• We’re in an economic cycle where small caps are being sold in favour of large caps
  • But indiscriminate selling can lead to good stocks being oversold
  • Experts chime in on how to find good quality small cap stocks

 

The old Warren Buffett adage of being “fearful when others are greedy, and greedy when others are fearful” has never been truer than in today’s market.

We’re in a cycle where few people want to own small caps, but that’s exactly the time when they get way too oversold.

As we can see, the current gap between the performance of large and small caps has never been wider:

 

Source: Google

 

Frankly speaking, there’s a perfectly good reason why people want to sell small caps right now – non-profitable small companies are probably the worst stocks to be owning when economic uncertainty is widespread.

Another factor weighing down on small caps is that many are surviving from one capital raising to the next, and this is where the wheels have pretty much come off since mid last year, where IPO activities have dried up to a trickle.

There were 87 ASX IPOs in 2022, well down from 191 in 2021, and we’ve only seen seven so far in the first three months of 2023.

We’ve been here before and we know that in this kind of environment, there’s bound to be indiscriminate selling. But this is exactly where long term investors could find quality small caps at opportunistic levels.

Novice investors are being warned not to be tempted to buy too quickly when share prices fall however, because they might be confusing a big decline with a bottom.

 

How to identify quality small caps

One thing that that has prevented people from buying small caps is they don’t know how to identify the right ones.

So here are some basic fundamentals that will help create a well-positioned, defensive and profitable portfolio at the smaller end of town, according to experts.

Follow the momentum

Dean Fergie, portfolio manager at Cyan Investment Management, said he rarely buys stocks that are falling in price.

“Don’t be afraid of buying a stock if it’s cresting a record high. As a rule at Cyan, we do not buy stocks if they’ve fallen to a record low and rarely buy into shares that are in a downward trend.”

“The only time we overlook this rule is when there has been a material change to a business; new management team, a capital raising providing a growth catalyst, an attractive acquisition, or a competitor misstep.”

Invest where the addressable market is huge and quantifiable

Tyler Laundon, chief analyst of Cabot Small Cap, said that he would only buy small caps that serve large, burgeoning markets because they can then realise tremendous growth with even a small market share.

“The sheer size of the markets creates the potential for huge gains while helping to reduce your risk profile,” Laundon said.

Invest before the big boys do

Ultimately, it is the big institutions that drive the share prices of listed stocks.

By doing some research, Laundon says retail investors can invest in companies before most of the big boys get on board, like mutual funds, hedge funds and pensions.

“In many cases, I’ll invest in companies that have less than 50% institutional ownership. The idea here is that subsequent investments by institutions will drive up the value of the stock,” said Laundon.

Invest in what you understand

Fergie says he only invests in sectors that he understands, and avoids those where the technology and science are outside of his grasp.

“All this is not to say significant returns cannot be generated from investing in those industries,” said Fergie.

“Just be humble enough to recognise what you feel you can understand and have some hope of predicting.”

Cash is King

“Revenue is Vanity. Profit is Sanity. Cash is Reality” – so goes the old saying.

The most valuable financial report released by companies to investors is the cash flow statement, according to Fergie.

Even better are the quarterly 4C statements.

“The cash flow statement is the very first thing we look at in a company’s financial report,” said Fergie.

“They can be a clear indication as the true cash profitability of a business, or for those in earlier stages of their lifecycle, if or when a company might be required to raise capital.”

Laundon agrees, saying that he wants to see a small cap’s balance sheet that has solid cash and little, if any, debt.

“Cash is important because it can carry a company through unexpected events.

“For example, should the much-anticipated launch of a product be delayed, I want the company to have enough cash available to see the product to market,” Laundon said.

Alpha, not Beta returns

Frontier Advisors’ head of Equities Research, James Gunn, told Stockhead that genuine skill is rewarded overtime in small caps investing.

Gunn says that Frontier maintains its conviction in small caps through Alpha opportunities, in other words by investing in individual stocks instead of the index or broad-cap portfolios.

“That being said, small caps do tend to move in quite distinct cycles relative to large caps, depending on economic conditions and the general appetite for risk,” said Gunn.

“As a result, we continue to view the primary source of return enhancement from small caps from a whole-of-sector perspective to be the Alpha opportunity, rather than the Beta, noting limited evidence of a persistent small cap premium at least in the Australian market.”

Alpha refers to a stock’s excess return over the market index, while Beta measures the market index return itself.

 

Finding cheap ones through PE multiples

“Good stocks aren’t cheap, and cheap stocks aren’t good.”

While that might be true, finding cheap stocks based on their P/E multiples may still have some merit.

Price Earnings Ratio (or P/E ratio) is a classic measure that helps investors gauge whether a company is cheap or expensive in the market.

It’s simply the current stock price divided by the company’s earnings per share for a designated period, usually the past 12 months.

P/E ratio = Current stock price/Earnings per share

In simple terms, a P/E ratio conveys how much investors are paying per share for every dollar of profit a company makes. The higher the P/E ratio, the more you’re paying for the stock and vice versa.

Fergie told Stockhead however that a lower P/E ratio may not necessarily mean that you’re buying into a cheaper stock.

“Companies that have low P/Es could be businesses that are going backwards, or those that are cyclical or mature,” he said.

In other words, a stock could be cheap due to many reasons such as losing market share.

“When you compare a stock against a cohort of similar stocks that are trading on higher P/E multiples, you might think there’s a disconnect there. But a P/E ratio doesn’t always indicate the future direction of the share price,” Fergie added.

In addition, P/E ratios of smaller companies might be skewed to the upside especially on stocks like tech, due to the high growth estimates used.

“P/Es are very relevant for stocks that are very stable and mature. And that’s just really not applicable for a lot of small caps,” explained Fergie.

That said, here’s a couple of tables showing the lowest and highest P/E ratios for small caps listed on the ASX as of 30th March.

(Source: Commsec, 30th March 2023).

 

Lowest P/E multiples for ASX small caps

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Highest P/E multiples for ASX small caps

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Managing volatility of small caps

Finally, how do we manage our small caps portfolio once we have purchased those stocks?

Our own Nadine McGrath spoke to Prime Value Asset Management portfolio manager Richard Ivers, who explained ways investors can reduce volatility in the ASX small caps market.

The most important factor Ivers said, is diversification, where you want stocks which are ideally uncorrelated with each other.

Another way to avoid volatility is that you want to avoid loss-making companies because they are burning cash.

There are other ways to manage your small caps risk, and to read the rest of that story, read: Prime Asset Value’s three tips to manage volatility in the ASX small cap market.

 

The views, information, or opinions expressed in the interview in this article are solely those of the interviewee and do not represent the views of Stockhead.

Stockhead has not provided, endorsed or otherwise assumed responsibility for any financial product advice contained in this article.