U.S. equity capital is highly concentrated among large capitalization firms. As shown in the charts below, over 70% of all public companies have a market capitalization below $500 million, yet those companies comprise less than 3% of the total capitalization of the U.S. equity markets.
Investment dollars are similarly concentrated among large institutional investors. In order to maintain prudently diversified portfolios, large institutional investors allocate their capital to the largest and most liquid public companies.
In seeking to profit from the flow of capital from large institutional investors to large capitalization companies, Wall Street firms generally assign analyst coverage to the public companies with the greatest trading liquidity, which correlates strongly with size. The result is a lack of research coverage for the smallest and most illiquid public companies.
This lack of institutional investor interest and equity research coverage depresses the stock market valuations of small capitalization public companies. Discovery Group identifies those small capitalization public companies which have inherent economic value greatly exceeding their current public market trading valuations. Careful trading practices allow the accumulation of sizable and attractively priced investment positions. Concentration of the fund's capital among companies that are likely to recapture the unrecognized shareholder value offers a long-term return opportunity consistent with private equity.