Why do investors routinely avoid small cap stocks when they are the easiest to analyze?

Question

Investors seem to routinely avoid penny stocks and small cap stocks, concentrating their investment in index funds and "blue chips". They seem to think that small stocks are risky. Penny stock investors are sometimes called "penny stock gamblers". I don't understand this attitude. Before making any investment decision, any competent investor would conduct an extensive analysis. Small companies are among the easiest companies to analyze. It is far easier to analyze a business consisting of one factory than a mega cap multinational diversified industrial conglomerate. Given the relative ease of analysis, why do investors flock to large and complex companies while avoiding the small and simple ones? Am I missing something important?

Answer 1

It is far easier to analyze a business consisting of one factory than a mega cap multinational diversified industrial conglomerate.

Is it?

If the business consists only of one factory, you have to analyze many things:

• What if the factory will not be competitive in today's marketplace? A blue chip company having 100 factories will most likely have some that will be shut down and some that will stand the test of time.
• What if the product the factory produces suddenly changes its market price? A blue chip company having 100 products will see many differences all the time, some increasing profits, some decreasing profits. A 1-factory company could go bankrupt due to slight changes in market price of the product.
• What if the product the factory produces will go out of fashion? A blue chip company having 100 products will see many such events all the time, but all the time 99 of its other products won't go out of fashion so the factory producting the out-of-fashion product can be closed to be replaced by a newer factory producting something else.
• What if exchange rates change unfavorably? A blue chip company has production in different areas using different currencies. Thus, exchange rate fluctuations rarely are a reason for a blue chip company to go bankrupt.
• What if refinancing debt cannot be obtained, and the dividends the company usually pays are not enough to pay back the loan? Soon the investors lose their dividends. Some time after that, the company is in possession of its debtors. In contrast to this, a blue chip company may lose 1 of its 30 sources of debt. The remaining 29 won't usually be lost.
• What if the factory is destroyed by a large-scale explosion that destroys so much other buildings that the local insurance company will fail because it cannot pay for all the damages? In contrast, a blue chip company may have access to other insurance companies, bigger global ones, and as a matter of fact a blue chip company may not even need insurance! A blue chip company may be so large that it can act as its own insurance company.

In fact, I would say the easiest company of them all to analyze is Corporate America. You know it has a certain gross domestic product. You know that usually the gross domestic product increases at a rate of 2% per year in real terms, or 2+i% per year nominally where i is the inflation rate. You know certain percentage of the gross domestic product is corporate profits. You know certain percentage of the corporate profits are reinvested to operations and other percentage of the corporate profits are distributed back to shareholders of Corporate America. Thus, obtaining valuation for Corporate America is very easy.

You can invest into Corporate America by investing into S&P 500 index fund.

Investing into Corporate America is always a wise choice, unless the valuation can clearly be said to be excessive.

In contrast, investing to an individual company may or may not be a wise choice.

Answer 2

Your conclusion is also incorrect - index funds may well contain thousands of small caps, matching a selection like Russell 3000 or similar. There are also lots of small cap ETFs that are handpicked by people that do it professionally.

Answer 3

Penny stocks and small cap stocks are not the same thing. "Penny stock" generally refers to a stock with a very low share price (under $1, or sometimes under $5), while "small cap stock" refers to a stock with a low market capitalization (under $1 billion or $2 billion). There are no "official" definitions so the exact numbers can vary depending on who's talking, but it's pretty standard that "penny stock" has to do with the share price while "small cap" has to do with the market capitalization.

There are many small cap stocks which are not penny stocks. The Russell 2000 is considered a small-cap index but many of the companies included have share prices far above $1.

As to why investors avoid them: When it comes to penny stocks, many are not listed on major exchanges, which can make it harder to buy and sell them. That alone is reason enough for many to avoid them. As far as small cap stocks, I would say it's largely not true that investors avoid them. It's true that investors won't get these stocks if they just buy into the S&P 500, but there are plenty of available small-cap index funds that track the Russell 2000 or similar indexes, and plenty of people buy those funds.

Also, note that most people who buy stock in Amazon or Chevron aren't really analyzing those companies either. Insofar as there is a reason people don't buy penny or small-cap stocks, it's most likely the same reason they don't buy any individual stock, which is that it's cheaper, easier, less risky, and likely more effective in general to simply invest in an index fund rather than attempting to analyze individual companies, large or small, at all.