Small-Cap Fact Patterns Investors Avoid: The First Ever “Cheat Sheet” for CEOs5 minute read

Perhaps more so than any other buy-side constituency, small-cap investors are students of history.  And while they certainly are known to revel in their success stories, they have exceptionally accurate, long-term memories of fact patterns that gave rise to the “L” word.  Yes, investors don’t suffer losses well.

Why should this matter to CEOs?  Well, setting out on a strategic arc that hundreds of investors are negatively predisposed to is… an arduous – likely underperforming – path.

Here’s the problem: investors don’t publish a list of fact patterns they are leery of.  They just silently vote with their feet (and cash), and CEOs are often left wondering – sometimes even to strangers on airplanes – why their public company is virtually ignored.

So, here’s a “cheat sheet” for a CEOs with respect to money-losing precedents seasoned small-cap investors know too well.

Roll-upsData depicts that the overwhelming majority of small-cap roll-up strategies are value-destructive. It’s not even a close call. Though there have surely been some success stories…. most experienced small-cap investors would be hard-pressed to name one. To be sure, lots of inexperienced retail investors view roll-up strategies favorably. But seasoned retail and institutional investors know there is very little precedent for that strategy’s success in the small-cap realm.  Why? This research from the Harvard Business Review depicts that something like 70–90 percent of acquisitions are value destructive. And that includes large companies with hyper-experienced leadership, and sophisticated, purpose-built integration teams. When you consider that small-caps are often run by far less-experienced executives, and might not have any experienced integration professionals, you can get a sense why the failure rate for small-cap acquisitions is probably much closer to 90 percent than 70 percent.

Holding companies.  As fellow SCI editorial board member, Ian Cassel, likes to say about micro-cap investing: “It’s hard.” He’s right.  And you learn as a professional investor in micro- and small-cap stocks, that simple… is always better.  Simple stories, simple cap tables, simple SEC filings, and simple website and investor presentations are all good. Unlike larger companies, smaller companies are susceptible to a daily array of existential threats, so adding complexity of any kind really erodes the probability of success.  That’s one of the reasons why there is scant historical precedent for successful small-cap holding companies.  When you tell a room full of experienced small-cap investors that you have a “small-cap company that operates an array of complimentary subsidiaries,” most investors in that room are thinking the same thing: “When has that ever benefitted shareholders?”

Celebrity boards.  Through lots of trial and error, investors have learned to always be circumspect about nascent companies that have famous, independent board members.  Why? Because – and pardon the frankness – it is likely to be a cover-up for business weaknesses. This is particularly the case when celebrity board members lack any domain expertise in the company’s industry. For example, none of Theranos’ world famous directors were experts in clinical pathology or microfluidics, and equity investors lost 100% of their capital in that debacle.

Large corporate partnersWhen small-cap companies are materially dependent upon a single, large corporate partner for success, the movie tends not to end well for the smaller company (and its shareholders). There are several common reasons why.

  • Large companies are far more risk averse, and move slowly (i.e., the exact opposite of how smaller companies need to behave).
  • Large companies don’t have any incentives to speak publicly about what they’re working on with small partners, but smaller companies are desperate to feed any tidbits they can to information-hungry investors.
  • Negotiating leverage is often so incongruous that even “success” might not be that beneficial to the smaller company’s shareholders.
  • Smaller companies that are vying to join the supply chain of a much larger partner often spend enormous amounts of time and money – that they might not have – to conform to the requirements of larger partners, but larger partners typically retain the ability to terminate supply agreements on a moment’s notice with no financial risks.
  • Some large companies disingenuously string smaller companies along until they get in financial distress, and then purchase the technology they were interested in for cents on the dollar.

Scientist and engineer CEOs.  If it weren’t for scientists and engineers, we would have an innovation-free economy – that much is a certainty.  That said, veteran small-cap investors have learned the hard way that when life science and technology companies become revenue-producing, having a scientist or an engineer at the helm becomes less advantageous for shareholders.  Why?  Perhaps the same things that make scientists and engineers masters of ideation conspire to make them less effective people managers and salespeople?  One well-known investor I was privileged to meet early on in my tenure as an institutional investor told me, “When in doubt, Adam, invest in CEOs that have backgrounds in sales and marketing.”  I’m not sure there’s a lot of “science” behind that… but I can anecdotally vouch for the fact that he was right.

Small-cap investors can’t be risk averse, because risk is everywhere.  But they can mitigate the risk somewhat by betting with well-recognized percentages.  If you ignore those percentages as a CEO, you could well end up being fantastically successful.  But… a good part of that journey is likely to be a lonely trip.