You kids know I’m a big fan of the small-cap stocks. Unlike most of the other things I like, stocks are arguably better the smaller they get. NO, I’M NOT TALKING ABOUT THAT, PERVS.
I’ve outlined the reasons approximately 5,399 times before, but I’ll do it again for the one guy who’s new around here. You’re welcome, Vin. That’s a dumb name anyway.
Small-caps are great because at least 80% of the market won’t even touch them. Size limitations eliminate at least half of the remaining 20%, leaving a playing field filled with a lot of average Joe investors. That’s a good thing. It’s far easier to outsmart your buddy John than Bill Ackman. I once saw John pick out a wedgie and then smell his fingers. Do you think Ackman would ever do a thing like that?
I’m a value investor, so I go looking for bargains. Out of the thousands of small-cap stocks out there (my definition is a sub-$1 billion market cap), chances are you can find at least a couple dozen that are cheap enough to buy. It’s the same thing if you’re a growth investor or even a dividend investor.
There’s lots of good stuff in small-cap land that is constantly overlooked. The strategy is to buy it up, hold on until the rest of the market gets it, and then sell into the strength. This is easier said than done, of course, but it’s something that’s been proven to work over the long-term.
There’s a bit of a problem with this kind of investing, however. The supply of small-cap stocks is slowly dwindling, and it doesn’t look like the trend will stop, either.
Why are small-caps becoming an endangered species?
Screw saving the dolphins. Let the Japanese fish them to death. We’ve got small-caps to save!
According to research done by an American firm, the number of publicly traded small-cap stocks in the United States fell from 3.726 in 2006 to 2.666 in 2016. The market lost a net 31 small-cap stocks in 2016.
In Canada the problem is even worse. Most of our small-cap stocks are either in the gold or energy space, and are hugely influenced by the price of the underlying commodity. There are thousands of these companies that are basically financial zombies, yet still pay outlandish salaries to insiders to do nothing.
So what’s happening with small-caps?
There are a few things that are killing that part of the market. Let’s start with Dodd-Frank, the bill many say is strangling small banks in the United States. Dodd-Frank made reporting requirements for all banks much tougher than before, a cost that’s really being felt by small institutions. There are thousands of these banks in the United States. Many are publicly traded.
It’s also becoming more and more expensive to stay publicly traded. It costs a minimum of $1 million per year in the United States to have your own ticker symbol. Many companies pay much more than that. The Sarbanes-Oxley act has made it more expensive for U.S. public filers.
And remember, active investing is becoming less popular as more and more busy people throw up their hands and buy ETFs instead.
But these issues pale in comparison to the elephant in the room. The reason why small-caps are slowly going away is because there’s so much private money floating around. A U.S. company doesn’t have to file with the SEC until they have 1,500 shareholders. If each investor contributes a paltry $10,000, you’d get $15 million before having to list. And that’s not including debt or having this guy as your backer.
In Canada, you can continue growing forever as a private corporation without having to list on the stock exchange. Jim Pattison has done it. You can too.
Why would someone growing a company ever IPO the thing, except as a way to get their capital out of it? And even then, it’s not impossible for a founder to just sell some shares privately whenever they want to buy an island. There are plenty of rich guys who want a piece of a high-growth private company.
The bottom line
The advantages to listing a company’s shares publicly are quickly going away. They’re being replaced with higher costs and additional disclosure requirements. Small exchanges like the TSX NEX Exchange are trying to replace that by giving smaller companies a stress-free way to go public, but as I pointed out before, the TSX NEX is filled with trash.
Small-cap stocks will always exist, but until the rules change to make it more friendly to businesses, look for the number to keep decreasing. It’s not a huge deal now, but it could really start to matter in 10-20 years. Fortunately for me, I don’t plan to live that long.