The Small-Cap Advantage

Bares runs a small-capitalisation and microcapitalisation investment firm and wrote this to explain why the segment offers returns that larger managers cannot access and how a firm should be structured to pursue them.

The structural argument concerns capacity and coverage. Small companies are followed by few or no analysts, so information is genuinely less processed than in large-cap securities. Institutional investors cannot take meaningful positions without moving prices or breaching ownership limits, which excludes most of the capital that competes elsewhere. Index funds hold small caps in proportions that do not reflect quality, since index construction is mechanical. These conditions mean that fundamental research produces more information advantage per hour spent than the same effort in a well-covered large company.

The constraints are the other half of the argument, and Bares is explicit about them. Capacity is limited, so a firm pursuing this strategy must close to new money at a size far below what the industry considers viable. Liquidity means positions take time to build and to exit. Volatility is higher and drawdowns are deeper, so the client base must be able to tolerate them. Business risk is therefore high: the strategy that works cannot support a large asset management business.

The practical content covers research process, including direct contact with management at companies too small for institutional attention, the concentration required to make research effort worthwhile, and the argument for holding a small number of positions.

The book is written by a practitioner about his own approach and the evidence is his experience rather than systematic data. The academic literature on the small-cap premium is contested, and the premium has been weak in many periods since the effect was documented. The structural argument about analyst coverage and institutional capacity constraints remains valid.