The upside of pessimism and why investors should give small caps a look

As seen in Financial Post on Aug 31, 2023

“Buy not on optimism, but on arithmetic.”

So said Benjamin Graham, father of value investing and author of The Intelligent Investor, a perennial bestseller. 

Since 2018, there hasn’t been a lot of optimism in the small-cap space. And, consequently, not a lot of buying, which has compressed multiples to levels not breached since March 2009, when the price-to-earnings ratio (P/E) for the S&P 600 was hovering around 15, close to where it is today. Compare this to the large-cap tech universe represented by the top contributors to the S&P 500 in 2023, which has had a nearly 50-per-cent multiple expansion, year to date. 

The gap between the have and have-nots here is striking on both an absolute and relative basis. And that is why I am, not a doe-eyed optimist and certainly not a pessimist, but a realist. History has shown that times like these, similar to 2000 during the dotcom bust and 2009 at the nadir of the global financial crisis, offer an upside to pessimism, providing an investor understands the value of what they are buying. 

The upside of pessimism 

Right now, there is a lot of pessimism reflected in small-cap stock valuations. But once you understand some of these individual businesses and their management teams, it can be much easier to convert extreme pessimism into strong conviction. 

Our priority when we initially meet with a company is not to deploy capital right away, but to get to know the business. This is essential in all investments, but critical in small-cap investing, especially among early-stage businesses on the runway to profitability. We do some screening and use some third-party and sell-side research, but nothing replaces a boots-on-the-ground approach to information collection to provide an investment edge. 

This way, we can respond quickly when a market opportunity presents itself. Our favourite hunting ground is among those sectors struggling under the weight of undue pessimism. And there is probably no sector more underestimated today than small Canadian technology companies, making this an ideal time to build positions in high-quality companies at attractive prices. 

Making money fast and slow 

Historically, the small-cap premium implies that small-cap stocks outperform large-cap stocks over the long term. The outperformance isn’t linear, but particularly notable in periods following excessive pessimism towards small caps. 

For example, the last time the valuation gap between large and small caps was this wide was in the technology, media and telecom run-up in the early 2000s. Following that period from 2000 to 2005, the S&P 600 outperformed the S&P 500 by an average of 12 per cent per year. 

Part of the reason for the outperformance is the share prices of smaller companies were significantly discounted compared to their large-cap peers and that valuation discount closed in those subsequent years. 

Making money in small caps can come about in several ways. Multiple rerates occur when a company that was trading at a depressed valuation becomes profitable and is now perceived as a growth darling or when the collective investor mood becomes more risk-on and there is mean reversion back up to historical levels. 

Also, as larger funds seek to deploy risk capital again, they gravitate to the most liquid names and then move into the less liquid ones. Because small-cap stocks tend to be less liquid, rising demand can generate very rapid price appreciation. 

And then there are M&As. We are in a target-rich environment for buyers right now, but there is a paucity of sellers. A company that previously traded at 30 times revenue two years ago may now be at five times revenue. Eventually, management, board members and shareholders will come to grips with this new reality and be more amenable to being acquired. 

An investor needs to understand if money can be made fast or slow when evaluating a potential investment in a small-cap stock. In other words, whether it is a “close-the-discount” opportunity because the market has severely underpriced the company, and a valuation re-rate can quickly create capital gains, or a long-term compounder that will become more valuable over time. 

If the company is at an earlier growth stage, how long is the growth runway? It may generate $20 million today, but can it get to $200 million or $2 billion, or will it peter out at $30 million? Those different scenarios are worth different amounts of money today. 

This approach can be compared with private-equity investing where the investor must have a very high level of conviction because of the lack of liquidity. In non-public companies, selling may not be possible for long periods or, even, forever. Fortunately, public markets offer greater liquidity should an exit be required. 

Canadian icon Margaret Atwood once said: “Optimism means better than reality. Pessimism means worse than reality. I’m a realist.” Translate that into “investment-speak” and we agree with her realist view: Companies that continue to create value will be recognized by the market and reward shareholders.