Small-Cap Value Investing

LOOKING FOR THE “DIAMOND IN THE ROUGH”

We love finding unknown, undervalued companies in emerging industries that possess excellent growth potential. This requires looking beyond the obvious. Unlike growth investors who pay a fair and often inflated price for companies with high growth potential, value investors buy companies that are undervalued relative to their assets or growth prospects.

For decades and across many market cycles, small company equities have performed strongly on both an absolute and relative basis. The Stocks, Bonds, Bills, and Inflation (SBBI) Yearbook, published annually by Duff & Phelps, is the definitive study of historical capital market data in the United States. Containing many charts and graphs, this book is seen as the industry standard data reference for market performance measures, with comprehensive historical return records dating back to 1926.  This annual publication continues to show that, while riskier, small company equities have produced the strongest returns since 1926.

A strong belief in greater return potential has led us to focus on smaller companies. While we consider companies of all sizes, our search for the rare combination of high growth and low valuation often bring us to the small-cap universe. Currently, we consider small caps to be publicly traded companies with market capitalizations up to $2 billion.

The small-cap universe is never without intriguing revelations. Of the many criteria we look for in a company, each investment candidate typically demonstrates many of the following fundamentals:

• Low valuation relative to assets, market indices, peer group and growth rate of the company
• Earnings growth superior to its industry and the general economy
• Relatively low debt; relatively large cash position
• Expanding cash flow
• Strong, credible management
• Sustainable competitive advantage

The risk of investing in small caps is considered greater than larger cap stocks, but so can be the potential reward. It helps to invest with experienced professionals who know how to optimize risk, return, and capital preservation. Small cap investing requires a team of vigilant and experienced professionals who can spot opportunities and avoid deadly pitfalls. It is certainly not an easy way to invest in the stock market, but we believe our clients will eventually see the reward.

Our selection criteria results in stock holdings that don’t fall into neat categories popular with mutual funds. We try to be initiators rather than followers. Our value approach results in three broad categories of stocks.

1. Growth at a discount 

The majority of First Wilshire stocks have historically fallen into this category. We seek to buy companies growing faster than the S&P 500 and trading at price/earnings ratios below the market average. First Wilshire often invests in emerging industries that are poorly understood by the investment community. Portfolios have often contained more than one company in these industries. First Wilshire might also buy a single company servicing a growing niche market that is not addressed by other products or services. Finally, we may buy an out-of-favor company that is misperceived by the market to be slow-growing, but in fact is a growth company in disguise because of a new distribution channel, a new product introduction, a new emerging business, or a new strategic focus.

2. Deep value/pricing inefficiencies

These sorts of investments are trading at very low valuations, such as price/earnings ratios in low single digits, discount to tangible book value, and market values less than cash. These companies often have certain common characteristics: they operate in mature industries and have been overlooked by investors for long periods of time. They may be consistently buying their own shares and may make a bid to take the company private. Stocks with P/E’s of three or four can double in price even with a small amount of recognition by the investment community. Similarly, profitable companies selling for less than cash value usually return to normalized valuations rapidly. Another type of trading situation may occur during a period of extremely negative market sentiment or when a large holder must exit a stock quickly, driving down the price to a temporarily low valuation. To take advantage of such opportunities requires a fast and efficient analytical process.

3. Turnaround situations 

Good value often occurs after the plight of a company, industry or market segment has driven down the stock price. The company may have missed earnings estimates, stumbled in product quality, or lost a key customer. Analysts have dropped coverage of the company. Disappointed investors, focusing on near-term results instead of long-term potential, sold their stock at depressed prices. Our interest would probably begin with such negative sentiment. We look for signs of a turnaround, such as return of revenue growth and positive earnings, completion of a major restructuring, or a new management team. If our research proves fruitful, we would take an initial position, often at a multi-year low price, and add to it as our confidence in the story increases. In these situations, a catalyst that would help investors recognize the value of the issue is a big plus. Such a catalyst might be a management change, debt reorganization, litigation settlement, regulatory change, new business line, or a renewed investor relations effort by the company.


Focusing on a larger number of undiscovered companies increases the odds of uncovering hidden value

1) Higher Growth/Nimble Operations

Small companies grow from a smaller arithmetic base. It is easier to double sales of a $10 million company than sales of a $10 billion company. Small companies are often in growing industries and find it easier to change their strategy in response to market conditions. Smaller companies are often run by their founders or a small group of managers who are more motivated to increase shareholder value.

2) Greater universe of opportunities

The 80-20 rule of investing: 80% of Wall Street research is focused on under 20% of publicly traded companies, those with market capitalizations of over $2B. This leaves a large number of companies with scant analyst coverage. With few investment managers performing in-depth research on small cap firms and the rest relying on conventional research, an astounding number of small cap companies get overlooked.

3) Inefficient market

Because few, if any, brokerage firms cover small companies, there is a greater possibility of market inefficiencies. Because most small companies have relatively few shares freely trading, a liquidity problem exists. This liquidity problem prevents many large institutions from investing in these companies. This reduces the number of buyers for the stock and can cause the stock price to be unjustifiably low. Conversely, when a large buyer tries to buy an illiquid stock, the price can go up dramatically. This inefficient environment works to our advantage: we aim to accumulate the undervalued shares and hold on to them for the long term. A small company that grows and performs well will draw more attention, increasing trading volume and driving up valuation.

4) In-Depth Research can make the difference

One of our favorite things is to roll up our sleeves and really try to understand a small company, its lifecycle, its management, and its prospects. In many cases, we kick the tires, going above and beyond information readily available on the Internet and in public financial filings. For example, we have called retail outlets across the country while researching a consumer products company and have inspected facilities of companies all over the world. Because large investment firms cannot invest in smaller companies, our analysts are often the first ones to visit in several quarters or even years. Management of small companies are far more accessible and our analysts typically establish good rapport with top management. Once we invest in a small firm, we try to help them with investor relations to enhance shareholder value.


Risks

Risks associated with Growth and Value investing strategies

Both value and growth investing involve risk and can result in a complete loss of principal. Compared to investors in growth stocks, investors in value stocks attempt to limit downside risk by buying companies trading at relatively low price-to-earnings or price-to-book multiples. However, there can be no assurance that any investment strategy will be successful. Value investing typically involves buying stocks at low price-to-earnings or low price-to-book ratios with the expectation that the stocks are undervalued and will eventually return to a fair valuation, resulting in an increase in stock price.

Risks associated with investing in smaller companies

It is important to keep in mind that investing in smaller companies can be particularly risky.

  • Small-cap stocks have lower trading liquidity which means that there may not be enough sellers of shares at an acceptable price when we want to buy or that we would not be able to sell shares quickly at an acceptable price when we want to sell. Additionally, low trading liquidity results in higher transaction costs.
  • Smaller companies have less financial resources and limited access to capital compared to larger companies. This may make it more difficult to obtain financing to pursue new growth opportunities or to endure economic and industry downturns. Similarly, they have less resources to defend themselves in the event of a campaign to drive down the share price to profit from shorting.
  • Some small companies do not have long operating histories or proven business models. This can make small companies more vulnerable to aggressive competition from larger competitors or regulatory scrutiny. A small company is less likely to have a following of loyal customers who believe in its business model, leaving it more exposed to risk from rapid shifts in customer preferences.
  • Less information is publicly available about small companies than large companies. First Wilshire’s analysts and portfolio managers rely to some extent on the integrity of company management, auditors, and the applicable regulators charged with oversight.