With markets in turmoil, now is the time to unearth small-cap stocks with attractive valuations, writes Don Walker
Mega-cap stocks in the US have become a safe haven for investors around the world. Despite a global economic slowdown, until recently, money has continued to pour into the large-cap, index-tracking ETFs, pushing the indexes to all-time highs. However, as the trade continued and valuations became bloated, risk was becoming underappreciated. Then came coronavirus and the fastest 10%-plus correction in history.
As we know, volatility creates opportunities. Although we don’t yet know for certain what the long-term impact of COVID-19 on the markets at large will be, the shakeout certainly has the potential to create opportunities. As stock pickers, this is exactly what we are looking to do: roll up our sleeves and find those great opportunities.
One area of the market that has our attention in this regard is small caps, especially in Canada. They have largely been out of favour for the past five years, basically already assuming a recession. More than 70% of the stocks listed on the TSX Venture Exchange having a market cap of less than $300 million, and most investors have avoided the space in favour of larger-cap stocks and passive products.
Contributing to the low following in small-cap stocks is the lack of analyst coverage from sell-side research firms. With low trading volumes, many firms have decided to discontinue coverage of small-cap stocks in Canada. Because of this, anyone looking to invest in a small-cap stock must dig deeper to uncover opportunities.
A disciplined, active stock-picking approach can unearth great businesses trading at attractive valuations. But this requires investors to do a rigorous, bottom-up analysis on their own. The reward is the potential for compelling returns gleaned from combining both longer-term growth and multiple expansion.
The greatest challenge with small-cap investing is getting to know the companies you’re looking to invest in. Identifying the companies that will succeed, and ultimately realizing the return potential that small caps offer, often means meeting management and performing a long-term due diligence process.
The ideal outcome is to identify a company that can evolve from being an overlooked small-cap name to a more widely followed company. There are no guarantees in investing, but there are common threads among these ‘ideal outcome’ companies.
Over years of investing in small-cap companies, we have found a few key predictive attributes that have led to better outcomes – attributes which, over time, have shaped our investment approach.
The first of these is high insider ownership. When managers have placed a meaningful portion of their own net worth in their company, they tend to run the company more like an owner than a caretaker. We often find them to be more disciplined about capital allocation, as opposed to spending cash just to grow. They tend to be better stewards of shareholder capital and more closely aligned with shareholders’ interests.
Second, we look for deliberate conservatism, which is often a byproduct of high insider ownership, born out of the desire not to put the company at risk. These companies can be criticized at times for being too conservative, but under-leveraged balance sheets allow them to perform better through economic cycles. They often have a net cash position, which allows them to deploy capital counter-cyclically. With a well-maintained balance sheet, they can look to invest or acquire at the bottom of the cycle, when things are much cheaper.
Third, does the company have a long runway of repeatable growth embedded in its strategy? While this is important for any asset class, it is particularly impactful for a small cap. As the company grows from micro- to small- to mid-cap, the liquidity generally picks up and the multiples expand as larger pools of capital recognize the company’s merits. Multiple expansion can prove more powerful in contributing to shareholder returns than actual earnings growth.
Overlooked and unloved, Canadian small caps have waited patiently on the sidelines for investors to take notice again. Buying opportunities existed long before the COVID-19 outbreak, in large part because investors have been able to find growth at the top of the markets. But if the selloff at the end of February has shown us anything, it’s that for all their strength, US mega-caps are not impervious to risk, and index-tracking ETFs might not be the easy ride to growth they once were. Maybe it can also serve as a reminder that, despite all the recent trends to the contrary, good things do still come in small packages.
Don Walker is a portfolio manager at PenderFund. He joined the firm in November 2019, having spent the previous nine years managing small- and micro-cap equity strategies for an investment firm in Calgary.
