What Kind of Easter Egg Hunt Are You In?

One of the Most Important Decisions Of Your Investment Career

In the spring of 2000, a man named Reed Hastings traveled to Dallas, Texas with a big business idea.

Hastings approached the management of movie rental giant Blockbuster with a proposal. He wanted Blockbuster to buy his small business for $50 million.

At the time, Hastings’ company, Netflix, had a promising business model. It allowed people to rent movies through the mail. Netflix was also small and struggling to turn a profit.

Hastings believed a Blockbuster purchase of Netflix would be a win-win deal for both parties while Blockbuster’s managers did not. They didn’t think Netflix’s business model made sense for them. A Netflix executive later said that Blockbuster essentially laughed Hastings out of the room.

You probably know the rest of the story.

Netflix secured investment from other sources and built a hugely popular mail order DVD rental business.

Around 2007, it made a brilliant move and began transitioning into America’s #1 movie and television “streaming” service. This innovation crushed traditional brick-and-mortar rental companies like Blockbuster.

In 2002, Netflix had less than 3 million subscribers. By 2018, it had reached 125 million subscribers and had climbed to a market valuation of $160 billion.

Blockbuster’s market valuation in 2018?

Zip.

It went bankrupt a long time ago and its “pass” on Netflix is widely regarded as one of the worst decisions in modern corporate history.

To give you an idea of what an investor would have done with an early Netflix stake, consider that Netflix stock fell to a split-adjusted low of $0.35 per share in 2002. Assume you did not buy the bottom, but instead invested $5,000 at $0.50 per share, picking up 10,000 shares of Netflix.

In 2018, that $5,000 investment would have been worth $3.67 million (a 734-fold return).

Netflix’s story is one of my favorite examples of one of the most powerful concepts in the world of finance and investing.

The concept?

If you want to make giant returns in stocks, you must be in the right Easter egg hunt.

Below, I explain why.

Where Stocks That Can Return 100-Fold Hide

On Wall Street, companies are often grouped and labeled according to their size. Investors typically place a company in one of three size categories: Large caps, Mid-caps, and Small caps.

“Cap” is short for “market capitalization.” This is the term used to describe the value of a public company. To figure out a company’s market cap, all you do is multiply the total number of shares the company has in the market times the market price of a single share. It’s that simple.

The group names are common sense. Large caps are large, small caps are small, and mid-caps are in between.

For example, the popular software company Microsoft is a large cap. In 2018, its market cap was around $700 billion. Or, take iPhone maker Apple; it’s also a large cap. In 2018, its market cap was around $850 billion and went on to become the first company to pass the market cap milestone of $1 trillion.

Mid-caps are smaller than large caps. Typically, companies with market caps in between $2 billion and $10 billion are said to be mid caps.

The difference between a large cap and a mid-cap can be huge. A mid-cap company worth $5 billion is less than 1% of the size of giant Microsoft.

Finally, we have small caps. These are companies with market caps under $2 billion.

While the difference between a mid-cap and a large cap can be huge, the difference between a small cap and a large cap can be incredible.

Take a small cap with a market value of $500 million, for instance.

This is just 10% of a mid-cap with a market value of $5 billon, which means it is less than one tenth of one percent the size of a large cap like Microsoft.

Large caps can be good investments. They are routinely stable, established, profitable companies and often pay dividends. Large caps can be great investments for conservative investors.

But if you’re interested in making 10, 20, even 50 times your money (or 734 times your money like in Netflix) in a single investment, it would be wise to look at small cap stocks.

Small cap companies have much greater potential to produce giant returns for their shareholders in a short time than any other kind of company.

The reason is simple.

It’s much, much easier for a young, $500-million small cap to grow 10-fold than it is for a mature $500-billion giant to grow 10-fold.

That’s just basic math. If your daughter sold 10 boxes of Girl Scout Cookies around the neighborhood on her own, you could probably help grow her results 10-times (selling 100 boxes) by driving her around and putting a little pressure on your friends or coworkers to buy some boxes.

What if your daughter was a natural saleswoman and had sold 100 boxes on her own? To enjoy 10-times growth under that scenario, she’d have to sell 1,000 boxes. Not so easy anymore. That’s the mathematical challenge behind enjoying giant growth when a company is already doing giant sales.

The giant’s “super growth” days are behind it. Now, that doesn’t necessarily mean it’s a bad investment. It just means that it’s not an ideal investment for someone looking to make giant returns in a relatively short period of time.

Remember, a $500 million small cap is just one-tenth of one percent of a $500 billion large cap.

That’s why a search for stocks with huge growth potential should start in the small cap stock world. This is where companies with the potential to grow 10, 20, 50, (even 734) times larger live and hide out, but it gets even better for small cap investors. There’s another tremendous benefit they enjoy that large cap investors do not.

I believe this benefit is best explained with the story of an Easter egg hunt.

The Story of the Easter Egg Hunt

Picture this…

It’s Easter and you’re ready for the neighborhood Easter egg hunt.

Over 100 eggs have been hidden in a small, local park. Each egg has a treat inside it. You’re told that one special egg even has a cash prize in it.

If you’re in this hunt, which of the two following scenarios would you rather be in?

A: In addition to you hunting for eggs in the park, there are 1,000 other people hunting for eggs. It becomes a madhouse.

B: In addition to you hunting for eggs in the park, there are just 10 other people hunting for eggs.

If you’re like most reasonable people, you picked B.

You’d rather have this:

Than this:

You’d rather have just 10 people in competition with you instead of 1,000 other people picking over the park like a swarm of locusts.

What does this have to do with investing?

Well, this same dynamic is at work in the stock market every day.

The financial market is where millions of people go to pick through opportunities in stocks, commodities, currencies, options, bonds, and real estate.

In this big market, everyone is looking to buy assets for less than what they are worth and looking to sell assets for more than what they are worth.

Essentially, everyone is trying to outsmart everyone else.

Everyone is looking for eggs.

The financial markets price most assets correctly most of the time.

However, it’s not a perfect system. Windows of opportunity where you can buy assets for less than what they are worth or sell assets for more than what they are worth, appear from time to time. In the investing world, these windows are called “market inefficiencies.”

These are the opportunities that can make us big money.

Although, the more people that are studying, monitoring, and picking over a market and its opportunities, the more competition you have in that market and the less likely you’ll be able to find market inefficiencies.

The more people picking over a market, the smaller its pricing inefficiencies will be, and shorter windows of opportunities will be open.

In the financial markets, the biggest competitors are “institutional investors.”

Institutional investors are the elephants of the financial markets. This group includes mutual funds, pension funds, large hedge funds, and insurance funds. It also includes sovereign wealth funds, which manage the savings of entire countries.

A single, large institutional investor can manage over $10 billion in assets. So, even a wealthy individual with $5 million in assets is a mouse compared to this elephant (in this case, the elephant is 2,000 times larger).

Some institutional investors manage much more than $10 billion.

The sovereign wealth fund of Norway, which has been fattened by oil revenue for years, was over $1 trillion in 2017.

This is 100 times bigger than the large institution with $10 billion to invest.

In other words, the large institutional investors of the world have a ridiculous amount of money to invest in stocks, bonds, and other assets.

These large institutional investors typically employ armies of investment analysts that spend hundreds of thousands of hours every year scouring the world for opportunities.

These analysts perform a lot of old fashioned “financial detective” work by visiting public companies and interviewing industry experts. They also use the world’s most advanced computer algorithms and “Big Data” analytical programs to comb through market data. The programs run 24-hours a day, 7 days a week, sifting all the world’s financial data a thousand different ways at warp speed, hunting for pricing inefficiencies, small and large.

Picture the Easter Egg hunt again and realize that you are in a brutally competitive Easter Egg hunt.

That’s the bad news.

The good news is the financial market is a big, diverse place and there are Easter Egg hunts the big guys can’t participate in.

The Problem of Size

In the investment world, professional investors obsess over “liquidity.”

When it comes to buying and selling investments, liquidity is a measure of how easy or difficult it is to transact in a security.

Take Facebook stock. Since Facebook is one of the world’s largest companies (worth over $500 billion in 2018), and many people like to buy and sell the stock, we can say Facebook stock is “very liquid” or “has huge liquidity.”

There is a large market for Facebook stock where buyers and sellers execute many sales each day. In 2018, it was not uncommon to see over 20 million shares of Facebook change hands in a day.

On the other side of the spectrum, note an unknown small cap firm with a market cap of just $50 million (less than one-tenth of one-percent of Facebook). Seeing as this company is tiny by stock market standards, and most people have never heard of it, the company’s stock will not have much liquidity.

Remember, market cap is simply the number of outstanding shares times the share price. That means with small cap stocks, there simply aren’t all that many shares out in the market (compared to, say, Facebook, which we just discussed). This makes is harder for someone to buy up a huge amount of those shares – there may not be all that many sellers.

Now here’s where it gets interesting…

Let’s say you manage a $10 billion stock portfolio.

For a stock position to make a meaningful positive impact on your fund’s results, you need it to represent at least 3% of your fund’s assets.

Most good managers would rather put 4% – 8% of their fund into a stock idea they believe is truly great.

If you’re looking to put 3% of $10 billion to work in a great idea, that means you are looking to place $300 million.

That is six times more money than a $50 million small cap.

Even if you wanted to put just 1% of your fund into a stock, that is $100 million.

You get the idea.

Big money managers can’t join in the small cap stock Easter Egg hunt. They also can’t “play” in other small markets with limited liquidity like many options markets, smaller investment funds (like closed end funds and ETFs), individual bonds, small cap foreign stocks, and penny stocks.

When you “play” in small markets with modest liquidity, you don’t take on the world’s richest, most powerful institutions armed with armies of top-flight analysts and the world’s best computers.

Instead of competing against thousands of other Easter egg hunters, you compete against modest amounts of them. In some backwaters of the financial market’s river system, you barely compete against anyone.

Successful investing and trading is all about tilting the odds in your favor.

The more you can get this advantage, the more successful you will be.

Hunting in smaller, less liquid markets, like the small cap market, for example, is one of the absolute best ways to do that.

Next I’ll discuss why the richest investors are the ones who appreciate a good financial crisis.

Regards,

Brian


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