Illustrating Investing in the Small Cap Cycle

I have drawn this rather crude illustration of what some call the “small cap cycle”. The Y-axis of profit stands for the growing profits of the business as well as the increasing investment returns over time (as, in the long-term, these two concepts should be one and the same). The X-axis represents time (probably years) over which this growth story plays out as a small loss-making start-up business breaks-even, begins to gain scale, exponentially ramps up its profits, the market re-rates its Price Earnings (PE) upwards and eventually it becomes a blue chip and its growth matures.

Note, though, that this does not happen to every small cap stock. In fact, it only happens to a rare few.

Thus, I put the caveat about “good quality” small caps into this cycle. By focussing first and foremost on the quality of the underlying business before anything else, I believe that you are increasing your odds that you will find (and invest into) a small cap that will go through this powerful cycle.

Refer to this short excerpt about investing in small caps with a quality-bias: We Have a Quality Bias. Then I strongly urge you to also reading through this article and then, finally, this one.

Spread across those three articles (and their links), you should get a good idea what I mean when I talk about “quality”.

Getting back to the small cap cycle and investing, the sweet spot is when the business has de-risked itself (start-up, sustainability, profitability risks are all largely resolved) and the exponential upswing in its profits has not yet happened (this rise in profits is often, but not always, due to Returns to Scale kicking in). The stock is probably cheap and does not feature on most investor’s radars, thus, you can buy a good quality business that growing quickly at a very low PE…

This, ultimately, is the “Holy Grail” of small cap investing and, even if you only find one or two of these your entire life, you will generate fantastic investment returns if you hold them through the full cycle (or at least its exponential part).

The latter part of this statement is quite key too: patience.

Worth thinking about.

 

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