The Crux of Small Caps

"Keep all your eggs in one basket, but watch that basket closely." – Warren Buffett

As 2020 comes to an close, I would like to do a holistic reflection on the year that has passed and more importantly, look at how 2021 can be an even greater year of learning. 

First and foremost, I have to thank Tristan Waine and Anthony Shi. These fellows are the most passionate, intelligent and generous value investors that I have met. Thank you for sharing the knowledge you have, focusing on the mission and paving the way for another one of your breed. I am deeply grateful, so thank you gents. 

In 2020, my value investing strategy became centred on having a concentrated portfolio of mainly high-quality small caps with conviction dictating portfolio sizing. The portfolio will have exceptions for larger sized companies with long runways. All of the portfolio constituents will also be held, long-term, with the intention of obtaining "multi-baggers" and "outsized returns." I now share the view that small caps are a commonly ignored, misunderstood and underappreciated segment of the market even though they arguably have the greatest potential. 

This investment strategy is coupled with the understanding of SQGLP (Size, Quality, Growth, Longevity & Price) and its role in outsized returns. All the components of SQGLP can be categorized within the two dimensions for growth (or investor returns).

The Two Dimensions for Growth

1. Earnings Growth (Size, Quality, Growth & Longevity)
2. Valuations Growth (Price)

In essence, an investor's total return will simply be the combination of earnings growth plus multiple expansion; these are considered the twin engines of growth or "The Davis Double Play".

Valuation growth is typically achieved when companies are initially bought at low multiples. As time goes by, the market may realise a company's potential by paying a higher multiple. If a company's P/E went from 10x to 20x, and the earnings went from $1 to $4, the total return would be 8x initial capital. Conversely, the opposite also holds true, whereby paying too high a price may cause an investor to run the risk of multiple contraction and therefore suppressed returns.

Earnings growth, on the other hand, can be categorized by the 4 dimensions below.

The Four Dimensions of Earnings Growth

1. Volumes Growth
2. Price Growth
3. Operating Leverage
4. Financial Leverage

All 4 dimensions are levers that a company can pull. For example, if a company does not have much debt, they can and increase earnings growth by employing financial leverage. Once they have employed this, and they have "maxed" out their leverage capacity, this dimension can not be counted as much as an optionality or driver for future growth (at least until they delever). The same logic can be applied respectively to each of the other dimensions by understanding the business economics and capital structure.

These dimensions can also be categorized simply as being contributive to either sales or margins growth. Having the ability to sell more and/or raise prices year-on-year affects sales growth whilst capitalizing on operating and/or financial leverage affects margins growth. This model helps to see clearer where the "puck is going to be" and to visualise a company as a mechanical system with multiple levers. I believe its applications are particularly important and helpful in finding high-quality small caps.

Another important aspect of small caps is the deep focus on management. Betting on small cap stocks can often times be likened to betting on the jockey. To maximize the probabilities of management success, capital allocation must be strong, inside ownership must be significant and management incentives need to be shareholder-aligned. 

In 2020, I also learnt to see a company from the lens of multiple disciplines, namely mathematics, biology, physics and psychology. 

For example, mental models of physical structures (or structural analysis), from physics, can be applied business models to understand structural loads, structural limitations, leverage, strength at links, etc., all of which, with many more concepts, can be used to test a model's robustness. Additionally, tendencies and biases from rudimentary psychology can be applied to understand such concepts such as consumers habits, the power of incentives and the pitfalls of irrationality.

Looking forward into 2021, my goal will be a continued focus on finding high-quality small caps, improving my understanding of business fundementals and further learnings of the multiple worldly disciplines. 

Thank you for reaching the end of this blog post and following me this far on my journey. I wish you all nothing but happiness and success in the new year...