Expert eyes on smaller prizes
It’s a big universe out there — of stocks, that is.
Yet most investors are drawn by the gravitational pull of a handful of very large stars that eclipse many other potentially profitable opportunities.
That’s not to knock the upside of investing in the largest companies trading on the Toronto Stock Exchange and the New York Stock Exchange. They’re big for a reason, and worth holding onto — in measured degrees — because the collective intelligence of investors is probably correct in expecting rising profits for the foreseeable future from firms like Amazon.com, Microsoft, Nvidia and Wal-Mart.
Yet even the largest 500 companies — the S&P 500 Index — in the U.S. represent only a fraction of what’s out there.
Beyond that frontier are many other companies, some of which are very much worth investors’ capital—yet-to-be-realized start investments, if you will.
That is, if you know what you’re looking for, says a leading Canadian investor in what’s referred to as the small-cap (capitalization) universe of the stock market.
“The irony is that large caps make up about one-tenth of the number of publicly traded companies, so the small-cap space is actually a way bigger hunting ground,” says Greg Dean, founder of and lead investor at Langdon Equity Partners, based in Toronto.
Yet few investors hunt for profits there.
Small caps, which are still large companies worth billions of dollars in many cases, are not widely held in Canadian investors’ portfolios.
That’s in part for good reasons. They are risky, volatile and, collectively, have underperformed large-cap indices like the S&P 500 in recent years.
Yet Dean says small-caps historically have outperformed their larger siblings over the longer term. One recent study shows that, on average, small-cap stocks have outperformed large-caps in the U.S. during market recoveries and expansions on an annualized basis from 1984 to 2024.
Track record aside, most investors at best take a highly speculative approach to small-cap stocks, Dean says. “Most people approach them like a ‘tourist’ investor.”
Their interest is piqued as equity markets peak, hoping the momentum of the broader market spills into this more high-risk and presumably higher reward corner of the market. “Investors have a different mental model for small caps.”
They think of words like ‘disruptive,’ ‘upside’ and ‘innovative’ to describe the companies they are looking for, Dean adds.
Yet those terms often apply to new companies with potential, but little in profits — if any at all. To small-cap managers like Langdon Equity Partners, “those words are meaningless.”
Dean adds that investing in small caps should be no different from the approach to large-cap companies where investors gravitate to companies with the best financial data, like growing profitability, low or reasonably managed debt loads and sustainable cash flows.
Those companies exist in the small-cap space too. Yet, because the small-cap market attracts less investor attention, it’s more likely that companies with strong sales growth, growing sustainable cash flows, and rising profitability are more likely to have a share price that undervalues their true worth.
“The reasons for that inefficiency are that most people invest as tourists—so they come and go, and that creates price volatility.” Typically, these investors overpay for small caps in bull markets, and they sell at a loss in bear markets. These buy-high/sell-low rhythms in the small-cap space create opportunities for investors who have done research to recognize good companies trading at discounts to their share price.
That said, many small-cap companies are risky. “There is a good reason for the volatility because there are a lot of early stage companies, with lower (profit) margins and higher leverage,” Dean says.
The Russell 2000 Index, which encompasses 2,000 small-cap U.S. stocks, is considered the benchmark measure for small-caps’ collective state, and it illustrates the collective risk.
Although highly diversified, the collective debt of its 2,000 companies is about four times their market valuation.
“For every dollar of profit, there is $4 of debt,” Dean says. “And it often holds a lot of low-quality businesses we call ‘zombie companies.’”
This is one reason why amid the ongoing debate over the value of active management — or stock selection — that paying a higher fee for experts to find undervalued, mispriced and overlooked companies can make sense.
How else might the average investor discover a company that trades for less than what its assets are worth?
Such companies do exist, like the Westaim Corporation — one of the larger positions in Langdon’s Global Smaller Companies fund. Trading on TSX, it provides financing to corporations, and its share price trades below its value on paper.
“Imagine you had $10,000 in your bank account, no debt and owned 50 per cent of the convenience store down the street, and I told you that ‘I want to buy all your assets for $8,000.’”
Dean says most people would answer: “‘You’re nuts! You’re not even paying me the value of my chequing account.’”
That describes Westaim, a company in business for 30 years with a strong track record that is “hardly a disruptive” enterprise.
Now, you could simply purchase shares in that company, or any of Langdon’s other small-cap top-10 listings (as you could do with any small-cap mutual fund), which are published regularly in accordance with reporting regulations.
Yet Langdon’s analysts track about 300 companies and only invest in a few dozen of them. They also visit these companies hundreds of times annually.
Despite their best efforts, even some of their selections are down 50 per cent — though others are up 100 per cent or more, Dean says.
As with large-cap stocks, a diversified approach to small-caps is likely to provide consistent long-term growth.
Yet despite the potential, too few investors even give small-cap stocks a thought, Dean says. “All too often investors will own three funds whose managers are focused on the biggest stocks — or just 10 per cent of the market — and yet have nobody else looking at the rest of that much larger part of the stock universe.”
Joel Schlesinger is a Winnipeg-based freelance journalist.
joelschles@gmail.com