Passive investors have been allowed to define active investing for active investors.  I want to even out the discussion from an active investor’s perspective.

How Passive are Passive Investments?

Let’s first call into question whether passive investing is really passive investing.  We’ll start with the American S&P 500 index.

Unbeknownst to many investors, the S&P500 index is picked by committee.  This sounds somewhat active, but I am willing to let it slide for now.  The index includes “the most widely-held” companies on the US exchanges.  Seeing as active management controls the majority of funds on the market, the S&P 500 holds the stocks active investors prefer.

The same is true with Canadian indexes.  Take the S&P/TSX 60, an index that frequently appears in passive investors’ portfolios.  The index holds the 60 largest stocks by market capitalization.  The largest stocks by market cap are, by necessity, stocks owned by most active investors.

Thus, passive indexes are propelled by active managers.  The difference between active and passive funds is the cost – holdings are virtually the same by nature of how the indexes work.

Taking Research too Far

I have no problem with any claim that the average actively-managed mutual fund will lose to passive portfolios.  The market indexes and all active managers essentially hold the same stocks.  Active managers charge higher fees for largely the same exposure – naturally active managers underperform.  This isn’t rocket science.  If investments are the same, the lowest fee fund wins.

Related: How Index Funds Compare To Equity Mutual Funds

Passive investors have taken this debate too far, however, to conclude that no one can beat the market averages over a long period of time.  Something must be said of “academic” research into the matter…if “academic” researchers were to find a way to beat the market, they probably wouldn’t be academics any more.  But I digress…

Here’s the thing: there is a very fundamental difference between mutual fund managers and individual investors.  There are liquidity requirements, diversification controls, and a slurry of rules and business realities that push institutions to favor a portfolio that looks much like a broad market index.

But most importantly, individuals do not manage large portfolios.

You Don’t Have $1 Billion

Passive investors like to say that since well-trained portfolio managers from Ivy League schools cannot beat the market, the individual investor absolutely cannot.

But there are really two different stock markets.

There’s the market professionals participate in – firms with market caps of $1 billion or more.  Then there’s the market that professionals do not touch – firms with tiny market caps of less than $1 billion.

Right now, 50 analysts watch Apple’s every move.  50 people – there is very little wiggle room for an independent thinker to do better.  Apple is just one company, though, and there are 3,100 other companies with absolutely zero analyst coverage.  Nearly one out of every three listed companies opens new stores, builds new factories, or reports earnings without a single professional listening to the news coming from the company.

As for who is doing the buying and selling in these small companies, it’s almost entirely individual investors and occasional rebalancing action from an index fund.  Brainless indexes making rules-based transactions, and individual investors with no real training in securities analysis, are not a market that lends itself to efficiency.

Some Examples

This post would be nothing without proof of the opportunity available in small companies – companies too small to attract professional asset managers.  In the past few years I’ve found several high-quality companies hiding in the micro-cap segment of the market.  I just had to look.

One was a health care company by the name of Metropolitan Health Networks.  It consistently increased profits, cut expenses, and traded at a very, very low multiple to its forward earnings.  It wasn’t until the company, worth $200 million in the first half of 2011, purchased another company that it attracted the attention of Wall Street analysts and mutual fund investors.

Sharks are hard to find until there’s blood in the water, but they come quickly when blood appears.  From October 2011 to June 2012, top mutual fund shareholders (almost entirely new funds that never had an interest in the company) increased their stake by 300%, and the stock rallied by 109%.  Nothing of material importance changed in that time – the company simply landed on the radar of more qualified investors.

Related: When To Fire Your Investment Manager

I should note that MDF’s acquisition was of another company in my portfolio at the time, CNU.  It was valued at roughly $300 million, and MDF paid a 30% cash premium plus shares for the firm before the combined entity rallied considerably.  I was essentially paid twice on the transaction – once in the buyout, and once more when the combined firm attracted institutional investors.  It just goes to show how much inefficiency can be found in smaller firms.

These aren’t risky, speculative pharmaceutical stocks, mind you.  They provide basic medical services to patients with a particular insurance company.  But because of their size, and size only, Wall Street had yet to go looking for them.

Another company is an excellent case for market irrationality.  For several quarters over the course of two years it sold for less than net working capital.  You need zero financial experience to know that purchasing a profitable company for $1 million when it has $2 million in the bank is a very good deal.  A golf company, Adams Golf would later sell out to Adidas for a 127% return in 17 months.  Those that got in even earlier saw 2 year returns of 200%.

The buyer? A giant in the space – Adidas!

The Key Detail

All of these companies were worth less than $250 million at the time of my investment.  They’re “too small” for institutional investors – professionals.  Few portfolio managers could justify watching a $250 million company when they have billions of dollars to manage.  Thus, information is “priced-in” by people who have limited academic or experience-driven expertise.

For ordinary people like you and me – people who do not have billions of dollars to move around – these market caps are more than adequate. And it is in this inefficient market of smaller companies that individuals have the greatest edge on professionals because there are no professionals to beat.

Related: 5 Common Mistakes Investors Make

In short, the biggest companies are usually very rationally priced.  There is a very efficient market for shares in Apple or Exxon Mobil.  Assuming all of the market is rationally priced, however, is to completely ignore that more than one-third of all listed securities are not even on the radar for institutional investors.  That detail alone should discount entirely the belief that the markets are always efficient, and that out-performance can come only from greater risk.

(For those who have any interest in examining smaller companies, I’ve put together a basic FAQ for active investing in smaller companies.)

This article was written by JT who blogs about finance at MoneyMamba.

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