Why investors should not ignore the small cap space

Small and micro cap companies used to command a premium over large caps, but are now out of favour and trading at a discount. There are opportunities to be found in small cap stocks for investors who do their research.

The year 2023 witnessed substantial global stockmarket gains, yet European small and micro cap stocks found themselves excluded from the celebration.

The question arises: why expend effort identifying winners among thousands of small cap stocks when investing in a handful of globally renowned giants seems to offer superior returns? The rise of the ‘FAANG’ American tech stocks, followed by ‘GAFAMs’, and now the ‘Magnificent Seven’, has shifted the spotlight away from smaller, less familiar, and often illiquid shares. So are we witnessing the end of stockpicking, prompting a universal shift to a ‘Magnificent Seven’ portfolio?

Despite this apparent trend, we continue to acknowledge the enduring significance of the ‘small cap effect’, initially articulated by American economists Eugene Fama and Kenneth French in the early 1990s.

This effect underscores that small companies tend to grow faster, face fewer bureaucratic constraints, and are often acquisition targets for larger entities seeking growth. Consequently, the ‘small cap effect’ translates into significantly higher long-term returns for funds investing in this stockmarket sector.

Trading at a discount

However, the current disdain for small and micro caps is unprecedented. These entities, which traditionally commanded a premium over large caps, are now trading at a discount in terms of all major valuation measures, compared to their larger peers.

Concerns about smaller companies being more exposed to rising interest rates and economic downturns contribute to this shift, albeit only partly justified, as many European small companies are less leveraged than their US counterparts. Additionally, apprehensions about profitability and susceptibility to economic downturns may be exaggerated, with our analysis suggesting a modest 10 per cent drop in profits for our universe of 1500 small/micro companies in Europe in 2023, potentially followed by a 15 per cent growth in 2024.

Apprehensions about profitability and susceptibility to economic downturns may be exaggerated

Despite these concerns, the outlook for European small caps has led to significant capital outflows from the sector, with all the money that entered European small cap funds since 2012 exiting by the end of 2023. This trend has exerted selling pressure, reducing many stocks to bargain levels. Our portfolio currently trades at historically low valuations, with numerous companies selling between five and 10 times the current year’s earnings, an occurrence seldom witnessed. Importantly, these are not weak or ailing companies; their balance sheets are robust, and business trends are generally favourable.

Interestingly, some companies are opting to go private, frustrated by undervalued stock prices. Companies like a Swiss entity speaking out against their own valuation and deciding to go private underline the extremity of this undervaluation. While this trend may not be a healthy long-term development, the abundant pool of more than 5000 quoted small cap stocks in Europe ensures opportunities persist.

Brimming with bargains

In our conviction that the universe is brimming with bargains, the frequently posed question is about the catalyst for a performance shift. Potential catalysts include new subscriptions into small cap funds, ambitious share buyback plans, increased private equity activity, or an escalating trend of companies delisting. The combination of several of these factors could be the key.

However, it's crucial to recall that during the Global Financial Crisis, when both small and large caps faced downturns, some funds exhibited rises of as much as 60 per cent over nine months from March to December 2009, despite little fundamental change.

Currently, small/micro valuations appear disconnected from reality, exemplified by the surge in public-to-private transactions. Regardless of short-term fluctuations, holding a portfolio of sound businesses with solid balance sheets acquired at discounted prices seems poised to tip the risk/reward ratio in favour of investors over time.

But in order to succeed in this sector, steadfast commitment to a value-oriented philosophy remains a huge plus. Relying on rigorous primary research, crucial for smaller companies with limited broker coverage, it is important to be consistently invested in good companies at great prices.

In order to succeed in this sector, steadfast commitment to a value-oriented philosophy remains a huge plus

Furthermore, constructive engagement involves fostering close ties with company leadership. Fund managers’ ownership stakes in companies have surged to 5-10 per cent, amplifying the increasing influence of investment managers. Termed ‘encouraging best practice’, this friendly engagement with management serves as an additional driver for value creation.

In our sustained engagement with French industrial conglomerate Groupe Gorgé, we advocated for strategic overhaul, resulting in transformation into Exail Technologies. Specialising in submarine drone technology for underwater mine neutralisation, with integrated inertial navigation systems, the company is now poised for lucrative contracts across Australia and Europe, with navies that will be charged with cleaning the Black Sea of drifting mines. Boasting high margins and a robust order book, the company is positioned for sustained growth.

Similarly, our strategic guidance influenced Swiss precision toolmakers Starrag and Tornos to explore synergies through a merger. Recognising the potential for enhanced global service coverage, the merger materialised in December, forming the StarragTornos Group.

With diverse product ranges, clientele spanning aerospace, medtech, and watchmaking, and geographical expansion, the consolidated entity promises substantial growth and margin synergies. We contend that the new StarragTornos Group is a more compelling prospect than its individual components.

Philip Best, chairman and founding partner, Quaero Capital