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When bigger is better in your investment portfolio

This Canadian advisory cautions investors not to count too much on a big breakthrough with a small stock, especially in markets like these.

When a small stock starts to move, it moves fast. The profits can be spectacular. There may not be a better investment than a small company that is bursting through into the ranks of the big ones.

The question is: how often does it happen? An advisory that has been tracing Canadian stocks for decades puts it this way:

“The trouble is that we have an all-too-human tendancy to overestimate the chance that this will happen.”

The Investment Reporter elaborates with the most well-worn phrase in the small-cap lexicon. “Scores of clichés about ‘ground-floor opportunities’‚ and ‘better mousetraps’‚ lure us into this over-estimation.”

We’re not sure why building a better mousetrap has become the catch phrase for small business success. The people in Waterloo, Ontario who have achieved breakthroughs were working on hand-held devices and the like, not pest control. But the point is clear.

Don’t count on it.

The number of things that can go wrong in the mousetrap business is daunting.

Marketing the mousetrap

“You also need to perfect the mousetrap design, market it to consumers who may be blind to its advantages, produce it at an acceptable cost and defend it against lower-cost competitors,” explains this advisory.

Even then, large-scale success may be elusive. Many people with top business skills will go directly to large companies. Those who stick with smaller businesses may “finance their companies without selling shares to the public, or only sell share to the public when the business needs the money to survive, or when investors are willing to pay an inordinately high price.”

When you further consider the nature of the marketplace today, that situation looks even shakier. With capital markets floating on a sea of bad credit (which has no discernable bottom as yet), and with interest rates getting dragged down by the central banks, this is not exactly the prime time for raising money.

And don’t underestimate the advantages of being there first. Companies that are already entrenched in an industry can get a lot of mileage out of their past successes.

Going broke in five years

Big-time breakthroughs happen for small stocks, but they are not easy or frequent. Most new businesses go broke within five years, the advisory informs us. “The better mousetrap simply passes into the hands of their creditors.”

People will keep on buying the established company long after they should have switched, adds the advisory. Or they’ll try that company’s “improved mousetrap” before they take a chance with a brand new company’s product.

“So entrenched companies can get awfully sloppy, yet still survive,” says the advisory. When recession comes, that company must tighten its belt to restore profitability, but it will likely keep going.

The younger company that didn’t sell enough of its great new products is liable to go under. The “sloppy” old company can then come in and buy up its assets at bargain prices — and, presto! it has a great new product.

Going down with a great idea

The previous scenario won’t happen every time, of course, but it happens often enough to make astute investors wary. A prime example is the high-tech business. It is filled with success stories, from Silicon Valley to Waterloo. But consider the number of companies that went down clutching a great idea, only to see it end up in the hands of a more successful company that did a better job of bringing it to market.

Was that successful company more technologically advanced, or did it just have a better marketing department?

For every Research in Motion (TSX-RIM) or Open Text (TSX-OTC) that survived and thrived, there are dozens that rode a similar wave of innovation and optimism until they crashed and burned. Unless you can judge precisely why RIM and OTC made it while many others didn’t, it may be wiser to avoid gambling on a fresh-faced start-up.

The best way to profit

When the economy has passed through a recession, established companies profit first (in some cases, with the assets they’ve picked up from smaller firms that didn’t make it through the crisis). Small companies that are still on their feet have to struggle to get their share of the market while bigger companies are off and running.

But you can never be too careful. Some established companies that have gotten sloppy might not be able to clean up their acts. “You need to watch for signs that old, entrenched companies are slipping,” says the advisory. “You also need to diversify, because nobody can predict the future with certainty.”

But it pays to put the bulk of your portfolio “in established, profitable companies that are entrenched in their industries and have survived the past few recessions.”

That’s the best way to profit from long-term growth in the economy — and from the fact that many of your fellow investors overestimate the chances that a small company with a great idea can actually translate it into big profits over time.

Finally, there is one more trap to look out for: stock promoters. There are many small stocks that are effectively fronts for stock promotion, that is, “companies whose insiders are more interested in boosting the stock price than in building the business.”

In short, when you are looking at small companies, be cautious, be skeptical, and be thorough in your research. By no means should you avoid small-cap stocks entirely: a well-chosen small cap can do wonders for your portfolio. But don’t hang all your hopes on it, warns The Investment Reporter.

You’re better off getting as close as you can to the sure thing, especially in times like these. There’s enough uncertainty out there as it is. Even if a big company isn’t interested in building a better mousetrap, it can probably still sell a whole lot more of them.