Small-cap stocks – big problems, or big opportunities?

Which view is an investor to follow?

I’ve sifted through many recent publications to analyze the debate, and to see if I can come up with some useful conclusions and recommendations.

Three observations, in particular, stood out as worth keeping in mind.

1. Small caps benefit from localization

There’s no doubt that small-cap companies are, by definition, more local. Smaller companies generate a higher percentage of their revenue in their home country, whereas larger companies generate a higher percentage of their revenue internationally.

During a recessionary environment that entails a weaker domestic currency, small-cap stocks are likely to face particular challenges. They cannot escape the weak economic environment of their home country, and the weaker currency makes their imported materials more expensive – both creating pressure on the companies’ profit margin.

Large companies, on the other hand, can compensate more easily. A weaker currency in their home market makes their exports to international markets cheaper and more competitive. When they bring foreign profits back to their country, they benefit from the exchange rate.

This should be a strong argument in favor of large caps, but we may still see some small caps perform unusually well over the coming years. There is one extraordinary factor that did not apply during previous downturns, and which will make the coming years an exceptional period in at least some aspects.

Given geopolitical developments in the world, we are going to see a strong trend to bring manufacturing closer to home. Countries such as China are likely to lose business to countries with a (perceived) lower political risk. Smaller, more local companies will be seen as being less exposed to risky regions, and they could pick up additional business.

Countries such as Poland or Mexico could be potential winners of this trend. Poland, for example, is cheap, has a highly educated workforce, and benefits from the millions of additional workers that came to its shores through the wave of Ukrainian refugees. Its stock market is one of the cheapest in the world, and there are countless smaller Polish firms that could benefit from new business coming their way.

Localization should be a huge trend during years to come, and at least some smaller companies could benefit greatly.

Because of factors such as these, one must not lump all small caps together.

2. Lack of liquidity can make for extraordinary opportunities

One of the biggest disadvantages of small caps is their lack of trading liquidity. There is a strong argument that when markets recover, the largest pools of capital will deploy capital into liquid names, first and foremost.

However, this argument also has a flipside.

The lack of liquidity in small-cap stocks works in your favor when taking advantage of the occasional extreme dislocations that happen in these markets.

True, large-cap stocks can get “cheap”. However, you’ll hardly ever find a large-cap stock that is “screamingly cheap”.

A recent, now famous example is that of Thungela (ISIN ZAE000296554, UK:TGA), the South African coal miner that got spun off from Anglo American in 2021. Because of the lack of trading liquidity and forced selling from ESG funds, the stock briefly traded at a price/earnings ratio of 1 -2. Some people recognized the extreme dislocation and used the period of forced selling to load up. 15 months later, they were up 17 (!) times.

You won’t find such outliers among large caps, but you can often enough find them among small-cap stocks.

In that sense, the recent massive sell-off of small-cap stocks will have laid the foundations for someone, somewhere to strike the next big winner. I am entirely convinced that we currently once again have the kind of dislocation in markets that enables you to find such outlier investments.

If you are in the market to one day land one truly big winner, small-cap stocks are probably the only place to go.

3. Open-mindedness and no constraints are as important as ever

Sifting through an entire pile of small-cap related publications, I was reminded of how important it is to stay flexible, open-minded, and unconstrained.

There is not even a generally accepted definition of “small-cap stocks”, and interpretations vary widely. Some people define small caps as stocks with a market cap of less than EUR 500m, or less than 250m. Others have an entirely different definition altogether. Goldman Sachs, for example, considers anything with less than a EUR 5bn (USD 6bn) market cap a *micro* cap.

So much for differing terminology. always strives to keep all options open. Just how important it is not to put yourself under any constraints becomes clear if you look at two of the potentially most interesting sectors right now:

  • Shareholders of energy companies could see years of excess returns, because of the combination of low valuations and persistently high energy prices.
  • Banks, particularly in Europe, could perform surprisingly well over the coming years, too.

However, you are unlikely to find many energy companies and banks among small-cap stocks. In these two sectors, companies tend to be pretty large, by any definition.

Small caps vs big caps.

ESG vs non-ESG.

Equities vs bonds.

The world is not normally black and white, but a lot of grey.

Much is down to individual cases, and these are even down to factors such as different terminology. Two investors or analysts might use the same term, but talk about something entirely different. The large-cap stock that one investor mentioned to you might be a micro-cap stock in someone else’s mind.

In that sense, even just trying to answer whether small caps will fare better or worse than the general market is mostly a waste of time. All you need is to find that ONE big winner to make a lasting difference to your financial situation.

Speaking of which….

Join me – dinner discussion of “small-cap” opportunities

On 22 November 2022, I’ll be hosting an informal discussion on “Small and midcap investment ideas – give me your best!“. Each participant brings one idea to the table, which they have to explain in two to three minutes while enjoying good food in the private dining room of an upmarket Central London pub. Without a doubt, we’ll also be discussing other timely subjects There are still a couple of places left – check here for more details if you are interested.

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