bottle side than the fortune 500 side when looking to invest. I doubt forum members have billions of capital like Buffett that they need to park. By focusing on cloning Buffett/Pabrai/etc, we individual investors give up our biggest advantage, our size.

 

 

Fun Fact: Buffett's partnership returns were higher than his returns at Berkshire. 

 

From 1957-1969 Buffett Partnership returns were 29.5%

From 1964 to the end of 2011: Berkshire's record was 19.8%

Both records are out of this world, but the first one is still higher, by 50%

 

Buffett is the greatest pound for pound compounder like Floyd Mayweather is the best pound for pound fighter. But if you put someone 5x the size of Mayweather in a ring with him, he is at an inherent disadvantage.

 

Individual investors have size at their advantage in the opposite way and it's a shame they don't use it to their advantage.

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Amen. This is something that continues to confuse me on a regular basis. I think the major reasons are:

 

1. Finding small companies is more effort up front. If I wanted to invest in Valeant, I could go read a massive thread on this forum and probably a thousand news stories elsewhere around the Internet. If I want to invest in $100 million dollar companies the general public doesn't care about I have to put much more effort in (doing screens, combing through OTC stocks, etc). The payoff is that these small companies are easier to value when you do find them and are more inefficiently priced. I don't expect casual investors to give a damn about finding small companies, but this forum should be biased towards serious investors and it's still heavily dominated by large cap investment ideas.

 

2. Investing in bigger companies is cooler and gives you a lot more to talk about at dinner parties. I told someone just last night that I run an investment firm. His first question: "That's awesome, so are you trading on a daily basis on where the market is going and stuff?" His next questions were about certain big companies/macro events and my opinions on them. When I explained my strategy and that I'm invested in small companies he's probably never heard of because they're more inefficiently priced he changed the topic of conversation shortly thereafter  :(

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AXP, AAPL, MA... All very small caps that are up approx 8x or more since 2009.

 

My point was that not that you can't make money buying mega-caps. Just that it's harder. I own some Apple as well but as a rule i try to stay below a certain threshold. Size is an edge, just like value is an edge or quality is an edge.

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- If you invest in nanocaps and microcaps, the business and management is usually quite worse than large caps.

 

Guy Spier basically said this recently when someone asked why he only invests in bigger companies. Also mentioned better corporate governance and that outright fraud is basically non-existent. All very valid points but this is exactly why small caps are more inefficient because fewer investors look at them for various reasons.

 

By the way, who claims investing in mega caps is better? Buffett has been saying for decades that BRK will never get the same returns he's posted in the past because AUM is an anchor on returns. Many other managers have said variations of the same thing: as their AUM grows, returns have to moderate because they can no longer invest in the smaller companies. Of course there are tons of individual big companies that have crushed the market (almost by definition actually, how do you think they got that big?), but that doesn't prove the large cap space as a whole is easier/better than small caps.

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To contribute something:

- If you talk about nanocaps, this forum can move prices. You can talk about them here, but expect to see 10-30% gain (or not - so don't pump and dump). It's your choice.

- If you invest in nanocaps and microcaps, you are not competing with professional money managers, which is a plus. But you are competing with insiders and people who talk to insiders (like oddballstocks). Which is a minus. It is not clear that you are actually competing with less informed investors if you buy nanocaps or microcaps vs if you buy large caps.

- If you invest in nanocaps and microcaps, the business and management is usually quite worse than large caps. (Unless you manage to get into a ground floor of FFH or BRK). You look at 99% (this is from thin air, so possibly wrong) of nanocaps and microcaps and you see no moat and mediocre to bad management. Look, if it was such a great business, why is it nanocap or microcap? Why it's not a megacap by now? Alternatively, it's great management, but hugely overpriced because people know the management and know the stock won't be microcap for long. (BTW, there was a thread on microcaps with moats too... take a look and decide if they look attractive ;)).

- But yeah all the arguments against buying large caps are also true. ;)

 

Jurgus, what you and others are saying is definitely true. Someone can always mention some obscure way of making money. And you cannot dispute that person.  Dan Negranue can say that it is easy making money at poker. But I am not going to do it. Someone who looks like Brooke Shields knows she can make money modeling. And some guy in Japan can say he made $30M day trading futures. But I am not going to follow him.

 

The fundemental goal (other than to have fun and feel productive) is to make as much money as possible with as little risk as possible. If someone thinks he can make money with large caps then I cannot argue with him because I don't know him. But what is he saying? He is saying that he can play the same game as the money managers and beat them. Only about 20% of money manages can beat the market. He is saying he is in that club. All I can say is good luck. Maybe he has a 150 IQ but for a guy with average IQ like me I'd rather stick with something that is more likely to work. (Also btw I also wonder why isn't he managing $1B if he is that good?)  And small caps are more likely to work because there are less smart money managers in the same game, and the choices are much greater. I feel I am a small cap investor but that does not preclude me from buying large caps when I see value. So what I play with is a superset of what a large cap investor who ignores small caps play with. Then it is logical that my odds of success at beating the market is great than someone with the same ability who only invests in large caps.

 

Again it isn't about looking in the rear view mirror at what has worked. For example someone buying Brk for 20yrs (and I am a 15yr holder of brk btw) and saying that will continue for another 20yrs. I am selling Brk now because I don't see how it can beat the market by a significant amount.  I've said this before and I got tarred and feathered for it, but I stand by it. Someone said let's revisit in a year from now and see how Brk does.... well, last 12 months it is flat.

 

 

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So you are arguing that the market becomes more efficient as the market cap moves up? It seems like it could be the case especially since I have read it from other investors so frequently, but to play devils advocate if you look at the price swings of large caps over a 52 week period, it seems hard to justify business values changing so drastically. Ill just pick one at random, MO, 52 week range 44.79 to 56.70 about 27%. I would submit that even if the large caps are more efficient the variability leaves plenty of room for mispricing.

 

With the water and car example, the primary issue is not absolute price of things it's the efficiency of the market.  In a club or movie theater the market is controlled, there is a monopoly at that moment and place. In the car example you are using a free market that is much more efficient, people can google prices, or craigslist etc and the market is not one sided. Also there is the whole information thing, I would argue that when it comes to pricing consumer items, people are much more familiar on where to look for information, they can ask their friends how much they paid, they may have bought something similar before etc... For the general public this is not the case when we are talking about companies, it really is a specialized knowledge set and temperament. I have met some very educated people who dabble, but when you talk to them they honestly have no idea what they are doing. I have a friend who I have talked to for many years about investing and believed he was totally rational, but recently when the market corrected 10% he panicked and sold everything and he was only invested in the VTSMX and some ETF's. Obviously if enough people like him do the same thing, it could affect large cap prices even though they are the most efficient, at least temporarily.

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Mathematically, your odds of beating the market are the same, regardless of market cap. The dispersion might be wider. Over a 20 year period, a concentrated large cap portfolio might have hypothetical expected returns of 8-12%. A concentrated micro-cap portfolio might have hypothetical expected returns of -20 to 40%. Both have an average of 10% per annum.

 

According to Loss Aversion, humans feel losses twice as much as gains. So on a psychological level, the large cap portfolio is highly preferred.

 

But due to over-confidence, most micro-cap investors will think they are above average. And due to survival bias, this forum will reinforce that over-confidence.

 

---

Other random thoughts:

 

- The informational asymmetry is not an advantage to most individual investors. In micro-caps, the "smart money" is often scammers, fraudsters, insiders, and cronies trading on illegal information.

- The smallest company in the S&P 500 has a market cap < $3 Billion. There are plenty of opportunities even in this limited universe.

- Artificially limiting yourself to small cap or large cap will reduce your opportunity set.

- The volatility of small caps makes it difficult for many investors to behave rationally.

 

 

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But due to over-confidence, most micro-cap investors will think they are above average. And due to survival bias, this forum will reinforce that over-confidence.

 

 

 

I think the best thing you can do is to constantly deny that you know anything special and remind others that you have no idea how to consistently get even 10% returns.  Otherwise they'll look at your past results and ask you for stock tips -- at that point if you indulge them you'll become their savior, and get swept up in it yourself until you start singing "I am the walrus".

 

I believe John Lennon once wrote:

 

"Superinvestor is a concept... by which we measure... our pain."

 

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Folks! I see 3 posts since my post but I am not sure if they are directed at me. I'll assumption such.

 

Firstly, I never said large caps are more efficient than small caps. I never really even thought about it in those terms.

 

Secondly, yes an average (or more accurately a typical) person, will have the same life expetency, the same chance of having a genius IQ and the same returns as the average person. It is a tautology.

 

What I am saying is that I have a chess rating of 1960, and I play in the under-2000 category. People who are experts and masters play in the above-2000 category.  I think I can win in my group.  The point is that Warren Buffett , Ackman and the like are all in the above 2000 group and are playing each other.

 

I said this in a post earlier, I believe if you are rational and your single goal is to maximize your wealth, then you have to believe you are above average if you apply the knowledge from this forum. Otherwise the rational thing to do is to join the Boglehead forum and apply the advice there.  The other explanation is that you want to have fun and feel productive.......

 

 

 

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I've worked with people at large and small companies.  If Spier thinks management is "better" at a large company due to size he's clearly never worked at a mega-cap.  Mega-cap management is often more political.  Those who survive can navigate internal politics.  At small companies results matter.  If you are insufferable but the sales king, you stick around.  I have seen absolutely terrible non-performers protected at large companies because they've built alliances.  Knew a guy at a small company who was storied..at one point threw up in the CEO's car from drinking, emailed the entire company ranting, yet made it rain and the CEO did everything possible to keep him.

 

Regarding advantages and who you're investing against.  Some do have advantages, by writing I've met a lot of other investors and learned a lot about this market.  Is that an advantage?  In many situations it is.  For example I'm putting together a piece about a company where I have spoken with the largest outside shareholder (owns 40%) multiple times.  He's owned since I was in elementary school, there's a wealth of knowledge from talking to him.  I'll temper this with the idea that you don't necessarily need to know this to do well.  You just need to be able to identify bargains, purchase and sit patiently.

 

Here's the other thing about small companies, the space is small.  If you put yourself out there pretty soon you'll get to know all the players.  People buy and sell for many reasons.  Some sell for estate planning, others fatigue.

 

I know this is a forum and we're all on the Internet, but I've found I've learned the most when I've picked up the phone.  I'd say maybe 40% of small cap knowledge isn't online, it's tribal, passed between people who've either learned on their own or been taught.  There are so many people with so much knowledge who are willing to talk, you just need to make yourself available.  Some will talk for hours, and then call again to talk for hours again!

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I know this is a forum and we're all on the Internet, but I've found I've learned the most when I've picked up the phone.  I'd say maybe 40% of small cap knowledge isn't online, it's tribal, passed between people who've either learned on their own or been taught.

 

So, let's invert: if you don't phone oddballstocks and/or management, you have 40% handicap on a small cap.

 

Suddenly mega caps look much more level playing field.

 

8)

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I know this is a forum and we're all on the Internet, but I've found I've learned the most when I've picked up the phone.  I'd say maybe 40% of small cap knowledge isn't online, it's tribal, passed between people who've either learned on their own or been taught.

 

So, let's invert: if you don't phone oddballstocks and/or management, you have 40% handicap on a small cap.

 

Suddenly mega caps look much more level playing field.

 

8)

 

I would disagree here.  Have you ever talked to some of the sell-side guys on a name, or analysts who cover large caps?  These guys know leagues beyond what could ever be knowable by any individual.  They have access to management that individuals don't either.  You can call the CFO of George Risk Industries and they'll pick up the phone and talk to an individual.  Try setting up a phone call with the CFO of Valleant. 

 

It's much easier to gain an informational advantage in a large cap because there are so many people in the company and tangentially related to the company.  If a small company won't talk that's it.  But at a large company you might have 15,000 employees that you can attempt to gather scuttlebutt from.

 

Sometimes things that surprise the market are "known" to anyone who works at the company or interacts with it. 

 

All of this said I firmly believe that an individual who simply reads annual/quarterly reports for small companies and invests with a process can earn superior returns.  No need to call management, no need to find other well informed investors, no need for any of that.

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I'd say maybe 40% of small cap knowledge isn't online, it's tribal, passed between people who've either learned on their own or been taught.  There are so many people with so much knowledge who are willing to talk, you just need to make yourself available.  Some will talk for hours, and then call again to talk for hours again!

 

This is really my point. With larger companies, most of the material information is publicly available. To outperform, I just need to be wiser and more rational than the market. For small caps, I need to hustle AND be wise and rational. There is no doubt that the payoff for being right with small caps is higher. But the cost for being wrong is also higher.

 

KCLarkin's Hierarchy of Investors:

 

Smart-Eager: Micro/Small Caps

Smart-Lazy: Mid/Large Caps

Dumb-Lazy: Index ETFs

Dumb-Eager: Real Estate

 

 

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I know this is a forum and we're all on the Internet, but I've found I've learned the most when I've picked up the phone.  I'd say maybe 40% of small cap knowledge isn't online, it's tribal, passed between people who've either learned on their own or been taught.

 

So, let's invert: if you don't phone oddballstocks and/or management, you have 40% handicap on a small cap.

 

Suddenly mega caps look much more level playing field.

 

8)

 

But because you can, then you are saying that it isn't a level playing field, because it favour YOU if you call mangement? Then what's the problem? It is the holy grail of getting an edge right?

 

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But because you can, then you are saying that it isn't a level playing field, because it favour YOU if you call mangement? Then what's the problem? It is the holy grail of getting an edge right?

 

I won't call management and will invest in mega caps.

 

You guys can have a huge edge over me. Which I was trying to tell you.

 

Are you satisfied now?

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I'd say maybe 40% of small cap knowledge isn't online, it's tribal, passed between people who've either learned on their own or been taught.  There are so many people with so much knowledge who are willing to talk, you just need to make yourself available.  Some will talk for hours, and then call again to talk for hours again!

 

This is really my point. With larger companies, most of the material information is publicly available. To outperform, I just need to be wiser and more rational than the market. For small caps, I need to hustle AND be wise and rational. There is no doubt that the payoff for being right with small caps is higher. But the cost for being wrong is also higher.

 

KCLarkin's Hierarchy of Investors:

 

Smart-Eager: Micro/Small Caps

Smart-Lazy: Mid/Large Caps

Dumb-Lazy: Index ETFs

Dumb-Eager: Real Estate

 

+1.

 

Though I think calling me "Smart-Lazy" is doubly wrong. ;)

 

I'm not Smart - there are tons of people here who are much smarter than I am.

And I am not Lazy - I don't call management not because I am lazy. I don't call them because ... oh well, we'd need to have at least 6 beers before I'd get to the reasons.  :-X

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Sorry - just curious why you think real estate is dumb?

 

I just mean you don't need an Investment IQ of 150 to do well in real estate. Same goes for indexing. These are smart investments for most people (say 99%). And micro-caps are dumb investments for most people.

 

I agree about micro-caps being dumb for most people.

I definitely fall into that category.

 

It's far easier for a simpleton like me to buy a great company after a big drop.

Buying a micro-cap seems extremely difficult to have 15%> CAGR long-term. At least for my feeble qualifications.

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