Why Young Companies and Smaller Market-Cap Stocks Create Asymmetric Upside
- Max Teh
- Mar 2, 2024
- 5 min read
Updated: 3 days ago
Table of Contents:
Disclaimer: This communication is provided for information purposes only and is not intended as a recommendation or a solicitation to buy, sell or hold any investment product. Readers are solely responsible for their own investment decisions.
KEYPOINTS:
🔑 Young, public companies offer exciting growth potential due to innovation and adaptability, but come with higher risk and limited data.
🔑 Consider a balanced portfolio with both young companies with smaller market cap (ideally under 10 years public) and established players for long-term success.
🔑 Deep research is essential regardless of a company's age; focus on sustainable advantages, strong leadership, and future growth potential.
In our journey to building a winning portfolio, let's explore the potential of young, public companies. While established giants have their merits, these newcomers can offer exciting opportunities for growth for your portfolio.
Why you might want to consider young companies with smaller market caps
High-growth potential: Young companies are often disrupting established industries with innovative ideas. This can translate to exponential revenue growth. Think of companies like Duolingo (language learning) or Airbnb (accommodation) that have revolutionized their respective fields in a short time.
Agile and adaptable: Being new often means being nimble and adaptable. These companies can quickly respond to market changes and seize new opportunities, unlike some established players burdened by legacy systems and processes.
3. Higher Probability of Being Acquired - A Bonus Catalyst for Investors:
While young companies (under 10 years) tend to offer outsized growth potential, another characteristic that can be equally attractive is when a company still has a relatively small market capitalization.
Smaller-cap companies ($300mill-$2bill market cap) often represent under-discovered opportunities where institutional ownership is low, competitive positioning is still forming, and valuation multiples have not yet fully priced in future growth. But beyond that, smaller market-cap firms also carry an additional potential upside.
Smaller companies, especially those with strong products, fast-growing user bases, or unique technology, are frequently acquisition targets for larger players looking to accelerate innovation instead of building it internally.
This means investors benefit not only from organic growth but also from the possibility of a takeover premium.A good example is Semrush, which was recently acquired by Adobe at a ~75% premium, instantly rewarding shareholders who accumulated the stock earlier at lower prices.
This “bonus scenario” shouldn’t be the primary reason to invest, but it does elevate the asymmetry of returns - giving you an additional upside path while the downside is still primarily tied to fundamentals.
3a. If the Company is not acquired- it can still become a long-term compounder
The beauty of focusing on young or smaller-cap companies is that they offer multiple pathways to win.
Even if the company is never acquired, as long as its fundamentals remain strong
• the product becomes more mission-critical, and
the business can still grow into a long-term compounding engine in your portfolio.
Some of the world’s greatest multi-baggers were never acquired; they simply compounded for a very long time because their underlying economics were solid.
It can be even more powerful when these young companies are led by Founder-CEOs
Downsides of Young Companies
However, it's important to remember:
Higher risk: New companies are inherently riskier as their business models are still evolving. They might not have a proven track record, and their long-term success is less certain compared to established players.
Limited financial data: Due to their short history, fewer financial data points are available for analysis, making it crucial to rely on qualitative factors like the company's vision, market potential, and team expertise.
Balanced approach is Key 🔑
While new companies can be excellent growth drivers, you should not neglect established players with strong fundamentals and long-term growth potential, like Apple or Microsoft.
Guideline:
Most desirable: < 10 years
Companies listed for under 10 years might offer a higher growth potential in the long-run, examples include: Duolingo (< 3 years), Airbnb (3 years), and Hubspot (<10 years).
Desirable: 10 to 20 years
Companies within 10 to 20 years of being public can still be attractive options, like Tesla (<14 years) and Fortinet (14 years). (notes):
as of today, majority of the holdings in my portfolio is invested in companies in this time range, but I will be open to allocating more weightage to companies under 10 years of timeframe when I find more promising ones in the future.
refer to this article to see CAGR of these popular companies even when investors invested in them 10 years post their IPOs.
Less Desirable: > 30 years
Companies listed for over 30 years can also be valuable additions, but ensure they demonstrate sustainable competitive advantages, strong leadership, and a clear path to future growth, like Microsoft (< 38 years) and Apple (43 years) (notes):
Downsides of Investing in giants with large revenue bases: Even if established players introduce groundbreaking products with high sales,
the impact on their overall top-line growth might be minimal due to their already massive revenue base, for example:
OpenAI's $2 billion revenue is minuscule compared to Microsoft's $227 billion.
Similarly, Apple's "Vision Pro" might not significantly impact their overall product revenue, as seen in this analysis.
On IPO investment
While exciting, I typically avoid buying companies at IPO due to limited financial data and often lofty valuations.
How to check the no. of years a company has been publicly listed for?
As Google may not reveal the full Stock Chart of Companies from the day they are publicly listed.
Case in point, Coca- Cola was listed in 1919 [1] but the stock chart on Google only showed data up to 1984.
You can find this information on stockanalysis.com
Look under Profile > IPO Date.
Conclusion
Remember, thorough research is crucial before investing in any company, regardless of its age. Look for companies with sustainable competitive advantages, strong leadership, and a clear path to future growth, irrespective of their time in the public market.
By incorporating both young and established companies, with a focus on the preferable timeframe, you can create a well-diversified portfolio with the potential for consistent growth and long-term success.
Footnotes
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