In Stocks, The Big Money Is In “The Long Tail”

Ever heard of “the long tail”? It’s an idea from statistics in which companies make their money by selling a small quantity of a very large number of goods.

Ever heard of “the long tail”?

It’s an idea from statistics which was made popular in the 2000s in a book by Chris Anderson, the editor of Wired. He was using it to describe the future of e-commerce, in which companies made their money by selling a small quantity of a very large number of goods. It’s an interesting idea, and it applies to lots of things.

It’s difficult to describe the statistical idea in words, so I’ll just use the picture below. What you’re looking at is a distribution of numbers ranked from biggest to smallest (the numbers are on the X-axis, and they’re ranked with the smallest on the left obviously).

The long tail is used to describe the way the small numbers on the right side, when added up, make up a big part of the overall distribution.

The numbers could represent anything, from product sales on Amazon to the size of cities, to the frequency with which words are used, to basketball teams’ followers on Twitter. Long tailed distributions pop up all over the place.

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All well and good. But where’s the investing angle?

Well it turns out that if you rank companies by their market cap (in other words, by how big and valuable they are), they follow this exact same distribution. See the chart below.

The chart is rough and ready, but here’s what you’re looking at: it’s a rank of companies on the UK stock market from largest to smallest, with the largest (BP) on the left side of the X-axis. The Y-axis shows the market cap of each company as a percentage of the entire stock market’s market cap. If you can make them out, the numbers on the X-axis show the companies’ market cap in millions.

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A couple of huge companies in the FTSE 250 totally dominate the overall market. And then you have thousands of small companies in the long tail. I’ve drawn the £500m market cap mark onto the chart – that’s where I’m saying the long tail starts.

This chart shows three things. First, it shows just how many small companies are out there. In the UK, we’ve got nearly two thousand to choose from. Second, it puts company size into its proper perspective. A market cap of £500m might sound like a lot of money, and a big company. But in the scheme of things, a £500m market cap is still tiny. It could grow ten times in size and still not join the big boys at the “head” of the distribution.

The third thing it does is hint at exactly why small company stocks tend to outperform.

I’m sure you’ve heard before now that investments in small companies tend to outperform investments in big ones. But just to refresh you memory – here’re some numbers. $1 invested in big companies in 1955 would have made an investor $3919 by now. If invested in small caps, it would have made $29,400. And if he invested in the smallest small caps, he’d have made $48,090. That’s an outperformance of 1,227% over big companies.

I could start to talk about what that chart has to do with the 1,227% number… But it’s a big topic, and I’ve kept you long enough. I’ll thrash it out tomorrow.

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