Strong Safety

The answer to this question is far from obvious. In the past ten years we’ve seen some spectacular failures among large companies: Lehman, Fannie Mae, Enron. And even more companies fell dramatically in price never to recover, like Citigroup and AIG. Small stocks have typically been pegged as a volatile asset class. But when the giants fail, where do you go for safe, blue-chip growth?

The short answer is, there is no such thing as safety. Our selective memories erase the spectacular failures of the ‘90s and ‘80s because—well, they haven’t been in the news for 15 or 20 years, and we just forget. And our minds tend to recall facts that have strong emotional associations. For good or ill, the sound made by a random tree falling in the forest a mile away isn’t as likely to make an impression on us as a limb from the maple out front crashing down on our car in the driveway.

The fact is that small companies have less experienced managers and more volatile business conditions. They tend to be regionally focused so local economies affect them more intensely. Since they slip under the radar screen of many auditors, accounting fraud and malfeasance are more likely. As a result, business failures among small firms are more common. They also grow at a faster rate, however, since expansion is not limited by the size of the economy. It’s much easier for revenue to double from $5 million to $10 million than from $500 billion to $1 trillion.

So small stocks are more volatile. Investors who buy them need to pay close attention to their balance sheets, business plans, and manager integrity. But there are no sure things in investing. It’s all a matter of managing your risk while you look for returns.

Douglas R. Tengdin, CFA
Chief Investment Officer
Hit reply if you have any questions—I read them all!

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