There seems to be a consensus in the value community, depending on who you read, that value is something that can best be found in small cap companies. This is a mantra that has been repeated in one form or another by many many different value oriented investors. It was born out in a famous study by Eugene Fama and Kenneth French. It has been repeated so much that I took it as a truth, it was a strategy that really made sense to me, until recently. What changed my mind? What am I even talking about? Keep reading.

The idea is basically that large cap companies are so visible and followed that it’s impossible to develop an informational or analytical advantage over the other players (large hedge funds, sovereign wealth, family offices, endowments, pensions etc.) They have vastly more resources to devote and so are much more likely to be able to correctly judge the value. Carrying it a bit further, the efficient market hypothesis should pretty much apply in these situations. This means that all the relevant information is baked into the stock price for large companies, including future projections for returns. There should be no alpha to gain.

Conversely small cap stocks are thought to be unloved and under-followed. The small size means that entities that have large amounts to invest cannot make meaningful returns, without spending the effort to analyze thousands of these small companies, and there are just not that many good ones. So they focus their time instead in the big companies where they can put much more capital to work, without worrying as much about liquidity, and without having to worry about filing SEC form 13D. In some cases an informational or analytic advantage can be found, because there are fewer people looking.

People with small amounts of capital should be enticed by the above structural inefficiencies. Small amounts of capital can be put to work in these obscure, small situations.  Meaningful returns can be made. You don’t have to compete against large investors. Why would anyone with small amounts, not want to work in this space? I sure thought it was a great idea for a long time.

First the factors I have described above are well known to many people, value investors in particular.In aggregate all these individual and small investors add up to a collective large competitive force. You are in fact competing against all this talent, looking for opportunity. You are trying to come in before the crowd, purchase some undervalued company, and wait for everyone else to catch on. But as an individual, competing in this pool, what are the chances that a company that appears to be a bargain will be so. I don’t have evidence, but I have a feeling this formerly empty space has become quite crowded, notwithstanding the recent issues surrounding people searching for yield.

Second these undervalued obscure companies by their nature take a long time to mean revert. Since they are less followed, it can take a painfully long time for the critical mass of value recognition to develop. Small companies also have less flexibility, one bad move can really damage the equity.

May I suggest an alternative? What if it were possible to find large undervalued companies. They exist, I can assure you. Sometimes in the normal course of business, bad things happen. Recently Wells-Fargo had a scandal, they cheated millions of people, caused great damage. A couple of questions come to mind. 1. are banks being undervalued as a group due to prevailing but temporary low interest rates? 2. what are the switching costs for existing customers both retail and institutional. 3. does the bank have a large benevolent investor, who has a significant stake and a track record of stepping in either behind the scenes or directly to salvage his investments when big PR problems come about? These factors in combination with the scandal created a very good value proposition in a large liquid company. In this case you don’t need superior information, just a divergent view. An additional benefit is that with so many people looking at the company as soon as the smoke clears, the revaluation will occur, and fairly quickly.

But if everyone is so smart and spending so much energy looking at this stuff, how do these events occur, shouldn’t people be able to figure out that some setbacks are temporary (obviously some aren’t as well). But with all the high paid wall-street types and market efficiency, it seems like sorting should be possible, yet the price still drops with bad news. I don’t have a great explanation, but you can still take advantage.

How about AXP and the loss of the COSTCO account?

I would challenge you to look at the next big scandal or adversity for a major company and ask if the damage is permanent or temporary. Big companies can take damage and not sink (think battleship). Think about 5 years out, will people still even remember the scandal? As John Templeton famously said, the time to buy is when there is blood in the streets.