Contrary to belief, small-cap investing doesn't have to be excessively volatile. By focusing on quality and portfolio construction, a portfolio of ~80 small-cap names can achieve a historical volatility of 10-13%, less than half that of the Russell 2000 index (25-30%), while remaining fully invested.
Related Insights
Contrary to the growth narrative, the MSCI China index returned just 3.4% over the last decade with over 24% volatility. During the same period, the emerging market ex-China index delivered a higher return of 4.8% with significantly lower volatility (17.5%), highlighting structural headwinds in China for investors.
WCM realized their portfolio became too correlated because their research pipeline itself was the root cause, with analysts naturally chasing what was working. To fix this, they built custom company categorization tools to force diversification at the idea generation stage, ensuring a broader set of opportunities is always available.
Historically, small-cap companies grew earnings faster than large-caps, earning a valuation premium. Since the pandemic, this has flipped. Large-caps have seen astronomical earnings growth while small-caps have lagged, creating a rare valuation discount and a potential mean reversion opportunity for investors.
Contrary to the belief that a moat always leads to large-cap status, small-cap moats often protect a profitable niche. The moat provides time and protection for management to operate, but the "castle" itself may have a limited growth runway, focusing on returns within a specific market.
Allocate more capital to businesses with a highly predictable future (a narrow "cone of uncertainty"), like Costco. Less predictable, high-upside bets should be smaller positions, as their future has a wider range of possible outcomes. Conviction and certainty should drive allocation size.
The speaker divides his portfolio into two distinct categories: stable, long-term "Quality Businesses" and high-growth "Micro-cap Inflection Point" businesses. Each bucket has its own specific criteria, allowing for a balanced approach between reliable compounding and high-upside opportunities.
The S&P 600 small-cap index has massively outperformed the more popular Russell 2000. The key difference is the S&P 600's requirement for profitability, which screens out speculative, pre-revenue "junk" companies that drag down the Russell 2000's returns, especially during speculative bubbles.
Sir John Templeton's success in 1960s Japan reveals a key pattern: the biggest opportunities lie where volatility and a lack of information deter mainstream investors. These factors create significant mispricings for those willing to do the necessary but difficult research, such as in today's micro-cap markets.
A 50% portfolio loss requires a 100% gain just to break even. The wealthy use low-volatility strategies to protect against massive downturns. By experiencing smaller losses (e.g., -10% vs. -40%), their portfolios recover faster and compound more effectively over the long term.
While biotech seems exceptionally volatile, data shows its average 60% annual peak-to-trough drawdown isn't dramatically worse than the ~50% for typical non-biopharma small caps. The perceived risk is disproportionate to the actual incremental volatility required for potentially asymmetric returns.
