The case for small-cap equities
People tend to react viscerally when they hear about penny stocks - but how about small caps? Do these stocks warrant the same prejudice given to pink slips? Most have heard about the Magnificent 7, FAANG, and other large-cap household names well, and investing in these stocks in the past decade would have yielded significant returns for any investor. However, there are numerous convincing reasons why you should take a look at investing in smaller companies.
A look back in time
Warren Buffet’s $25m investment in See’s Candies in 1972 is a prime example of success in investing in small caps. At the time, See's Candies was a small cap, overshadowed by booming oil companies and industrial giants. Yet Buffet's triumph with this investment serves as a powerful testament to the potential of small-cap stocks.
It's a well-known fact that Warren Buffet's first million came from ‘cigar-butts ’-obscure companies on the verge of collapse. The allure was that the share value was significantly lower than the assets' intrinsic value, often due to short selling, market pessimism, or a general lack of information. Buffet's approach was to make strategic management decisions, such as cost-cutting and asset liquidation, to restore value, but at Pendulum Capital, our strategy is not as hands-on. We seek out companies with aligned management direction and expertise, rather than those in need of drastic restructuring.
Patterns and trend
IWM - Russell 2000 (Small-Caps) vs. SPY - S&P 500 (Large-Caps)
Source: Yahoo Finance
As seen above, in the 20-year history between the Russell 2000 and S&P 500, the two indexes largely experience similar but not consistent levels of growth. Periods exist where one outperforms the other, but eventually, these lines return to intersect. In the previous 3 years, large caps have outshined small caps considerably, driven by consolidation and disruption from major technological advancements. These rising valuations have been backed up by stellar financial performances from the aforementioned magnificent 7, who have carried the S&P 500’s performance over this time span.
The divergence is growing, but we foresee the Russell-2000 and the underlying small caps will catch up in due time. AI and other technological advancements will benefit secondary and tertiary companies, which will be able to improve productivity and reduce costs. Additionally, the anti-trust threat will always exist when companies grow too massive, although recently, there has not been a notable case besides Apple and Amazon’s acquisition of iRobot. At this point, it becomes a political risk.
If we look at the past, the most extensive market cap stocks tend to have their periods of stardom, but this position has constantly been overthrown by other rising candidates. Citigroup, Exxon, Pfizer, and General Electric are names that we now scratch our heads, thinking how they were ever the most prominent companies, but it is with good reason. Like fashion, it is mystifying why trends develop and fade the way they do, but they do.
On a valuation basis, the relative P/E between large and small caps has been expanding in favor of large caps.
Relative P/E between Russell 1000 (Large-caps) and Russell 2000 (Small-caps)
Source: FactSet
The chart indicates that large caps have been the major beneficiaries over the past 14-15 years. Comparing the TTM mean PE ratios of the S&P 500 and the Russell 2000, the S&P 500 is 12.29 points higher (28.52 over 16.23).
Numerous factors could lead to the turnaround of small caps, but first, it is crucial to note the value that investigating this area can provide.
Small-Caps and their selling points
1) In-depth familiarity
Investigating small-cap stocks can give us a more intimate understanding of the business model of each company and the sector. To fully comprehend Amazon's complex business model is a daunting task; the company’s hundreds of billions in revenue is generated through countless sources. However, a small-cap company such as Corsair Gaming could be broken down and understood relatively quickly. The simplicity and compactness of the business itself offer a clearer view of the various factors influencing the company’s performance. Moreover, the granularity of the information from SEC filings enables us to identify which segments of the business are at risk of being jeopardized. Changes in consumer demand, supply chain, raw materials, and other macroeconomic factors within the value chain are all items that affect the outcome of each line on the income statement. This level of understanding could be used to strengthen the conviction of a certain investment case.
Over the years, the experience and knowledge gained from performing thorough due diligence in various sectors and industries should provide a clearer picture of the macroeconomic skeleton on which the economy operates. Connecting the dots from one industry to another and from one country to another will map out the interdependencies, trade balance, and numerous other relationships that exist between entities on this earth. At that stage, it may open up more doors and opportunities, but still less reliable than ones generated through fundamentals.
2)Oversight, under-coverage and exclusion
Generally, equity research coverage diminishes the smaller the scale and the less attractive a company is. Large-cap companies have numerous analysts covering them due to significant interest from investors in the form of funds, family offices, and high net-worth individuals. But when we go smaller, analysis and information become sparse, and hence, the market will not be able to price these as efficiently. Inefficient markets give players the ability to exploit mis-pricing and more opportunities to make correct contrarian views. It also lessens the required effort needed to make a fundamentally sound judgement.
We can plainly see this from the number of analysts covering a particular stock. The bars in the chart below display the change in coverage activity from a large-cap oil and gas E&P company (Marathon Oil Corp.) to a mid-cap (Callon Petroleum) and then finally a small-cap (SandRidge Energy).
Number of analysts covering the company, from Marathon Oil to Sandridge Energy
Source: WSJ.com
It is to our advantage to perform our own due diligence in these areas where a version has still not been widely published. We can expect that the market has still not used all available information at hand to make a precise valuation, and hence price.
It's crucial to note that while public mega funds may have the advantage of scale in information and execution, they are limited by their minimum investment size. Their responsibility of managing assets in the billions, adhering to portfolio diversification policies, and risk management hinders them from exploring small caps. Furthermore, it makes little sense for these funds to spend their time on investment pitches that they can only allocate a negligible portion of their portfolio. This creates a unique space for individual investors to step in and potentially reap considerable returns.
3) Growth and amplified movements
Dealing with small numbers gives us an advantage; favorable conditions or successful new business expansion that leads to revenue or income growth can significantly boost valuations. Larger companies often struggle to expand their top lines unless they are disruptive in nature, but a small push can propel small caps into the mid-cap market, where coverage begins to grow and the value proposition becomes clearer.
Once the potential is recognized, the newfound interest from financial institutions and inclusion in various ETFs could be a momentous and positive force for the target company.
This is reflected in the volatility of the indexes, as seen below.
Standard deviations of Russell 2000 and S&P 500
Source: Fact sheets from index websites
4) Merger and Acquisitions
One way that companies circumvent challenges in organic growth is through mergers and acquisitions. These activities can immediately add value to both companies beyond simple addition through integration, consolidation, and/or specialization. Typically, targets tend to be smaller companies that could be value-accreting to the purchaser, who are the sector leaders seeking growing companies to maintain their position or perform a new market entry. Private equity firms also participate as sizable contributors in M&A. These funds scout around the small and mid-cap domains to find undervalued companies to take private, representing roughly 30% of all deals. These take-private transactions have been historically priced at a 35% premium on average.
As such, confidence in the economy and healthy M&A valuations benefit this segment the most. Unfortunately, in 2023, the culmination of rising interest rates, political instability, and uncertain economic outlook led to disagreement between buyers and sellers on valuations and, ultimately, a decrease in transactions.
Global M&A deals, by type
Source: Bain & Co
We believe this factor has been priced in and is a contributing factor to the dislike for small-caps.
A pickup in activity to standard levels in the near future would be a positive sign for small caps, which would help them regain their footing and bridge the valuation and return gap with large caps.
Ongoing conditions
As short-term interest rates drop, we should also see some small-caps reap the benefits of quantitative easing. Small-caps tend to be more leveraged and hence pay a higher portion of income to interest costs. Higher interest rates punish the profitability of small-caps at a magnified level.
Leverage metrics , Russell 2000 vs S&P 500 (September 2023)
Source: Lazard Asset Management, FactSet
Lower base rates should also make lending more accessible. ISCR and DSCR covenants would be easier to meet, and access to capital would be cheap, incentivizing financial institutions to lend and refinance debt to a broader audience. Large and mega caps generally do not have issues tapping into the debt market, as seen from US investment grade spreads, now roughly 90bps. They also typically issue fixed-rate bonds, which are more favorable in high-rate conditions such as the one we are in. Conversely, small-caps, often highly leveraged companies, suffer first in adverse economic conditions, a risk discussed below.
Threats
Small-caps lack the financial resilience that could stabilize them in the face of economic turbulence. A drawback to the 'amplified movements' mentioned earlier is that it could swing the other way. A few quarters of underperformance can significantly impact a smaller company, potentially leading to irreversible damage and a negative downward spiral. Unprofitability necessitates the need for additional financing. However, in this process, lenders may perceive the business's deterioration and subsequently impose higher interest rates to account for the increased risk, along with stringent restrictions to safeguard their interests. This precarious situation can leave the company vulnerable in the future.
Risk to small-cap companies is not solely derived from internal factors, but also from the broader economic climate. During periods of economic downturn, small caps are particularly hard-hit. Lenders become reluctant to extend financing, and demand conditions severely impact profitability and growth. Given their typically higher leverage and limited options for raising additional funds, these companies are also more prone to defaulting at a faster rate. As such , the recession and contraction risks could be a factor in the discount we currently see in small caps.
In essence, the distinction between small caps and large caps can be likened to the contrast between investment grade and high-yield bonds. The risk spread represents the blend of risk and reward for taking a “lower-rated” company. In the case of debt, the rating is done by a few rating agencies, specifically tailored to examine the likelihood of default. For equity, the value “rating” on small caps is more intangible in nature and, hence, more idiosyncratic. That gap is where we hope to uncover the obscurity and use pinpoint analysis to determine a potential investment case.
Besides the fundamental aspects of small caps, reiterating the previous point laid out above, we have been years into the stage of the cycle that has preferred large caps. As history has demonstrated, the trends are temporary, and there will eventually be a shift. This cyclical nature of the market presents an opportunity for small-caps to outperform in the near future.
