Sidestep the Dangers of Big Stocks

 | May 03, 2012 | 1:30 PM EDT
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More than 90% of the investing population has a built-in advantage with respect to the stock market. I would guess that out of that 90%, three-quarters fail to exploit that advantage. The vast majority of investors are not constrained by size; the capital they work with allows them to invest in whatever size company they choose. Despite this ability, many investors find themselves focusing on the biggest, most widely held stocks.

There's an inherent disadvantage in buying the biggest, most highly valued companies: So many investors and analysts are watching these companies that you will rarely be able to purchase shares at a discount to intrinsic value. I realize that after reading the last sentence, many are going to scoff at my assertion and point directly at Apple (AAPL), the biggest and most valuable company in the world, and the returns it continues to generate. Guess what? Apple shares ain't cheap. They aren't at nosebleed valuations either, but anyone who buys Apple today is buying purely on the hope that it will continue to generate extraordinary earnings growth.

The party will end someday for Apple -- and when that day comes, so many financial advisors, mutual funds, pension funds, IRAs and other individual accounts will be holding Apple shares that you don't want to be waiting at the end of the line to cash in your chips.

You certainly don't have to buy the smallest companies to find the best opportunities, either. Keeping an eye on the sub-$5 billion market caps offers the best of both worlds: well-established businesses that may not completely be on the radar of Mr. Market. Many of the larger multibillion-dollar companies were once single-billion-dollar companies, and the single-billion-dollar companies were once multimillion-dollar companies.

The stock market has performed nicely this year, so the availability of attractively priced securities is not what it once was. But you find fertile spots when looking at smaller issues like restaurant chain Cracker Barrel (CBRL), which has a market cap of $1.3 billion. The company's largest shareholder, Biglari Holdings (BH), is a highly experienced and successful value-oriented holding company that believes CBRL is worth twice its current valuation.

Industrial equipment company Terex (TEX) has a market cap of $2.5 billion and continues to rebuild for the future. The company has divested slower growing businesses, gained more exposure to markets outside the U.S. and it is run by a great management team. In coming years, profits are expected to swell at Terex; analysts predict earnings of $2.86 per share in 2013. Shares currently trade around $24.

Auto parts supplier Motorcar Parts of America (MPAA) gets little attention from the investing public due to its $97 million market cap. The company recently completed the largest acquisition in its history, of Fenwick Automotive, but delays in reconciling accounting between the two businesses led to a selloff that leaves shares trading around $7.70. Last week, the company had no problems raising $15 million in equity capital at $7.75 a share. Earnings estimates see $0.62 in 2012 and $1.33 per share in 2013. Shares trade for 88% of book value.

None of us would wager our own money playing against Tiger Woods in golf or Roger Federer in tennis; it's a guaranteed losing bet. When you look at the biggest businesses, you are making a similar bet -- that you somehow have an edge over dozens of analysts who spend all day studying the business. Unless you are Warren Buffett or CalPERS and invest billions at a time, use size to your advantage.

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