Coiled Tight: Smaller Companies Are Primed for Outperformance

In his keynote speech at the Ben Graham Centre’s 2024 Value Investing Conference in Toronto, Jason Zweig, a veteran columnist for The Wall Street Journal, asked, rhetorically: “What cannot be ETF’d?”

Active investors are competing with Mr. Market, a.k.a. passive exchange traded funds, he stated. To generate meaningful alpha, portfolio managers must develop expertise in what cannot be packaged into an exchange traded fund, Zweig advised.  

The target universe for active managers is what Zweig called “left tail things” like size, liquidity, marketability, and popularity factors. These are the factors inherent in small-cap companies.

The spring is coiled tight in the small-cap space, and we view it as highly favorable for generating alpha.

While small-cap companies are ETF’d, passive investing in this group is a sub-optimal strategy for the creation of alpha over the long term. Portfolio managers must develop expertise in this market segment.

In the United States, small- and micro-cap stocks have lagged large- and mega-cap stocks for nearly a decade, based on price returns from the Russell 2000 and the S&P 500. Over the same period, the small-cap effect remained intact in the UK, Japan, Europe, and the emerging markets.

What accounts for the outlier status of the United States? Institutional allocations have shifted toward private equity and away from public markets. Global private equity AUM is expected to grow to US$8.5 trillion by 2028, and American firms are leading the charge with a CAGR of 11.3%, according to Prequin.

Today, fast-growing smaller companies have financing options they did not have previously. They can stay private much longer, living and growing inside the gated community of private equity. Some of these companies may never join the Russell 2000. If they grow to a sufficient size, they may jump directly to the S&P 500 or be sold to another large private equity fund. 

Spotlight on Canada

In Canada, the small- and micro-cap space has been in a bear market. Active small-cap-focused funds have seen outflows for the past 10 years, M&A activity is tepid, and IPO activity is weak. The total public capital raise for tech in Canada last year was down 88% from 2022 levels and 98% from 2021 levels.

This has created a negative feedback loop in Canada of fleeing capital and underperformance in this sector. During the first quarter of 2024, we saw the first glimmers of change with the S&P TSX Small Cap Index (7.9%) outperforming the S&P TSX Composite Index (6.6%).

Outlook for North America

Market valuations rose in 2023, which should entice some private companies to go public this year or next. Any improvement in IPO and M&A activity would be a positive tailwind for small caps, which are undervalued on both an absolute and relative basis.

We see a target-rich environment in small caps. The lack of research and capital has left the field wide open for astute investors.

Potential catalysts for a re-rating will be improved balance sheets, increased cash flow metrics, and increased M&A and IPO activity. Tailwinds include the inflection point on rising interest rates, quality companies continuing to compound business value and clean up their balance sheets, accelerating M&A activity to take advantage of discounted valuations, and mean reversion to historical valuations and sentiment levels.

The small-cap sector is best approached through an active investment strategy where expertise and a deep understanding of the individual businesses and their risk-and-reward characteristics are necessary for success.

Every investor who strives for outperformance must take on potential risks, however, one of which could be periods of painful unpopularity and underperformance like we have endured in the small-cap sector since 2016. As the Norwegian chess master Magnus Carlsen has said, “Not being willing to take risks is an extremely risky strategy.” 

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All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

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