Small Companies, Huge Potential: Finding the Next Big Winners

#23 Boost your Investing Game in 5mins every Saturday

You know the saying, "There's always a bigger fish"?

Well, in investing, some of the biggest winners were once the smallest fish in the sea.

Companies like Microsoft, Apple, Amazon, Netflix -- they all started out as tiny specks, renegade upstarts swimming circles around the whales of the time.

Nobody could have imagined their seismic waves that would ultimately shake up entire industries.

As an investor with a long time horizon, the greatest potential for life-changing gains lies in these very small, emerging companies that are just beginning to flex their muscles.

They may be tiny now, but look closer and you could be staring at the next decade's dominant force.

The Case for Small-Cap Investing

Here are just a few compelling reasons small-cap stocks deserve a serious look in your portfolio:

1. Superior Growth Potential: No surprises here -- small caps are the growth engines of the future. With leaner operations, they're built for hyper-scaling if their innovations catch on.

Take Lululemon for example. In 2009, when revenues were just over $350 million, their yearly growth exceeded 50%. Fast forward to 2021 with $6.2 billion in sales and that advantage paid off in a major way for early believers.

2. More Room to Run: Because small-cap companies lack analyst coverage and institutional fund ownership, their growth stories are often overlooked or mispriced initially.

You know who Amazon was back when they went public in 1997 at a meager $438 million valuation? An online bookstore with a wild vision.

Bezos maintained that mindset all along, and the mispricing by the market provided a massive opportunity.

3. Agility Factor: While large companies move like cruise liners, small caps can turn quickly to catch waves of disruption before anyone else. Their size is an asset for rapidly iterating, pivoting and harnessing new technologies.

Just think about Netflix. Way back in 2003, they boldly diagnosed the death of physical video ahead of time. That agility allowed a startup sending DVDs by mail to transform into a streaming juggernaut owning the home entertainment mantle.

So why are investors often still hesitant to go small?

But First...The Risks of Small-Cap Investing

While the potential rewards are immense, small-cap stocks aren't without their fair share of risks:

• Volatility: Think going on a rollercoaster ride with corkscrews and loop-de-loops each trading day. Expect plenty of gut-wrenching price swings. This isn't for the faint of heart.

• Unproven Track Records: These companies often lack the financial strength, brand equity, or established management teams of large corporations. Growth theses can be unvalidated or full of hot air.

• Liquidity Constraints: Lower trading volumes and lack of institutional interest makes it difficult to enter/exit positions smoothly around significant events or news.

• Broad Risks: Small companies can be heavily impacted by changes in the economy, interest rates, customer trends, and macroeconomic factors outside their control.

Yes, navigating these risks requires a healthy dose of conviction -- and discipline around valuation and risk management.

Which brings us to...

How to Find Small Caps with Big Potential

While there are no shortcuts to riches, employing the right evaluation criteria goes a long way toward improving your odds:

✅ Search for Enormous Addressable Markets: A common thread among big winners is they are disrupting and capturing massive, untapped markets like cloud computing, DNA sequencing, and plant-based foods among others.

✅ Growth Runway > Current Valuation: Revenue multiples and growth rate comparisons versus peers help reveal undervalued, over-earning opportunities. The goal is finding outliers where projected growth significantly outweighs the current valuation.

✅ Scalable, Capital-Light Business Models: Look for companies leveraging tech and distribution advantages to rapidly compound growth on lower incremental investment needs. Recurring revenues and high gross margins are key.

✅ Measurable Unit Economics & Cohort Data: Direct consumer brands and subscription business models provide critical visibility into user acquisition costs, lifetime values, and retention metrics to assess long-term profitability.

✅ Disruptive Innovation Edges: Competitive research helps uncover companies with intellectual property, patents, network effects or data/cost advantages. The more unique and protected the better.

✅ Founder-Led Missions & Incentives: Companies with fervent, founder-led visions often possess more ambitious dreams and skin in the game over the long haul. Their equity incentives are aligned with investors.

Admittedly, much of this is an art of storytelling and vision projection.

But understanding the science of business models, unit economics, and growth drivers provides the facts.

Small-Cap Investment Evaluation Checklist

Lessons From Giant Underdogs

To drive these frameworks home, let's revisit some of today's household names during their small-cap days:

Apple (1980):

• $117 million valuation

• Early pioneer of the personal computing revolution

• Massive secular tailwind for affordable desktop computing

• Strong unit economics in bundled hardware/software business model

Qualcomm (1991):

• $1.4 billion market cap

• Undervalued patent/licensing assets around CDMA wireless tech

• Rode mobile phone growth trend before broader adoption

• Created industry standard leading to recurring royalties

Netflix (2002):

• $300 million market cap

• Disrupted home entertainment with DVD rental mail service

• Negative working capital cash-generating subscription model

• Visionary pivot to streaming video with tech infrastructure built

Each at the time was simply a speck but created revolutionary impacts on the economy well beyond their modest beginnings. So keeping a keen perspective is required!

Final Thoughts

There's no denying small-cap investing amplifies risks. But it's also where the potential for creating lasting legacy wealth exists.

History's greatest companies are proof you simply cannot afford to overlook small caps entirely.

That said, don't dive in blindly.

Develop a systematic, fundamental process for evaluation. Study the actual innovation taking place and disruptive forces at work. Always remain grounded in financially quantifiable metrics like revenue growth, gross margins, and unit economics to back the long-term visions.

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That’s it! Thanks for reading :)

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This newsletter is for informational purposes only and is not intended as financial advice. The insights provided are illustrative and should not be the sole basis for investment decisions. Readers should conduct their own research and consult professional advisors before investing. The authors and publishers are not liable for any financial losses resulting from actions taken based on this content. Investing in the stock market involves risk, including potential loss of capital.