James Gowen, CFA, CIO, Small Cap Equity
March 3, 2023
The investing world seems to bounce from fixation to fixation, and the obsession du-jour is whether we see a “hard”, “soft” or now a “no” landing for our economy. Add to this the micro examination of everything said, tweeted or even rumored as to what the Federal Reserve “might” do with interest rates, and you seemingly have a recipe for short-term volatility, frayed nerves and excessive and unproductive activity.
After a difficult 2022 for nearly every investor in most asset classes, we ask ourselves, then what are the indicators that small caps might be one of the more productive areas for investment? In our experience, small cap stocks have inherent attractiveness from several perspectives. There are more of them and the market is less efficient with fewer analysts covering each company, thus the opportunity for an advantage gained by fundamental research rises. There is a greater treasure hunt possibility, meaning there is a higher percentage of stocks in the Russell Index, for example, that rise over 20% each year than in the S&P 500 Index. Generally, these small cap stocks have higher ownership by the management teams that run them, aligning them more with shareholders than at comparable large cap companies. They also tend to be more domestically oriented and more concentrated in their business lines, allowing investors to put their investment focus and results where intended. Growthier small caps tend to be underrepresented in the industrials and financials sectors, which can be more cyclical and interest rate sensitive.
While small cap stocks can be volatile, we believe this is part of the territory, and as longer-term investors, think this is an opportunity to leverage through additions and trims resulting from outsized stock moves up or down.
We believe another indicator of the relative attractiveness of small caps is the actions of the management teams, i.e., are they buying stock in the open market or are the company boards authorizing share buybacks (where such a use of capital makes sense relative to the balance sheet, liquidity and valuation). We are also heartened by the activities of “smart money” investors like private equity and strategic buyers who have recently been quite active in the small cap arena, highlighting the relative undervaluation of smaller public companies. In fact, Jefferies noted their relative valuation model of small caps against large caps showed the largest discount since 2000. We saw this firsthand in our small cap growth strategy as five of our holdings have been acquired since the second half of 2022. For example, the inefficiency of public small cap growth stocks gets highlighted when one reads before the opening bell of an overnight bid by private equity at a premium of 124% to the previous day’s close!
Today, we see other actionable inefficiencies throughout the US small cap market, from how an index inclusion or exclusion drives ownership, and therefore valuation, to the dynamics these factors drive, as to how many investors are doing the fundamental work needed to understand a particular equity investment. Our conversations and visits with management teams have served to highlight the strengths and resiliencies of their business models and especially their growth opportunities, importantly largely independent of the macro uncertainties mentioned earlier. It is always fun and interesting work as we uncover opportunities in the market, such as analyzing companies that have come public through a SPAC and are now combined with operating businesses that enable us to understand, evaluate and value these on a forward basis. Other areas ripe for excitement in innovation and opportunity and valuation remain healthcare and technology, always fruitful sectors to find new holdings. Though our small cap strategies do not generally buy companies contemplating expected takeouts, the healthcare and tech sectors have seen the most merger and acquisition activity over the last five years. Overall, we believe there’s a great opportunity in small caps today and look forward to seeing how this year plays out.
The views expressed are those of Spouting Rock Asset Management (“SRAM”) platform, as of March 1, 2023, and are not intended as investment advice or recommendation. For informational purposes only. Investments are subject to market risk, including the loss of principal. Past performance does not guarantee future results. There can be no assurance that any SRAM strategy or investment will achieve its objectives or avoid substantial losses. There can be no assurances that any of the trends described will continue or will not reverse. Past events and trends do not imply, predict, or guarantee, and are not necessarily indicative of future events or results. Investors cannot invest directly in an index.