Study after study on the market indicates that investors in smaller companies often get a return premium over time.
There’s some common-sense explanation behind that superior return. Bigger, more established companies may get all the attention in the market, and investors may have already paid up to own a big, established, blue-chip name. But smaller companies that could become the next great blue-chip firm still remain off-the-radar, and consequently far cheaper than they have any right to be.
But there’s another way smaller investors tend to profit in excess of investors in larger companies. Through a process called industry consolidation, over time the number of companies that are needed to serve an industry will naturally shrink. Unprofitable companies will go by the wayside, and small profitable companies will be bought out at a premium to bigger companies looking to grow quickly.
This process plays out with varying speeds in various industries. Today, there are only three major automakers in the United States, and a few small players. But there used to be hundreds of automotive companies when the industry was starting out and growing at a rapid pace.
The trend is playing out well in the financial space. 35 years ago, there were nearly 14,000 different bank companies. Today, there are around 4,000. In the next 35 years, if this rate of consolidation holds, there will be a few hundred.
Investors looking for smaller banks can find better valuations than some of the larger, more established players. And they can find companies that are looking to grow by acquiring competitors. It’s a win-win situation, if you know what metrics to look for.
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