I look at smaller companies because they can offer much better upside than larger companies. Part of this upside is the result of rapid earnings growth. Small companies can be more nimble and efficient than larger companies. However, earnings growth isn’t always where you make money. Often, you can make just as much money on multiple expansion.
What is multiple expansion? It refers to when the price/earnings ratio expands because investors value those earnings more highly and will pay more for them. Think of a stock that trades at $5, or five times $1.00 of earnings. If investors suddenly are attracted to this business and the shares trade up to $15, the company now trades for fifteen times earnings. Nothing has really changed, but you’ve tripled your money.
Often, it’s pretty obvious why investors want to pay up for a certain stock. They usually do it because they think earnings are going to increase in the future. Sometimes, this is predictable based on fundamental analysis. Sometimes, stocks go up for mechanical reasons.
When you look at the market, stock prices are determined by supply and demand. Only big institutional investors have the demand necessary to really move stocks higher. Therefore, what they do matters. A quirk of the small cap market is that most institutions cannot own them. This means that many smaller companies are naturally underowned and undervalued. This is what creates the opportunity for us. However, at a certain point, three virtuous process start—which all feed on each other.
The first process is based on market cap. Every institution has its own rules, but generally, most institutions cannot own companies with market caps under $100 million. Ironically, as the market cap increases, institutions can buy them. Once they start acquiring a position, they continue to buy and force the shares up—which lets other institutions with different thresholds buy. It’s a virtuous cycle. Higher share prices let other investors buy—which forces shares up even higher.
Even more importantly, share price matters to institutional investors. I do not know why, but most institutions do not like owning stocks that trade below $5 a share. Once over $5, these institutions now can buy. This means that a move over $5, often leads to a move that goes much higher.
Finally, the big buyers are the index funds. There are lots of different indexes, but when you look at the small cap market, the Russell 2000 and Russell 3000 are the key ones to watch. These indexes do not do any fundamental analysis of a company. They simply buy when the market cap hits a certain threshold. It’s really pretty arbitrary. However, once something is included, there is often a big pop the day that the index fund acquires the shares needed. Even more importantly, many institutional investors are really just closet indexers. They buy what’s in the index because their job is to roughly track the index performance. This means that in the months following inclusion to the index, there’s additional buying from these funds. In total, inclusion to an index will often mean that 10% or more of the shares outstanding are owned by investors who HAVE to own the shares. This is a lot of buying—especially for a smaller company which is likely to be somewhat illiquid in the first place.
These three functions all feed on each other. They push the stock higher which opens the playing field to more potential investors who also push the shares higher. You need to pay attention to this. Earnings growth is nice, but multiple expansion is even nicer. When you combine the two, you can have huge upside from your smaller companies. While earnings growth isn’t always predictable, multiple expansion can be predictable because it’s so mechanical.