Don’t be put off by the market’s downbeat view of small-cap shares: for the patient investor, they really deliver, says former small-cap value fund manager David Stevenson.
What type of shares will make you the most money over the long term? Big blue chips? Hot new technology stocks? No. For the patient investor, ‘small-cap value’ shares – in companies with market caps of ÂŁ500m and below – should be a key element of your portfolio.
In a nutshell, small-cap value stocks are so-called because they’ve been given very low valuations (I’ll explain exactly what this means in a moment) by the stockmarket. But a small market capitalisation (a company’s share price multiplied by all the shares in issue) doesn’t automatically mean an equally small company. Often, such firms have sizeable sales, assets and profits compared with their market valuations. They can be major players – even world leaders – in their areas of business. It’s just that the market has put a very modest price on their heads.
This can happen for a variety of reasons. Maybe a stock has fallen foul of investors, for example because of a profits warning. So it may still be in recovery mode. Or perhaps a firm is in a sector that’s dropped right out of favour and so has been de-rated. In other words, profits have continued to grow, but the amount investors are willing to pay for those profits has fallen. Or maybe certain shares or sectors have always stood on a low rating because the market is wary about earnings being volatile.
Of course, buying such shares isn’t risk-free – they’re in a less widely understood corner of the market. And because investors deal in them less often, and thus trading volumes are lower, their prices are more volatile than larger stocks. So buying into small-cap value requires patience – it can take time for the market to appreciate what it’s been missing. But eventually, ‘value will out’. Here are six reasons why I believe the risks are more than offset by the potential rewards on offer – and why small-cap value stocks stand at the top of my ‘buy and hold’ list.
1. You get much more for your money
For the best small-cap value plays, all the company valuation measures will look more appealing than for your average stock. Think price/earnings (p/e) ratios as much as 50% below the market average. And price/cash ratios, which measure how much cash a firm generates compared with its market valuation, are similarly lower than you’ll find elsewhere. It’s the same for the price/sales measure. When a large firm’s total revenues exceed its market cap, analysts will often tell you it’s looking cheap.
But for small caps, you can often find that turnover is several times the firm’s stockmarket valuation, and no one pays a blind bit of notice. Same goes for price/book-value. Within the ranks of blue chips, it’s quite rare to find companies that sell on a discount to shareholders’ funds – that’s the net asset value (NAV) after deducting the firm’s net debt. But some small-cap stocks are selling on sizeable discounts to NAV.
Another balance-sheet test strengthens the case for a number of small-cap value stocks. Businesses with very low net-debt/equity ratios, where borrowings are small compared with the NAV, get extra brownie points in my book. That’s because low debt means a firm won’t be paying out much of its gross profits in interest bills. If the economy turns down and profits suffer, that can be crucial. Indeed, several small-cap value stocks have no net debt at all – their balance sheets actually contain net cash.
Many stocks in the sector also boast dividend yields that are higher than the average for the overall market. What’s more, because lots of these stocks are cheap – a low p/e means a high level of earnings compared with a share price – dividend yields are often well covered by earnings.
That little lot should be enough to interest any potential shareholder. But there’s more…
2. Long-term, these stocks are the market’s top dogs
If buying small-cap value stocks didn’t make you any more money than investing in anything else, there would be no reason to bother with them. Yet here’s the irony. Small-cap value shares may be unloved, but they have consistently done the business for their shareholders.
Researcher Ibbotson Associates has analysed data on the sector for the 71-year period from 1926 to 1997. The firm discovered that US small-cap value stocks outperformed the general market by 4.3% annually. That’s more than any other type of share. Specifically, from 1927 to 2009, in the US, large-cap growth stocks averaged 9.1% a year, according to Professor Kenneth French at Dartmouth College. Small cap growth stocks achieved 9.2% over the same period, while large cap value plays averaged 11.2%. But the small cap value sector managed 14.2% per year.
This is backed up by analysis from Vanguard and Fund Evaluation Group. And a report by French and financial economist Eugene Fama shows that, even in recessions, small-cap value stocks tend to outperform all others. So it’s a win-win sector over time.
3. Small-cap value stocks have more scope for money-making
For the most part, research analysts cover large, relatively well-known stocks. That’s because the analysts’ main clients – fund managers at the large investment institutions – prefer to invest in businesses they know well. The corresponding lack of research on small-cap value stocks means these firms’ businesses and prospects are less widely appreciated.
Furthermore, funds managing billions of pounds of assets are constrained by the proportion of a company that they can hold. Any investments in small caps would be nearly insignificant compared with these funds’ holdings in large companies. In turn, this means such small-cap investments would make very little difference to most funds’ overall performance.
As a result, these stocks are often ignored, generally unloved, and quite possibly actively disliked by most of the people who research and buy individual shares. But the market can be equally quick to refocus on a sector, as long as it’s given a reason to do so. When that happens, a stock can be re-rated just as fast as its valuation has been slashed. In short, the market’s view on small-cap value stocks is generally so downbeat that it can only improve. For the savvy investor, that opens up great opportunities to make money while most other market players are looking the other way.
4. The truly great investors love these stocks
One of the best examples is the superstar investor Peter Lynch, who ran Fidelity’s flagship Magellan Fund between 1977 and 1990. Over that time the fund grew in size from $20m to $13bn, notching up a staggering 29% annual compound return – around double the total return achieved by the S&P 500 index.
Lynch bought hundreds of tiny holdings in a wide range of small-cap stocks whose prospects he liked. He then held these stakes until the market realised their value. That could often take time, and each individual stock made little difference to his fund’s performance. But when all the profits were added up, they made the Magellan fund atop-notch performer.
And here’s Warren Buffett himself on the subject: “Look for small securities in your area of competence where you can understand the business,” he said over ten years ago. “Working with a very small sum, there’s an opportunity to earn very high returns.”
5. They are natural takeover candidates
Large, quoted companies are always struggling to deliver better returns to their shareholders. Growing a ‘mature’ firm that’s already achieving large sales and profits isn’t so easy. So rather than splash out vast sums on research and product development, for many monoliths it’s easier to bid for smaller and cheaper rivals; or to use some of those chunky corporate cash flows to add on another business division by snapping up a relatively cheap acquisition.
And there’s another source of possible takeover activity. Sure, the best days of the private-equity (PE) sector may be over – borrowing money to buy up undervalued assets is much tougher these days. But when the PE brigade spots a bargain, it still seems to be able to come up with the cash to unlock the value. A classic case in point is the recent bid by Apollo Partners for England cricket sponsor Brit Insurance. In the box on page 24 we look at another stock in the same cheap sector.
6. Small caps can turn into big caps
Of course, this doesn’t happen overnight. But a smaller business with a lesser slice of its market can increase both its sales and profits much more rapidly than a company that’s already the leading player in its field. Most large caps started life from much humbler beginnings, but gradually grew to their current position.
As a smaller company increases in size, so does its ability to access the capital markets for additional funds, for example via rights issues. Progressively, more major financial institutions are then able to invest in it without being concerned about market cap constraints.
In turn, this can lead to a stock price re-rating as the market places a higher value on the company’s profits. What’s more, as a firm’s market value grows, it will be included in more stockmarket indexes, which will lead to investment by the index funds that track them.
To recap: buying into small-cap value stocks can prove very lucrative over time. But it can often take time for the wider market to latch onto the value that’s available. So an investor in this sector will need more patience than investors in large caps. What’s more, small-cap value stocks don’t always perform in line with their larger cousins. Indeed, in the short term, small caps often tend to outperform when large caps are falling. This occurred between 2000 and 2003 and also for much of this year as this chart of the S&P Small Cap Value index compared with the FTSE 100 index shows.
Now several times recently, we’ve recommended you should hold defensive, highly liquid blue chips as the best way to see you through the current market turmoil. And we certainly still believe that large caps which offer both good value and high yields are the current place to be.
So, although the long-term case for small-cap value stocks is clearly highly compelling, why are we suggesting it right now? Because there’s yet another reason for buying some of these small-cap value stocks right now. And this is where there’s a clear ‘value catalyst’. In other words, where something is about to spark investors into buying such stocks.
It could be a management change, the sale of a loss-making division, a major profit turnaround, a better-than-expected upswing in business, a sudden increase in demand for a firm’s products… anything that’s set to spotlight and unlock the true worth that these stocks contain. Below, we spotlight five shares that we believe tick all the boxes.
The five best shares to buy now
Laird (LSE: LRD) is world leader in making electromagnetic shields that stop interference for mobile phones. The firm also sells antennae, thermal management products and wireless systems. The ÂŁ320m market-cap firm sells on just 60% of its sales and a price/NAV of 0.58. Net-debt/equity is just 10%. The forecast p/e for the current year is 10.7, according to Bloomberg, while the prospective dividend yield, twice covered by forecast earnings, is 5%. And the ‘value catalyst’? Business has been tough, but a 62% rise in first-half operating profit is “the first indication Laird may be turning the corner”, says Richard Paige at JP Morgan Cazenove. Also, the loss-making ‘mechanisms’ product line is to be stopped. “With the group’s profit-mix moving away from volume components towards higher value-added products, this improves the income quality,” says Steve Medlicott at Altrium Securities. The shares “look oversold”.
Chaucer Holdings (LSE: CHU) underwrites at Lloyd’s of London, the world’s leading insurance and re-insurance market. The firm provides cover in over 28 insurance classes, including global marine and non-marine, energy, aviation, UK motor and nuclear. With a ÂŁ250m market cap, Chaucer is on a current year p/e of below 8.8, which is set to drop to 5.7 in 2011, says Bloomberg. The prospective yield is over 8%, but next year’s forecast earnings rise should see the dividend still twice covered. The price/NAV ratio stands at 0.8.
As for the catalyst, “returns have been depressed by weak motor underwriting”, says Martyn King at Edison Investment Research, “but rates here are now improving strongly”.A new management team is expected to shake the business up. And a top ‘international liability’ team has just been hired to take advantage of another potential rate recovery in this area.
Low & Bonar (LSE: LWB) is an industrial fabric manufacturer – it turns polymers and additives into floors, yarns and carpets for civil engineering, transport, and sports and leisure uses. On a market cap of £100m, Low & Bonar sells on 30% of its sales. The 40% debt/equity ratio is higher than our other value stocks, but the price/stated-NAV is 0.66. The stock sells on a current year p/e of 8, says Toby Thorrington of Edison Investment Research, while the consensus dividend forecast is for a prospective 4.3% yield.
The group is on the comeback trail. After a painful 2009, it posted a 31% first-half pre-tax profit rise. “New products are driving market share gains”, says Thorrington, “and there’s margin improvement to come”, which should be helped by a new Abu Dhabi grass-yarn joint-venture. So profit estimates could “be further raised before long”.
International Ferro Metals (LSE: IFL) produces ferrochrome at its South African mine and smelter. Ferrochrome, an alloy of chromium and iron, is a key material for the production of stainless steel, which it protects from corrosion, while improving tensile quality and colour. International Ferro (market cap ÂŁ157m) is on current year p/e of 8.3, says Martin Potts at Daniel Stewart.
There’s no dividend, though the price/book-value stands at just 0.6. And there’s almost no net debt. “Demand for ferrochrome is rapidly returning to the point where it exceeds supply,” says Potts. “But the positive impact of this on International Ferro Metals hasn’t yet been recognised.” He sees 200% upside for the stock.
Finally, Collins Stewart (LSE: CLST) is a stockbroker, corporate finance adviser and fund manager with a ÂŁ182m market cap. It’s great value wise, on a sub-11 current year p/e and a prospective 4% yield, which is forecast to reach almost 5% in 2011. The price/book-value is just above 0.68 – indeed, almost 80% of the NAV is in cash.
While markets have been “difficult”, says the firm, assets under management are growing fast. And with British companies finding the bank manager’s door generally shut these days, they’re likely to be raising more money in the equity markets. That must be good news for Collins Stewart’s team of corporate finance advisers.
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