As published in Conseiller (in French) on 12 August, 2024.
Investment success over the long term is based on the positive synergy of three pillars which form the basis of alpha generation through various market cycles. For professional investors, table stakes are 1) clarity of goals and alignment across the whole company and, 2) having a skilled investment team. But without the ability to identify attractive opportunity sets, the first two attributes alone cannot ensure success. This is especially true in the small-and mid-cap sector where the opportunity set is less obvious. For example, nearly 40% of companies in the Russell 2000 Index have reported negative earnings surprises and they are more levered than larger companies making them more vulnerable to rising rates.
Owning a basket of smaller companies via an index ETF can be tricky. Smaller companies are idiosyncratic. This makes it essential to separate the “ones” from the “zeroes”. A small company that grows into a larger one can generate significant returns for investors who buy in early. Conversely, one that slowly withers on the vine from a lack of liquidity, comes with a high opportunity cost.
The last several years have been punishing for smaller companies— and those who invest in them. The YUCs, “Young Unprofitable Companies”, have been hit especially hard due to capital flight from small-cap-oriented funds and the drying up of capital market activity in response to rising interest rates and recession risk. In the wake of negative investor sentiment and capital flows, smaller companies saw analyst revisions drift lower and valuations compress. Fortunately, the cycle appears to be changing.
How to identify attractive opportunities in small caps:
Is there a discrepancy between value and price? This is the first major opportunity set. During periods of extreme investor pessimism, market values may become unmoored from intrinsic values. Often this is a contrarian set up for strong future gains.
Is it a good quality business? Each business tells a story. Sometimes investors get caught up in the narrative without evaluating the fundamentals. Is it profitable? If not, when is it likely to be? What is the quality of senior management; do they have the skills and experience necessary to compound growth?
Is the sector out-of-favour? Industries experiencing controversy or ones that have recently disappointed investors may also still harbour good or great businesses. This is the classic case of ‘throwing the baby out with the bathwater’.
Is there a potential catalyst? In some cases, sectors in distress may turn around based on a catalyst, such as a regulatory change. The cannabis sector is a good example. The industry had a boom, then a bust, and now with regulatory changes by the U.S. Drug Enforcement Agency (DEA) easing restrictions, cannabis firms will be able to benefit from tax credits and business deductions which will support their profitability.
In Canada, Thinkific Labs is an example of how to identify a good small cap opportunity. This is a provider of cloud-based software solutions that enable entrepreneurs and established businesses to build, market, and sell online courses. Like many smaller companies, Thinkific did an IPO in 2021 to much fanfare and a high valuation. As part of the go-public process they invested heavily in staffing to scale the business and to justify the capital raise. Yet by 2022, the market perceived Thinkific as a money losing enterprise that was going to burn through their balance sheet and go bankrupt. Instead, the company cut costs and focused on achieving profitability by Q4 2023. It achieved profitability a quarter early, and the stock promptly rose 42%. Initially, Thinkific was thrown in with other companies which had a IPO’d at high valuations and subsequently went bankrupt. A thoughtful understanding of their business showed a dedicated management team, a history of profitability, and strong unit economics. Today, Thinkific’s fundamentals continue to improve, and it has the potential to become a “Rule of 40” company where its revenue growth combined with operating margin is 40% or higher.
Investors must ‘look under-the-hood’ to understand and value smaller companies. In small caps, it is often the micro factors—company specific fundamentals that drive returns. In other words, small cap investing is a stock pickers market.
