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Small Caps: The Easy Game for Active Managers?

What is true in small caps as well, patience is usually a virtue, especially for investors looking to win the hard game

Christopher Davis 01.09.2017

Imagine you've entered a poker tournament and have the choice to sit at one of two tables. Seated at table one are enthusiastic newbies you surmise as being likely to show their hands, bluff badly, or make otherwise unwise bets. At the second table are players you recognize as contestants from the World Series of Poker. You might relish the challenge of taking on the latter, but playing the amateurs instead of the pros would maximize your chances of winning. The table of amateurs offers what the insightful strategist, author, and professor Michael Mauboussin calls "the easy game." Easy games are those whose players aren't very skilled, and the payoff from winning is high.

Games like these have become scarce in investing, Mauboussin argues, because less-informed investors have moved to passive investments, leaving the most skilled investors to compete against each other. Technology, both because it promotes transparency and can be used to efficiently sniff out market anomalies, has also helped make investing a harder game to win.

If there are still easy--or at least easier--games in the public markets, we might expect to find them in the small-cap arena. It's not that small-cap investors are any less skilled than their large-cap counterparts. Their playing field is bigger and less crowded than in large caps. Small caps account for a tiny slice of the stock market's total value, but there are 3 times as many small-cap stocks as large caps, according to data from O'Shaughnessy Asset Management. The largest stocks are more liquid and therefore attract more assets from institutions. Such neglect should leave more under-exploited opportunities in small caps than in the large caps.

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About Author

Christopher Davis  Christopher Davis is a senior fund analyst with Morningstar and editor of Morningstar's Fidelity Fund Family Report, a monthly newsletter that offers independent, no-holds-barred guidance on the pros and cons of this dominant fund family. He welcomes e-mail but cannot give investment advice. Click here for a free issue of the Fidelity Fund Family Report.

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