Charles’ Note: Finding white eggs suitable for coloring is a lot harder than you’d expect in Peru. Eggs are cheap and plentiful here, but the shells are almost always brown because the hens here are a different breed. 

Well, it took some looking, but we found the right eggs… and I’ll be coloring them with my four year old daughter this evening. Easter crisis averted. 

What has this got to do with investing?

Well, as my friend and co-founder of The Freeport Society Brian Hunt points out, successful investing is a lot like Easter egg hunting. 

And with the market still reeling from the trade war, bargains are already starting to present themselves. But where does it make sense to look for those prime “Easter eggs”? 

Brian has the answer. As he explains, you’re not going to find that gem of a stock that can return 100 times your money by looking in the same places as everyone else. 

Take it from here, Brian!

What Kind of Easter Egg Hunt Are You In?

By Brian Hunt, Senior Investment Analyst, InvestorPlace

In the spring of 2000, Reed Hastings traveled to Dallas with a big business idea.

He approached the management of movie rental giant Blockbuster with a proposal. He wanted Blockbuster to buy his small business for $50 million.

At the time, Hastings’ company – called Netflix – had a promising business model. It allowed people to rent movies through the mail. Netflix was also small and struggling to turn a profit.

Hastings believed a Blockbuster purchase of Netflix would be a win-win deal for both parties. Blockbuster’s managers did not. They didn’t think Netflix’s business model made sense for them. A Netflix executive later said that Blockbuster essentially laughed Hastings out of the room.

You probably know the rest of the story.

Netflix secured investment from other sources and built a hugely popular mail-order DVD rental business.

Around 2007, it made a brilliant move and began transitioning into America’s No. 1 movie and television streaming service. This innovation crushed traditional brick-and-mortar rental companies like Blockbuster.

In 2002, Netflix had less than 3 million subscribers. By 2022, it had reached 222 million subscribers and climbed to a market valuation of $129 billion. Today, it has 301 million subscribers, with a market valuation of $420 billion.

Blockbuster’s market valuation in 2018?

Zip.

It went bankrupt a long time ago… and its “pass” on Netflix is widely regarded as one of the worst decisions in modern corporate history.

To give you an idea of how an investor would have done with an early Netflix stake, consider that Netflix stock fell to a split-adjusted low of $0.35 per share in 2002.

Assume you did not buy the bottom, but instead invested $5,000 at $0.50 per share, picking up 10,000 shares of Netflix.

In 2022, that $5,000 investment would have been worth $2.87 million… a 574-fold return.

Today, it would be worth $137 billion.

Netflix’s story is one of my favorite examples of one of the most powerful concepts in the world of finance and investing.

The concept?

If you want to make giant returns in stocks, you must be in the right Easter egg hunt.

Below, I explain why…

How to Find Stocks That Can Return 100-Fold

On Wall Street, companies are often grouped and labeled according to their size: large-caps, mid-caps, and small-caps.

“Cap” is short for “market capitalization.” This is the term used to describe the value of a public company. To figure out a company’s market cap, you multiply the total number of shares the company has in the market by the market price of a single share.

The group names are common sense. Large-caps are large. Small-caps are small. Mid-caps are in between.

For example, Microsoft is a large-cap company. Today, its market cap is $2.89 trillion.

Or, take iPhone maker Apple. It’s also a large-cap. Its market cap is around $3.4 trillion, making it the world’s most valuable publicly traded company.

Mid-caps are smaller than large-caps, between $2 billion and $10 billion in size.

The difference between a large-cap and a mid-cap can be huge. A mid-cap company worth $5 billion is less than 0.2% of the size of giant Microsoft.

Finally, we have small-caps.

These are companies with market caps under $2 billion.

While the difference between a mid-cap and a large-cap can be huge, the difference between a small-cap and a large-cap can be incredible.

For example, take a small-cap with a market value of $500 million.

This is just 10% of a mid-cap with a market value of $5 billion… which means it is less than one tenth of one percent the size of a large-cap like Microsoft.

Large-caps can be good investments. They’re typically stable, established, profitable companies. They often pay dividends. They can be great investments for conservative investors.

But if you’re interested in making 10, 20, or even 50 times your money (or hundreds or thousands times your money, like with Netflix) in a single investment, you’d be smart to look at small-cap stocks.

Small-cap companies have much greater potential to produce giant returns for their shareholders in a short time than any other kind of company.

The reason is simple…

It’s much, much easier for a young, $500 million small-cap to grow 10-fold than it is for a mature $500-billion giant to grow 10-fold.

That’s just basic math.

If your daughter sold 10 boxes of Girl Scout Cookies around the neighborhood on her own, you could probably help grow her results 10-times (selling 100 boxes) by driving her around, putting a little pressure on your friends, neighbors, and coworkers to buy some boxes.

But what if your daughter was a natural saleswoman and had sold 100 boxes on her own?

To enjoy 10-times growth under that scenario, she’d have to sell 1,000 boxes. Not so easy anymore. 

That’s the mathematical challenge behind enjoying giant growth when a company is already doing giant sales.

Or, think about these situations…

When a small $300 million market-cap beverage company creates a hit product that generates an additional $1 billion in sales, it’s a huge deal that can make the company’s stock rise by hundreds or thousands of percent.

However, if beverage giant Coca-Cola creates a way to generate an additional $1 billion in sales, it barely registers on its massive income statement.

When a small $200 million restaurant company with 40 locations expands to 200 more locations, its market value can soar. 

But if mega-chain Starbucks adds 200 new locations to its already massive 14,000+ locations, it’s a blip on the company’s balance sheet.

When a small $600 million software company creates an amazing new way to collect, manage, and analyze healthcare, financial, or marketing data, it can increase revenue by over $1 billion… and its stock can soar 10-fold.

However, if giant Microsoft adds $1 billion to its $100 billion annual revenue, it’s a drop in the bucket that won’t even make the news.

Now, all this DOES NOT mean a large company is automatically a bad investment. It just means that it’s not an ideal investment for someone looking to make big returns in a relatively short period of time.

Remember, a $500 million small-cap is just one-tenth of one percent of a $500 billion large-cap.

That’s why a search for stocks with huge growth potential should start in the small-cap stock world.

This is where companies with the potential to grow 10, 20, 50… even 1,000 times larger live and hide out.

But it gets even better for small-cap investors.

There’s another tremendous benefit they enjoy that large-cap investors do not. I believe this is best explained with the story of an Easter egg hunt.

The Story of the Easter Egg Hunt

Picture this…

It’s Easter and you’re ready for the neighborhood Easter egg hunt.

Over 100 eggs have been hidden in a small local park. Each egg has a treat inside it. You’re told that one special egg even has a cash prize in it.

If you’re in this hunt, which of the two following scenarios would you rather be in?

1. In addition to you hunting for eggs in the park, there are
   1,000 other people hunting for eggs. It’s a madhouse.
2. In addition to you hunting for eggs in the park, there are just 10 other people hunting for eggs.

If you’re like most reasonable people, you picked B.

You’d rather have this:

Than this:

What does this have to do with investing?

Well, this same dynamic is at work in the stock market every day.

The financial markets are where millions of people go to pick through opportunities in stocks, commodities, currencies, options, bonds, and real estate.

In this big market, everyone is looking to buy assets for less than what they are worth and looking to sell assets for more than what they are worth.

Essentially, everyone is trying to outsmart everyone else.

Everyone is looking for eggs.

The financial markets price most assets correctly most of the time.

However, it’s not a perfect system. Windows of opportunity – where you can buy assets for less than what they’re worth or sell assets for more than what they’re worth – appear from time to time.

In the investing world, these windows are called “market inefficiencies.”

These are the opportunities that can make us big money.

However, the more people who are studying, monitoring, and picking over a market and its opportunities, the more competition you have in that market… and the less likely you’ll be able to find market inefficiencies.

The more people picking over a market, the smaller its pricing inefficiencies will be and the shorter its windows of opportunities will be open.

In the financial markets, the biggest competitors are “institutional investors.”

Institutional investors are the elephants of the financial markets. This group includes mutual funds, pension funds, large hedge funds, and insurance funds. It also includes sovereign wealth funds, which manage the savings of entire nations.

A single large institutional investor can manage over $10 billion in assets.

So, even a wealthy individual with $5 million in assets is a mouse compared to this elephant (in this case, the elephant is 2,000 times larger).

Some institutional investors manage much more than $10 billion.

The sovereign wealth fund of Norway – which has been fattened by oil revenue for years – was worth more than $1.6 trillion in 2017.

This is 165 times bigger than the large institution with $10 billion to invest.

The large institutional investors of the world have ridiculously giant amounts of money to invest in stocks, bonds, and other assets.

These large institutional investors typically employ armies of analysts who spend hundreds of thousands of hours every year scouring the world for opportunities.

These analysts perform a lot of old fashioned “financial detective” work by visiting public companies and interviewing industry experts.

They also use the world’s most advanced computer algorithms and “Big Data” analytics programs to comb through market data.

The programs run 24 hours a day, seven days a week… sifting all of the world’s financial data a thousand different ways at warp speed… hunting for pricing inefficiencies, small and large.

Picture that Easter egg hunts again… and realize that the stock market is a brutally competitive Easter egg hunt.

That’s the bad news.

The good news is the financial market is a big, diverse place.

And there are Easter egg hunts the big guys can’t participate in.

The Problem of Size

In the investment world, professional investors obsess over “liquidity.”

When it comes to buying and selling investments, liquidity is a measure of how easy or difficult it is to transact in a security.

For example, take Amazon stock. Because Amazon is one of the world’s largest companies (worth about $2 trillion today), and since many people like to buy and sell its stock, we can say Amazon stock is “very liquid” or “has huge liquidity.”

There is a large market for Amazon stock where buyers and sellers execute many sales each day. ABout 56 million shares of Amazon change hands in a day.

On the other side of the spectrum, take an unknown small-cap firm with a market cap of just $50 million (less than one-tenth of one percent of Amazon).

Because this company is tiny by stock market standards, and since most people have never heard of it, the company’s stock will not have much liquidity.

Remember, market cap is simply the number of outstanding shares times the share price. That means with small-cap stocks, there simply aren’t all that many shares out in the market (compared to, say, Amazon, which we just talked about). This makes it harder for someone to buy up a huge amount of those shares – there may not be all that many sellers.

Now here’s where it gets interesting…

Let’s say you manage a $10 billion stock portfolio.

For a stock position to make a meaningful positive impact on your fund’s results, you need it to represent at least 3% of your fund’s assets.

Most good managers would rather put 4% to 8% of their fund into a stock idea they believe is truly great.

If you’re looking to put 3% of $10 billion to work in a great idea, that means you are looking to place $300 million.

That is six times more money than a $50 million small-cap.

Even if you wanted to put just 1% of your fund into a stock, that is $100 million.

You get the idea.

Big money managers can’t join in the small-cap stock Easter egg hunt.

They also can’t “play” in other small markets with limited liquidity, like many options markets, smaller investment funds (like closed end funds and exchange traded funds), individual bonds, small-cap foreign stocks, and penny stocks.

When you “play” in small markets with modest liquidity, you don’t take on the world’s richest, most powerful institutions armed with armies of topflight analysts and the world’s best computers.

Instead of competing against thousands of master Easter egg hunters, you compete against modest amounts of them.

Think of it like you would buy a house. 

You want to be a buyer in an area with just a few other buyers… instead of being a buyer in a town where lines form down the block after homes go on sale. When you’re a buyer, you don’t want loads of competition.

I can’t resist rolling out one more analogy to get you on board…

Think of it like fishing. 

You don’t want to fish in the same spot as 1,000 other anglers. You’d rather have a quiet stream and its fish all to yourself.

Successful investing and trading is all about tilting the odds in your favor.

The more you can get this advantage, the more successful you will be.

Hunting in smaller, less liquid markets – like the small-cap market – is one of the best ways to do that.

Regards,

Brian Hunt
Senior Investment Analyst, InvestorPlace