By Rodney Drinnon, managing partner, McCathern Houston
When people look at any kind of competition, they’re often inclined to bet on whoever appears to be the biggest and strongest. This holds true whether in a courtroom, a boxing ring, or the stock market. So it’s no wonder that, as The Motley Fool reported, “when most investors begin their hunt for a new stock, it starts and ends with a large-cap name valued at over $10 billion.”
But in all these arenas, the smaller player (or proverbial “little guy”) can pack the bigger punch. On Wall Street, small caps can deliver bigger rewards, outpacing their larger rivals. The problem is that, as the New York Times put it, “small-cap value stocks rank among the market’s riskiest fare.”
How can you know which small-cap companies to bet on, particularly when they face much larger competitors in their same industry? Through years of experience, I’ve learned what to look for.
I’ve built a career betting on the little guy -- and, often, being one myself. As a litigator, I frequently represent smaller businesses (and I take on cases that revolve around investments). I’m also a boxer, and represent fellow boxers. In the ring, my clients and I often face off against larger rivals. The lessons I’ve learned in both spaces are the same. Smaller corporations, just like smaller fighters, can punch above their weight.
In choosing which ones to bet on, look for companies that have these attributes going for them.
Exceptional preparation
When smaller companies are vying against industry leaders, they can have an important built-in advantage: being underestimated. For example, as McKinsey wrote, large established companies are sometimes “so focused on their traditional competitors, they don’t even recognize the threat developing from low-cost rivals.”
Of course, small caps don’t need to be low-cost in order to give larger rivals a run for their money. The key is for the smaller player to be more prepared than its competition, no matter what the size. For example, the smaller company’s leaders should know how to take advantage of any untapped spaces they may discover in the market. They should know how to jump quickly on any mistake their larger competitor makes -- such as a marketing mishap, for example. They should study what larger companies have done to try to stave off smaller competitors and develop strategies to respond to every possible move.
I follow the adage, “Proper preparation prevents poor performance.” In court or the boxing ring, my clients and I must be prepared for every eventuality we can think of. In conversations with executives and investor relations representatives, as well as in earnings calls, ask small cap leaders about what they expect from their larger rivals and whether they have strategies in place to respond.
Fearlessness
Intimidation is a destroyer. The leaders of a smaller company must be fearless in taking on a behemoth. “Don't be intimidated by giants in your market,” an Entrepreneur column put it (alongside an image of a small figure in boxing gloves having apparently knocked out a giant). This is more difficult than it sounds. It’s natural to feel intimidated when your opponent is much larger. It can cause stress, which alters your mentality, taking you off your game.
Strong leaders of smaller companies are people who feel absolutely confident that they can win any piece of business, grow their market share, and beat the competition at every step. They know that size means nothing, because anyone can have the smarter strategy and win. Take a close look at the leaders of small caps, and try to get a sense of whether they’re genuinely confident, or engaging in bluster.
Patience for the long haul
Success takes time. I’ve gotten hit with a straight right hand in the ring many times, only to ultimately win on points or a TKO. I’ve had legal cases drag on for years in which I was up against a much larger, more expensive team of lawyers on the other side, but we ultimately won.
Strong leaders of a smaller competitor will want to win every round, but won’t become despondent when they lose one. They’ll be realistic in their projections about how quickly their businesses will grow -- balancing hope with a legitimate look at the numbers. They’ll also show no signs of being erratic, suddenly switching strategies all the time. They’ll keep moving forward with patience and determination.
When you find a small cap that exhibits all these traits, investing in them is a smart bet. Of course, there are no guarantees -- just like everyone, I’ve lost a few cases and some bouts. But I’ve won more. If you look at businesses with this kind of discerning eye, you will too.
Rodney Drinnon is co-managing partner of McCathern Houston.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.