Starting with questioning the basics of small-cap, illiquid companies to Value vs. Growth, diversification and the concept of “moats”, I decided to think through what could actually be true about investing and how looking at companies as cities that develop people could be a pond to fish in. 

It all started with: Am I fishing where the fish are?

It’s a common line from Munger in his Berkshire and DJCO annual meetings:

"It’s so hard in a competitive world to get big advantages just buying securities, particularly when you’re doing it by the billion, and then you add the burden of very high fees and think that by working hard and reading a lot of sell-side research and so forth, that you’re going to do well. It’s delusional. It’s not good to face the world in a delusional way. And I don’t think, when Berkshire came up, we had an easier world than you people are facing this point forward, and I don’t think you’re going to get the kind of results we got by just doing what we did. That’s not to say what we did and the attitudes that we had are obsolete or won’t be useful, it’s just that their prospects are worse. There’s a rule of fishing that’s a very good rule. The first rule of fishing is “fish where the fish are,” and the second rule of fishing is “don’t forget rule number one.” And in investing it’s the same thing. Some places have lots of fish, and you don’t have to be that good a fisherman to do pretty well. Other places are so heavily fished that no matter how good a fisherman you are, you aren’t going to do very well. And in the world we’re living in now, an awful lot of places are in the second category. I don’t think that should discourage anyone. I mean life’s a long game, and there are easy stretches and hard stretches and good opportunities and bad opportunities. The right way to go at life is to take it as it comes and do the best you can. And if you live to an old age, you’ll get your share of good opportunities. It may be two to a lifetime, that may be your full share. But if you seize one of the two, you’ll be alright.”

And, 

“….like a bunch of cod fishermen after all the cod’s been overfished...that’s what happened to all these value investors. Maybe they should move to where the fish are."

Starting With Roll-Ups

Earlier in my investing journey, much of my investing was focused on “high ROIC” businesses.. I mean, who doesn’t start that way? Specifically, they were roll-ups (in hindsight, I don’t think I understood the debt component quite well). 

Classic businesses rolling up fast food restaurants and convenience store chains. Oh, and they were "levered up to the gills" too. I imagine if I knew about the company earlier, Dominos may have fit in the portfolio of what I was gravitating towards. A world where I was ignorant of cheap debt funding rapid growth. 

Size + Volume

Then, I moved over to small caps with low liquidity. 

That seems to be where the “logic” has taken me. Whether it’s the micro-cap community or the work of Roger Ibbotson of Yale/Zebra Capital on how illiquid stocks tend to outperform. Not to mention the number of ‘research’ that supports the view that small companies should outperform larger companies.

I mean, small companies become large companies. It just fit my limited imagination that the likelihood of a $100M company could become a $1B to be more feasible than a $100B company becoming $1T. Both 10x but one seems to have a higher probability given there are many more $1B companies than $1T companies. On a given day we might have about ~3 of those (for now). 

I guess if I were to think about early-stage investing and VC/angel investors making investments at $10M in market cap… the logic of investing in them while they are small would hold merit. Of course, most fail at that size/stage. 

There is much to be said about how many small-cap stocks are ’undiscovered’. How they are illiquid and how that might be because of large insider ownership, which can be seen as a positive. It’s also preferred to see minimal (or absolutely no) ownership from institutional funds. 

So small-cap companies will compound returns via growth and have the additional return channel of being “discovered” by an institutional fund that will pump up its market multiples. Things like getting into ETFs and various index funds will help generate returns in addition to the business fundamentals improving of course. It’s about getting there first. 

This was a big part of my thesis when I picked looking at illiquid small-cap companies as well. Not to mention that the businesses were simpler and easier to understand. There was that structural advantage where bigger funds could not invest in companies of ~sub-500M in market cap because of their liquidity constraints. 

I think there is a general idea that for such illiquid companies one is competing against retail investors and if you are the individual to do deeper research on the name and do the required scuttlebutt, that you can discover great companies (needles in haystacks). 

The Crowded Small-Cap Fish Pond?

But what if the field is full of very smart investors? 

There is perceived career risk for people who go off on their own to start small funds of their own, become full-time investors etc… and many smart and hardworking people will take this path with the belief that their edge is on attacking the illiquid and undiscovered part of the market. And this is where my bias might kick in but there are definitely a lot of smart people that focus on this space. 

As my attention drifts, I used to think Toronto’s TSX and TSXV were great pockets to find quality small-caps but turns out many US small-cap investors know that too. I’ve also heard the US exchanges aren’t as open to having small companies list. 

Then there are the conversations I have with folks in the finance industry in Canada where there are a number of investment banks who will prop up a bunch of garbage small cap companies to make a quick buck on commission too. I mean, look at the marijuana hype… you don’t think there were investment banks manipulating things there? 

The reality is that most small cap companies are small for a reason. They are not great businesses. But the few that aren’t…. Are bound to be discovered by the number of smart, driven small cap investors who’ve read everything on Buffett to dig into. 

It’s quite intimidating to see so many smart and driven people driving across the continent to meet managers, to turn over as many rocks as they can etc… Though large funds have more ‘resources’ I do think these small funds have a greater tenacity and that lets them dig into all the crevices to find great small cap companies. Doing the unscaleable. 

Assessing the Competition & Game To Play 

On the back of the possible 'structural advantage’ of being ahead of institutional money… the question becomes whether I want to fish in the pond that is filled with people who went out on their own because they love investing so much.

The popular belief is that large caps are more efficient than small caps because there is much less volume and institutional ownership. You know, the “smart money”. But as passive ownership of businesses increase over time and it becomes “easier” for retail investors to just buy all kinds of index funds…. Isn’t it possible that there has been a switch where the actual smart money is all in quality, small, illiquid companies and the dumb money is actually all in large caps? 

There is less career risk to join large investment funds where you can live a great life being a mediocre fund manager.  These funds will just hug the index… which is made up of large cap companies. They are the ones who truly won’t be able to think long term, compared to the small funds run by entrepreneurial investors with a kicker of entrepreneurs investing in the fund at times.

There is also the view that it would be perceived as career suicide for a large cap fund manager to put 30% of their fund into a quality company like AAPL compared to the marginally acceptable (and advertised as concentrated) ~10% or the widely accepted 4%. Berkshire’s equity portfolio was 43% AAPL at one point in 2020. I doubt there are many multi-billion dollar AUM funds that would ever consider allowing that would happen. They would ’trim’. 

What about the so-called mid-caps? Is that another overfished pond where funds specifically look for names that fit a paradigm? The same narrative of a $5B company is more likely to be a $50B company? 

Arguably, a highly liquid large cap company may have greater bouts of inefficiency given the actual investors involved in them and their desire to never concentrate a holding compared to small and illiquid companies who will either be insiders and long-term oriented investors who dig a ton. 

This is another form of inefficiency. As was evident with 2020’s COVID market drop, when shit hits the fan, everything correlates to 1 and they all drop together. All stocks are equal in the face of the hammer. So…. Maybe market cap/liquidity isn’t really a ’truth’...

Questioning Investing 'Truths'

Maybe it’s not about looking at market cap ranges to determine an edge… let alone liquidity. It could be that these are possible areas for an edge but maybe they are overfished.

Though we have historic data showing the value of illiquid companies and small cap companies outperforming large cap companies…. it is still an inference of historical events with the belief that it will somehow rhyme with the future… nay, possibly repeat. 

But what if the conditions for small illiquid companies outperforming weren’t predicated on the fact that they were small and illiquid? It could’ve been the fact that there really weren’t as many investors investing there… there weren’t all these forums, conferences and sites dedicated to small investors… the availability of capital to seed small investors who dig into small caps…. And a much different economic environment in the 2020s than it was in the 1960s. 

Yes there is power in large numbers of data and many do look at an index of hundreds and thousands of companies to make this inference. But given how a handful of companies will tend to always outperform the market…. Maybe it doesn’t matter whether they are small, mid or large cap companies. Maybe it matters that you merely try to identify them… 

The reason for this thought process is to ask myself if I really should be narrowing my focus into small and illiquid companies and questioning whether the probability of achieving high returns will be true compared to investing in large companies. The fact is, I don’t think so anymore. It’s that I don’t necessarily think it’s true that small and illiquid companies are a better pond to fish in than others. 

So what do I think is probably true? 

A Possible Truth from Diversification

There then comes the idea of diversification too. At least in public equity, Greenblatt’s literature on diversification is commonly cited as how after about ~16 investments (of different businesses) will eliminate about 93% of non market risk. Greenblatt’s historically held a 6-8 investment portfolio at Gotham. 

"Statistics say that owning two stocks eliminates 46% of the nonmarket risk of owning just one stock. This type of risk is supposed to be reduced by 72% with a four-stock portfolio, by 81% with eight stocks, 93% with 16 stocks, 96% with 32 stocks, and 99 percent with 500 stocks.” - Per Greenblatt’s “You Can Be a Stock Market Genius”. 

From Munger, Fisher and Buffett, the importance of concentration is frequently touted for investment outperformance. Though, on the opposite spectrum, there are those who take a 100+ stock portfolio approach and do well as well. It can be said that early stage investors tend to take the latter approach given the higher failure rate of early stage companies. 

Once again, there is much research supporting the value of concentrating investments and the approach of averaging up (watering your flowers).. which also seems to be the approach of many VC funds as they participate in the continued funding rounds of their portfolio companies that survive and grow. 

This might further support the approach of possibly replicating such a strategy in the public markets with small cap companies. Trying to find the undiscovered, illiquid companies that could grow fast etc… and taking a larger than 15 stock portfolio and letting the winners come out. 

Maybe a truth from this is not that one needs to have a concentrated portfolio… but that there will always be a handful of companies that generate most of the returns and it’s finding and holding them. That’s Munger really advocates for. You just to seize the handful of best opportunities. 

Concentration just becomes a result of a possibly extremely stringent process and also the natural evolution of most companies being trash compared to a few diamonds. Hence, a truth isn’t to concentrate but that a handful of companies will make all the difference for the market and your portfolio.

Other Possible Truths.

I think a business that returns a high return on invested capital being a good business is probably true. I think a business that has returned 40% on its invested capital over the last 5-10 years is better than the one that’s done that for 15% for the same period of time. 

I think it’s true that there is a way to make extremely near-term predictions with enough/right data. I think Jim Simon’s at Renaissance has shown that. I think it’s true of the opposite that the longer you look out the harder it is to ever forecast with the ever so increasing amount of random variables that can impact the business. But businesses take time to build. Products take time to build and grow. This is another truth that makes it the only logical solution to have a long-term oriented…. Really, a patient, view with investing in businesses. If one is not investing in a business but a ticker symbol… I highly doubt they will be able to hold for a long term anyway. 

A continuous theme from my evolving outlook on investing has been to invest in owner-operators. They could be founders or someone who took over an existing business. Regardless, it’s been about finding companies run by individuals with material ownership in the company. It’s just hard to imagine that from the handful of great companies, most would have a non-owner-operator. A few might but they would be the exception. I just think it’s near impossible for someone who is not an owner-operator to do something weird (which is required to succeed) and give a damn about the company. 

Shareholder Base + Wealth Building

Does the shareholder base also matter? Buffett’s previously spoken about the importance of attracting the right long-term oriented shareholders to one’s business… to create a community of individuals in it for the long term. Leonard at Constellation has noted the same as well. 

I imagine it would reduce volatility in the valuation of the business for sure. I also imagine the market valuation to become more efficient with the fundamental business valuation as well. The possible intention being that investor’s should only see a financial return from the growth of the business itself, not multiples/hype etc…. (Not that you can ever rule those out but just the skew of probability to the former than latter). 

I shouldn’t kid myself that investing in the public markets is purely an intellectual pursuit. It is also to build wealth. This is something I consider when thinking about the importance of a shareholder base. I think if the goal was to retain wealth, I would want my businesses to have extremely long term oriented shareholders where there is limited volatility and market value represents business value. But, if I am building wealth, wouldn’t I want a good amount of irrational shareholders to continuously create wider bouts of inefficiency (aka opportunity)?

I’m not saying various ‘glamour’ or ‘battleground’ stocks are the ones to then go all in on. Once again, there does not seem to be a single factor of importance. It’s a myriad of things to consider. 

However, I am beginning to question the validity of structural boundaries like market cap and liquidity. It’s just a divergence from concepts I used to hold very dearly. 

Thinking Through Fish Ponds and Individuality. 

So, it comes down to the notion of what pond to fish in. All the well, keeping in mind, my own individuality as an investor. 

I am not a trader, nor a quant. Just not my personality. 

As I think through the concept of ‘edge’… or ‘variant perception’… both are marketed quite heavily…. I used to think of mine as structural (i.e. illiquid small caps). But an edge is also flexible as in some cases there can be a pure analytical edge in understanding a culture/language. Sometimes it’s a different point of view… and there is the most commonly touted time-arbitrage. 

Another edge that many don’t talk about is independence. A fund manager can’t do everything I can. Professionals don’t get to evolve quickly and change their minds as quickly. Some do but only few can actually execute on the change. 

Something I lack are the resources. Sometimes in the form of smart teammates. Though I believe investing to be closer to a solo sport, a community is quite important and a great fund could help create that. But, thanks to technology, one’s Twitter community might be more powerful than that of an average fund’s. At least in the public markets, information is endless. For most, all this information will be dangerous and won’t help (maybe deter) performance. 

There is also the extremely selfish part of me that wants to create a different strategy. It just seems innate in my personality to try and make something of my own (though I am probably copying someone… I may not realize it). It’s a round about way of saying to focus on companies with decentralized systems for innovation. Something akin to what I constantly think about as a utopian company. 

I can’t help but think that the idea of analyzing moats is backward looking. You try to put an ‘answer’ to why a company may have higher returns on invested capital over a period of time and one of those is to try and explain it with moats. At the moment, I believe in many of the characterizations of these various economic moats to be approximately right. 

But if investing is using the present to see the future, I think one has to look at whether the systems that are currently present have the ability to build upon or create new moats. An analysis of an existing moat may give some cadence to possible resiliency… but one cannot predict how it will actually fare in the future. Rather, I think the creation of such moats should be examined for possible evidence of a system that can innovate and adapt or was a one-off fluke product acquisition.

For example, there are a lot of assumptions put in place that companies that collect a bunch of customer data will be able to use some sort of machine learning to extract value and improvement out of it. Really? Could they really? I forget where but another commonly touted piece of research is that the amount of data is more valuable than having the best data scientists. I don’t disagree with that at all. I think a company with more data will be able to do more with mediocre data scientists than a company with much less data but with the best data scientists. 

However, I don’t think one can easily assume the existence of data and/or competitive positioning to mean the company can execute going forward. In many ways, unless the business has demonstrated an ability to constantly adapt and change and cannibalize itself (not in buying back shares but in disrupting its own products) will it be able to build upon any existing advantage/create new ones. 

Each of the big tech companies in the US have demonstrated an ability to achieve that. I’m still unsure on FB but AAPL, GOOG and AMZN have definitely shown an ability to do so. And I think a large part of this is the ability to acquire, develop and retain talent. Because for people to do amazing things for an organization, they need 1) an environment supporting creative pursuits, 2) to stay long enough to see the project/product work out. 

This is why I don’t think institutions that constantly see talent bleed like professional services will ever be able to grow through innovation… they always seem to be reacting most of the time. 

But just like how cities (lesser extent countries) have been hotbeds for innovation, I think companies are more likely to takeover such roles and see possible superlinear trajectories if they can build a system that allows for it. Most, will fail and decline and become institutions of old-standing brand names that see talent bleed out. 

As I think through all this, I think about whether the pond is not an industry (i.e. tech… I mean how is that even an industry now), market cap (large caps may be more inefficient than small) or various other financial/geographical factors individuals use to ’specialize’ for the sake of selling a product/service. 

Maybe it’s finding organizations that can grow superlinearly by emulating cities… If they can be centers of innovation where human creativity can be pushed to its furthest. Many companies fail. But VCs are betting on the large number of opportunities and things randomly working out as the universe magically aligns to some companies. As a public equity investor, one can take that same route to invest in 100s of small cap companies…. Or… I wonder if there is a case to be made for investing in a handful of organizations that can prove they can reinvent the wheel over and over again on the back of a system that’s allowed individuals within to test 100s of products. 

Final Thoughts.

I’m not saying size doesn’t matter. It does in relation to aspects like addressable markets. But I don’t think it’s necessarily a truth to investing. 

I think a few truths of investing are: high ROIC businesses are better than lower ones (sustained over a period of time), patience to hold for a long term, owner-operators, and a few companies will be great. 

I don’t know if it’s true yet but one I think to be true and a possible ‘pond’ is  

Disclaimer - I’m writing this for myself. For my past, present and future self. Much of what I write is my opinion. If it somehow ignites agreement in you then great, I’d love to hear about it. If it sparks disagreement in you, don’t reach out because I don’t care for it. There always are obvious exceptions and the flawed person in me hasn’t considered them all.