Micro-Caps : Amidst the Carnage, is now the time to be brave and back Small Caps?
“…When times are tough active stockpickers can peer through the wreckage and take advantage of the opportunities that present themselves, often in plain sight…”
Countless articles have been written about the current volatility in the markets. But what does it mean for the small cap investor? In a word: opportunity.
So far 2022 has been terrible for the tech growth stocks that soared through 2020 and 2021, their rise sparked by the shift to stay-at-home technologies facilitated by the pandemic, and supported by highly favourable market conditions underwritten by the commitment of central banks to quantitative easing and exceptionally low interest rates.
This year, tightening monetary policy, soaring inflation, straitened global supply chains, and the shadow of renewed war in Europe have forced a severe market correction. The most expensive quintile of stocks is down 30pc in the US and 20pc in Europe. The tech-heavy Nasdaq index has lost a third of its value. Netflix has fallen by 70pc, and Amazon and Tesla by 40pc. High-flying growth funds like the Ark Innovation ETF and Scottish Mortgage Investment Trust are down by 60pc and 40pc respectively. Scottish Mortgage manager Tom Slater believes the past few months have been the worst start to a year for growth stocks since the Great Depression.
Many good tech stocks will come good again: as MoneyWeek editor Merryn Somerset-Web puts it, ‘investors have not turned against growth so much as the price of growth.’ But in the mean time their prominence in global markets has dragged all indices down: the MSCI World Index has fallen 13pc this year. And bonds have been no refuge. The iShares 20+ Treasury bond ETF and the S&P 500 are both down 18pc.
For many private investors the best advice remains the age-old adage: ‘do nothing’. Throughout their history markets have been continually disrupted by bear markets, recessions, speculative bubbles, record debt levels, collapses in consumer confidence, interest rates hikes, foreign currency runs, and wars. But the long term trend is inexorably up. The market actually rises about 75pc of the time, and recoveries from down periods tend to be swift and aggressive.
“…AIM stocks can become ‘lobster pots’ – easy to get into but hard to get out of, not, at least, at the price a seller might be looking for…”
But for traders and more active investors the present turbulence offers upside. When times are tough active stockpickers can peer through the wreckage and take advantage of the opportunities that present themselves, often in plain sight. Most obviously they might rebalance their portfolio towards the energy and commodities securities that have surged during the supply crunch. Energy is up 38pc, and the consumer staples and the ‘old economy’ stocks of the Dow Jones Industrial Average are more or less flat.
The small company effect
A less noted strategy, however, of more direct interest to TMS readers, would be to take advantage of the well documented ‘small company effect’: the capacity of the best small caps to sustain growth even in times of economic stagnation. Clearly, all businesses, large and small, tend to do better when times are good. But because of their dominant market shares the growth of larger companies is more closely correlated with economic trends. Good small companies, however, can continue to grow by taking market share during downturns. Their value is more closely correlated to the quality of their operations: they need only increase their market share at the margins to secure decent growth. They have greater opportunity to innovate, and more quickly adjust to changing market conditions. The best demonstrate the qualities of ‘anti-fragility’ defined in Nassim Nicholas Taleb’s influential book, growing stronger when exposed to volatility. And – crucially – they tend to be overlooked by analysts, with share prices that can be grossly inaccurate relative to their earnings potential.
In his book The Future is Small fund manager Gervais Williams highlights the small company effect through a striking set of statistics. He notes that £1 invested in 1955 in (what is now called) the MSCI All-Equity Index, would – with income reinvested from dividend payments – have grown to £1,070 by the end of 2013, an annual gain of just over 12pc. Small caps have done better: over the same period £1 invested in the Numis Smaller Companies Index (NSCI), which benchmarks the smallest 10pc of companies quoted on the LSE by value, would have returned £4,907, an annual 15.5pc. But – remarkably – the same £1 invested in the ultra-small world of the MSCI World Micro Cap Index would have appreciated to £21,585. The smaller the company, the better the long term performance, and by some way.
Williams zooms in on a still narrower set of stocks. The returns generated by the most actively traded 25pc of securities on US markets from 1971 and 2012 was considerably lower than that of the least traded quartile. The differential between the performance of the most liquid stocks and the least liquid stocks – which tended to be micro-caps – was more than 14pc on average each year. Quite simply, the bias against investing in these tiny illiquid stocks means that many strong performers are overlooked, leaving rich pickings for those prepared to do so.
For Williams the best micro-caps fit the classic definition of the ideal value share. They have low price/earnings (P/E) and high price-to-book (P/Bk) ratios. They are free of debt. They have the capacity to grow organically. And because they are so small they are overlooked by fund managers and most private investors. He notes that while £1 invested in stocks at the bigger end of the NSCI from 1955 to 2013 would have returned £2,600, smaller stocks with value characteristics would have returned more than £61,000, an average growth of 15pc a year.
Shiny growth stocks attract momentum investors but they need to keep beating demanding market expectations to sustain premium ratings. When they begin to disappoint they fall back to earth, reverting to the mean. Value stocks, defined by low expectations, only need to do a little better than expected to outperform. When growth investments stutter value businesses can begin to draw ahead, even with modest growth. As Williams puts it, using a colourful nautical metaphor: ‘In comparison to the ocean-going vessels of the large corporation, smaller companies can be likened to small boats – some are fishing craft, others are lifeboats or racing yachts. When conditions are challenging, most will struggle to some degree. Larger companies are assumed to carry lesser risk, given the advantage of their major brands and sizeable market positions; they may suffer a reduction in sales, but the genuinely small could find certain niches completely blown away … In the shallow seas of a low-growth world, there are bound to be some smaller vessels that are perfectly placed to clean up, whereas the larger drafts of most of the bigger businesses constrict their opportunity.’
The historic outperformance of value
Williams’s thoughts on the capacity of smaller value stocks to stay the course through tough market conditions have echoes in a new book by veteran value investor Jim Cullen, founder of New York-based Schafer Cullen Capital Management. In The Case for Long-Term Value Investing Cullen marshalls a battery of statistics to show that securities chosen according to three classic value disciplines – P/E, P/Bk and dividend yield – have outperformed the all-share S&P 500 index over period from 1968 to 2020. Against an annual average rise in the market index of 10.3pc, the bottom 20pc by P/E rose by 14.6pc, the bottom 20pc by P/Bk by 13.9pc, and the top 20pc by dividend yield by 12.4pc. During the period value has comfortably outpaced growth: the bottom 20pc of S&P 500 stocks on a P/E basis has beaten the top 20pc on a P/E basis by 15.43pc to 9.43pc.
Value’s robust long-term performance is obscured by the market’s short-term oscillations. A well thought out value strategy will only begin to show its relative worth when assessed over a period of at least five years: the average outperformance over five year periods was 7.15pc. The logic is simple. Because company earnings tend to double approximately every ten years value stocks tend to make up for flat performance in a given period with a strong performance over the next one. For value investors this cycle is a feature not a bug. And the outperformance is manifested most strongly in small caps. Since 1968 the smallest 20pc of stocks by market cap in the S&P 500 have outperformed the market, returning a compound annualised return of 14.6pc against 10.1pc for the wider index.
So, where can good micro-caps be found? For the investor prepared to their research AIM can be a rich hunting ground. TMS readers will be well aware of the need to tread cautiously. A frequently cited London Business School study published on AIM’s 20th anniversary in 2015 found that of the nearly 3,000 companies that have listed on the market some three-quarters have never produced a return for investors. Shareholders lose 95pc or more of their initial investment in a third of AIM companies. And less than 40 companies in the 20 years since the index’s launch in 1995 – just 1.4pc of the historic total – have secured multiyear returns in excess of 1,000pc.
“…Shareholders lose 95pc or more of their initial investment in a third of AIM companies…”
The same conditions that make AIM attractive for entrants generate its relatively high failure rate. The market’s relatively light regulations give cash-light new starts the opportunity to list, and room to grow. But that means many unable to withstand long-term market scrutiny will slip through the net, some rapidly going down in flames, others burning out agonisingly slowly. AIM attracts speculative tech and natural resources companies whose prospects do not bear close scrutiny. And there have long been concerns about the stringency with which the market’s stocks are audited, and the ambiguous role of nominated advisers, who are appointed by the companies themselves. Though AIM companies must report regularly on material changes to their circumstances the relative lack of analyst and media scrutiny they receive can make it difficult for private investors to know who or what they can trust. Then there is the issue of liquidity. AIM shares can be tricky to offload: substantial holdings in the market’s smaller stocks do not always find ready buyers. To borrow the stark imagery of one fund manager, AIM stocks can become ‘lobster pots’ – easy to get into but hard to get out of, not, at least, at the price a seller might be looking for.
But AIM has fostered many lasting businesses that have grown organically, realising huge gains for early backers, including Harry Potter publisher Bloomsbury, and fashion portals ASOS and Boohoo, both of which have pushed beyond £4bn valuations. A £1,000 in ASOS when it first listed on AIM 20 years ago would now be valued at more than £160,000, an annualised return of 45pc. For Willliams AIM ‘has acted as a kind of Noah’s Ark for the genuinely small corporate fauna’, nurturing a broad ecology of small stocks that sets it apart from other markets. ‘Logically,’ he argues, ‘AIM should have withered and died. Countless similar markets set up to provide capital to smaller quoted companies have done so, or been subsumed into larger entities and lost their identity. Where are the Nouveau Marché, Neuer Markt or EASDAQ now? We are exceptionally fortunate that the long history of support for the smallest quoted stocks in the UK has resulted in AIM surviving when most others have foundered.’ Though located in the UK the index features many smaller international companies who see the advantages of raising their profile in London. And it offers investors certain pragmatic benefits: AIM investments are exempt from inheritance tax relief and stamp duty, and can be included in stocks and shares ISAs.
There is real evidence, then, that micro-caps can lend portfolios an edge that can help them cut through difficult market conditions. Due caution must, of course, be exercised, especially during downturns. Our series on trading the markets published last year covered core risk management principles. As we noted, without a plan decisions will be made on the hoof in response to events. Profits may be taken too soon, or more likely, wither on the vine. An exit strategy ensures trades are closed, successful or otherwise, on the investor’s own terms, rather than in response to rapidly changing conditions. And investments should be allocated across different sectors and assets to ensure portfolios are sufficiently robust to withstand losses within a particular sector or asset class.
It’s also worth re-iterating that the substantial empirical evidence indicating the potential of micro-caps to outperform applies to long-term holdings: short-term patterns cannot be predicted with any confidence. And in recent years, of course, the resolve of value investors has been solely tested. The performance of the Russell 3000 Value index over the past decade, the broadest measure of value stocks in the US, has tried the patience of even true believers, returning 80pc against more than 150pc for the S&P 500 index, and more than 240pc for growth stocks.
But the tide now seems to have turned. Stocks that have been overlooked for quite some time are coming good. And many of them are the small trades that mainstream fund managers and passive funds pass over. Those prepared to make the most of current market conditions might be well advised to check them out.