Small firms can generate big returns for smart investors
The Sunday Times - March 31st 2013
By Patrick Lawless
Since the start of the financial crisis, small-cap stocks have lagged the performance of larger and better-known companies, which attracted the bulk of investor attention during uncertain times. Small caps have become overlooked, under-owned and undervalued.
That small caps have underperformed for most of the last five years is surprising.
Since 1926, US small caps have generated an average annual return of 16.5%, compared with 11.8% for large US stocks. The long-term experience in the UK and Europe is similar; small firms can be more nimble and can grow faster.
While past performance is not a guarantee, we believe quality analysis can identify undervalued securities.
This shift in the markets towards large-cap stocks has created opportunities among small caps (those in an international context we define with a market value of €1bn or less).
Small caps generally trade on attractive valuations - but for the discerning investor many high-quality small cap stocks can now be picked up at attractive prices.
Investors should focus on high-quality, well-established companies with managers who think like owners.
Start-ups, loss-makers and ‘concept’ stocks should be avoided. The potential for windfall gains from high risk / high reward small caps is not enough to outweigh the risk of permanent loss of capital, particularly as potential returns from high quality small-caps are attractive.
By high quality we mean companies that have generated good returns on capital on a consistent basis and have delivered growth over the long term.
We also favour companies with little or no debt and / or robust cash generation. These firms can use their cash to reinvest in the business and make themselves stronger – or reward shareholders with higher and better-quality dividends.
In selecting small-cap stocks we look for companies with progressive dividend policies. Dividends have been, and will continue to be, the major component of total shareholder return from equities.
There is a significant group of companies that on average have higher returns on capital, higher growth rates and less debt than the market average. These can be bought on a discount of about 25% to the market, measured in terms of their price-earnings (P/E) ratio. They also have a higher average dividend yield than the market, and the capacity of their cash flow to cover this dividend payout is double the market’s.
The right companies are worth trawling for – beyond Ireland and Britain and into other EU countries, Switzerland and even the US.
There can be some hidden gems for investors who look closely enough. One example is Stanley Gibbons, quoted on London’s alternative investment market, which has specialised in selling rare or unusual stamps to collectors for over 100 years. It is currently valued at €90m million but has delivered returns of 30% a year since 2000.
German equipment firm Jungheinrich has been a leading producer of forklift trucks since the 1950s. It has delivered double-digit returns for investors since going public in 1990. It has a debt-free balance sheet and trades on a low P/E valuation of less than 10 times earnings. Its dividend yield is circa 3%.
Another debt free company trading on a similar valuation, but in the gaming arena, is Playtech. This is not a gaming company in its own right but is a provider of technology and support services to other gaming operators.
As such Playtech is a key facilitator within the industry and its investors can benefit from the growth in the gaming sector without having to try to identify which company is best placed to win the competitive battle in the market place.
Closer to home, media group UTV is worth watching over the medium term. Although best known in Ireland for its television station and local radio interests, its ownership of British sports radio station TalkSport represents a scalable growth opportunity. UTV is valued on a P/E of just eight times earnings and has a dividend yield of 6%, but the market appears to be overlooking the growth potential of its assets, and particularly that of TalkSport as well as its ‘Irish recovery’ dimension.
Another interesting aspect with small caps is the prospects for a wave of takeover activity in the space. This potentially could create windfalls for investors.
As larger companies are now finding it much harder to grow top-line revenues, and additional cost cutting opportunities are harder to identify, they are struggling to find ways to drive profit growth. With corporate balance sheets for large caps having deleveraged since the financial crisis and cheaper debt becoming available again for large corporates, growth through acquisition will become an attractive option for many.
Given the attractive valuations we see in small caps, some of these companies could become targets as takeover activity increases.
Equity markets represent fair value against their historical experience and we expect them to outperform cash and bonds over the next five years.
Right now, discerning investors can pick out niche, growth-oriented companies, high-quality businesses with high-calibre management and sound balance sheets that are not burdened with too much gearing but which are capable of paying attractive dividends.
If chosen carefully, small can be as beautiful as big.
Patrick Lawless is chief executive of Appian Asset Management. The views expressed do not constitute investment advice or investment research.