Investors following the ‘momo’ may be missing out on a growing opportunity

As published in the Financial Post on August 25, 2024.

British pop band Dead or Alive had a massive hit in the mid-80s with their song “You Spin Me Round (Like a Record)” on their “Youthquake” album. It’s a catchy little number. Over on the other side of the pond, in the investment world, something else is catching on—renewed investor interest in small cap stocks. They, too, have been spinning round, right round, in a long-awaited comeback in sentiment and capital inflows.

After being flat year-to-date, the Russell 2000 Index was up more than 12% to end of July. The Russell 2000 Index tracks approximately 2000 of the smallest public companies in the U.S. market. In Canada, we have the S&P/TSX SmallCap Index which includes 246 companies. Like all indices, including the S&P 500, these contain a grab bag of constituents of varying quality and profitability (or lack thereof). Studies show only a small percentage of companies generate the majority of returns over the long run. For example, in Canada from January 1990 to December 2022, only 21 companies generated over 64% of net wealth.

Because of the wide dispersion in the quality and profitability of smaller public companies this sector presents a less efficient opportunity set than the large cap sector. Hence, investors who passively follow the “momo”—the current positive momentum—must understand they are also buying a significant portion of companies with no earnings which potentially increases volatility and capital risk. 

Apparent tailwinds abound for experienced stock pickers, however. Now with rate cuts in Canada and the spectre of a September cut in the U.S., smaller companies—often viewed as cyclical and riskier—are starting to come out of their multi-year slumber. In comparison to large and mega caps, smaller stocks remain squarely in bargain territory with the TSX Small Cap Index trading at approximately 10-times forward price-to-earnings compared to the S&P/TSX 60 at close to 14-times. A mean reversion would give them a nice pop. Further, the change in the interest rate regime will bring welcome relief to the balance sheets of smaller companies which rely more on floating-rate or shorter-term loans and have been disproportionately oppressed by the fast-rising interest rates and reduced capital inflows of the past several years. For example, 30% of debt in Russell 2000 companies is floating rate compared to only 6% for companies in the S&P/500.

The attractive valuations of these companies are just too good to pass up. They are pulling the focus of private equity and venture capital firms which have a record setting US$2.62 trillion of cash reserves which could be deployed on a giant spending spree. At just past the halfway mark of the year, there have already been several high-profile acquisitions including Copperleaf Technologies, Nuvei, Héroux Devtek, and Sleep Country Canada, among others.

Current prices have a built-in margin-of-safety which should appeal to value investors. At the most recent Berkshire Hathaway annual meeting, Warren Buffett, (whose right-hand-man and likely successor Greg Abel just happens to be Canadian), told attendees:  
“We do not feel uncomfortable in any way, shape, or form, putting our money into Canada. We don’t have any mental blocks about that country. And of course, there’s a lot of countries we don’t understand at all.”

We agree with Buffett and Abel. We have no mental blocks either when it comes to Canadian companies as we continue to see an attractive set up for them. Even with the recent positive moves, valuations are still very attractive on a relative and absolute basis. Rather than thinking of small caps as a shorter-term tactical investment, smaller, high-quality companies make excellent long-term additions to a portfolio, providing the investor can accept short-term volatility.  Given how fast small cap markets can move, it’s important to have an allocation to the asset class to fully experience the long-term returns of small caps.

One silver lining of the past couple of tough years is it has allowed investors to position their portfolios into higher quality businesses trading at reasonable prices. While Berkshire, due to liquidity constraints, must restrict its shopping in Canada to very large enterprises, domestic investors can take a nimbler approach which means taking meaningful positions in a hand-picked selection of high-quality smaller companies.