Editor’s Note: This year, Wide Moat Research launched Wide Moat Confidential, our research service dedicated to small-capitalization companies with explosive growth potential. Today, we’ll ask Brad for his thesis on small-caps and what readers can expect from this new service going forward.
Van Bryan (VB): Brad, earlier this month, you launched Wide Moat Confidential, your research service for small-caps. Why small-caps and why now?
Brad Thomas (BT): This is an initiative I’ve wanted to get off the ground for a long time. Most subscribers know I’m a big proponent of reliable, dividend-paying stocks. But I’d argue that a collection of quality small-capitalization companies has a place in any diversified portfolio. That’s for a few reasons.
First, small-capitalization stocks – those with market caps under $2 billion or so – have superior growth prospects compared to their larger peers. After all, they’re in the earlier stages of their business life cycle. All else equal, it’s much easier for a $1 billion company to increase revenue or earnings meaningfully than it is for a $1 trillion company. As a result, the stocks can move very quickly.
One of the things I point out in our special reports is that in order for Apple (AAPL), to return 100% from here it would have to add the GDP of Great Britain to its market capitalization. And on a long enough timeline, maybe Apple can do it. But it’s days of rapid growth are behind it.
Compare that to a company with a market capitalization under $2 billion. It wouldn’t take much for that stock to move sharply higher. Of course, that can be a double-edged sword. Small-caps, by their nature, will be more volatile. Every reader needs to understand that before going forward. You have to buy that ticket and take that ride.
But the prospect for rapid growth is a big reason to be interested in small-caps. And one of the reason I’m interested right now is because smaller companies have generally underperformed.
VB: How do you mean?
BT: We can look at something like the Russell 2000 as a barometer for small-cap companies. Both the Russell and the S&P 500 were down in 2022, about 17% and 21%, respectively. But the S&P turned a corner in late 2023 and hovers around all-time highs. By comparison, the Russell only just recently returned to its former high, set in late 2021.
This isn’t entirely irrational. The bear market of 2022 was caused by the really rapid increase in interest rates. That made things more difficult for all companies. But it was the small-caps, which often have to finance future growth, were hit especially hard. And as a result, small-cap stocks have underperformed their larger peers recently.
But fortunately, that trend appears to be reversing. It’s still an open question of when rates will fall and by how much, but it does appear they will come down over time. That’s good news for small-caps. And I also think the new administration could provide a boost to this part of the market.
VB: What policies from the Trump administration are you looking at?
BT: Over the last few years, mergers and acquisitions (M&A) has really slowed. The Boston Consulting Group puts out an M&A report every year, and the numbers are interesting. During the first three quarters of 2021, there was more than $3.3 billion in deals. But that figure was just under $2.2 billion during the same period of 2022 and $1.4 billion for 2023.
Part of this has to do with interest rates, of course. But another difficulty for M&A has been the regulatory climate under the Biden Administration. I detailed specific examples in a special report, but Biden’s Federal Trade Commission Chair, Lina Khan, has proven very effective at stopping or stalling deals.
[Paid up subscribers to The Wide Moat Letter can access that special report right here.]
This combination of higher rates and a combative regulatory regime has led many companies to conclude that pursuing deals simply wasn’t worth the headache. But I think that changes under a Trump administration.
As we talked about last time, Trump promised to bring a more business-friendly, growth-oriented mindset to his administration. And I think that’s one of the reasons the Russell was up sharply during November.
By the way, my daughter actually covers M&A for The Wall Street Journal, and she contributed to an article that details more of that.
Renewed M&A would be a potential catalyst for small caps, as they’d be the most likely targets. But I want to be clear that I always analyze and recommend a small cap based on its own merits. Holding a stock that’s bought out for a large premium would be nice, but it’s not an investment thesis. We have to find small companies whose businesses we’d want to own for years.
VB: How would your research on small caps differ from your research on large caps.
BT: There are a lot of difficulties with researching small caps. For many large companies, we often have decades of financial performance to draw on, whether that’s earnings, dividends, and anything else. The large companies also tend to be well covered by analysts. Nvidia alone has dozens covering it.
But that’s not the case with small companies. Very often, they only have a few years of financial performance to draw on. And at most, there might be a handful of analysts on the stock.
And so, to understand these businesses, you really need to do a deeper dive. You need to almost get to the granular level to understand the value of these businesses, their avenues for growth, and whether the stock is properly valued or not.
For our very first recommendation, which I won’t name here out of fairness to our members, I flew down to view the company’s assets for myself. I even interviewed the CEO and CFO to really understand this business. You have to take that extra step. That’s what I’ve done, and will continue to do, for members.
But all of this can work to our advantage. Because there’s less attention on these names, that means there is the potential for some really severe mispricing where the stock is way undervalued, and the growth prospects are misunderstood.
Just as one example, our latest recommendation was trading at an approximate 40% discount relative to what I’d consider a fair value. That sort of dramatic mispricing rarely happens with larger names, but it’s more common with small-caps.
But I’ll also tell you how my small-cap research will be similar to my large-cap coverage. We’re only interested in owning “wide moat” businesses, that would be companies with a durable competitive advantage. And we want to own these names with such a wide margin of safety that it allows us to sleep well at night while holding them.
VB: What do you look for in a great small-cap investment?
BT: Every portfolio company has to have a few qualities.
Those would be a quality business model, which we just discussed, skilled management and capital allocation, and a mispricing on behalf of the market. And every recommendation made with Wide Moat Confidential must have the potential for 40% upside over the next 12 months. That’s at a minimum.
Our very first recommendation had all these qualities. It had a first mover advantage – it was the first company in its industry to do what it’s doing. And this differentiated business model meant the company was building a wide moat around its business.
It also has very attractive cost of capital, which makes it difficult for its peers to compete. Its management knows the industry inside and out. And as I shared in our writeup, the market appears to be completely discounting several growth avenues for the business over the next few years.
These are the types of qualities we need to see from a small cap before we ever recommend it. It can be a lot of work, but that’s the only way to find these diamonds in the rough. And that’s going to be the goal as we move into 2025.
VB: Thanks for your time, Brad.
BT: Anytime.
Editor’s Note: Wide Moat Confidential is now accepting new members. And if readers are curious to learn more about Brad’s new initiative, we’d invite you to go right here.
Tomorrow is New Year’s Eve. On behalf of Brad and the entire team, we wish all subscribers a happy and prosperous new year. Wide Moat Daily will return to our usual coverage on Thursday, January 2.