Paradigm
Capital
Management
Blog Post
Paradigm Capital Management Tips for Choosing Small Cap Value Stocks
- By Wilbur H. Stewart
- •
- 11 Dec, 2017
- •
1) Find the Big Fish in Small Ponds
It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and we do not want to be speculators but investors.
So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!
2) Management Matters
In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).
With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.
3) Debt is Dangerous
This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.
Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.
4) Diversify
When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see its business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a much focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.
5) Never Forget the Fundamentals
The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (15-25% return on equity, 25% or higher return on invested capital), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.
Don't be Afraid of Small Caps!
Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. However, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up.
For more info consult with Paradigm Capital Management a small cap company. By empowering individual portfolio managers to pursue their best ideas within the confines of a well-articulated research framework, we reward originality while promoting collegiality and oversight.
Our three decades of experience provide an exceptional level of insight that is reflected in our high-conviction portfolios.
Call us 212.364.1830 or visit us here: http://paradigmcapital.com/
It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and we do not want to be speculators but investors.
So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!
2) Management Matters
In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).
With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.
3) Debt is Dangerous
This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.
Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.
4) Diversify
When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see its business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a much focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.
5) Never Forget the Fundamentals
The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (15-25% return on equity, 25% or higher return on invested capital), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.
Don't be Afraid of Small Caps!
Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. However, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up.
For more info consult with Paradigm Capital Management a small cap company. By empowering individual portfolio managers to pursue their best ideas within the confines of a well-articulated research framework, we reward originality while promoting collegiality and oversight.
Our three decades of experience provide an exceptional level of insight that is reflected in our high-conviction portfolios.
Call us 212.364.1830 or visit us here: http://paradigmcapital.com/
