Four big ideas in the small cap space

New COVID variants, tech stock bubbles bursting, supply chain disruptions, higher inflation hurting companies and consumers, the winding down of quantitative easing and the prospect of higher interest rates in the year ahead.

You can forgive investors for entering 2022 with a sense of dread. It’s been an eventful couple of years and the future (at least for now) seems even less predictable than before.

Even against this backdrop, investors who have tracked a standard index during this time have likely achieved three consecutive years of strong returns. And while we don’t make many friends among our fellow active fund managers for saying this, at Forager, we’re big fans of index funds. They’re an attractive, low-cost way of investing in the world’s largest and most predictable businesses.

But therein lies the issue: because these stocks are so well covered by research analysts and because there is so much money chasing them, it can be tough for active fund managers to beat the market.

The case for small caps

Not so at the smaller end of the market, though.

Sifting through thousands of small companies with little to no brokerage coverage as well as a lack of media and market interest, the active investor can add value. We find that the more volatility and the more uncertainty, the more value that can be added.

Last year, for example, professional stock pickers shone in a time when it seemed active management had been all but left for dead. In the US, early returns from Bloomberg suggested that 85% of small cap managers beat the Russell 2000 index in 2021.

It’s true that small companies are usually less resourced and are, therefore, more sensitive to negative news headlines, market sentiment and economic downturns. But don’t let that scare you. There’s a lot of potential and some big ideas in the small cap space, and here are four reasons why.

1. A much larger universe

By looking beyond the big names on the major indexes, investors will find a much larger universe with thousands of opportunities.

While our international analysts have more than 10,000 stocks to choose from, our Australian investment universe comprises roughly 400 ASX-listed stocks that meet the criteria we invest against. You still need to pick the right ones, of course, but contrast that with a manager trying to invest $10 billion in large caps. They’re only left with about 40 Australian stocks in which to make a meaningful investment.

2. More opportunities to diversify

A larger universe lends itself to more variety and opportunities. Look a little closer and investors will find that there is more diversity in terms of the types of businesses on the market.

Large companies typically have more diverse revenue streams and any new initiatives pale in significance relative to existing businesses. If you like Facebook founder Mark Zuckerberg’s plans for the metaverse, I can guarantee investors will find a small company that is a much ‘purer’ bet on the same idea – we think of it like a sports boat versus a cruise liner.

One example is NASDAQ-listed Fathom Holdings, a tech-driven real estate services platform held in our International Shares Fund. Have you ever wondered why the modern real estate agency even bothers with a physical store? Buyers do all of their research online and meet the agent at the property ... simple. These days, many large real estate agencies have begun slowly adapting by cutting their office spaces. But Fathom began as a digital native, and that’s why it has attracted more than 7,000 agents to its platform in less than a decade. The theme is fairly obvious, but only in small cap land can you receive pure exposure to it.

Our Australian Shares Fund has its largest investment in a company that only does cloud-based mining software. That’s a niche alright. But it’s an attractive niche because it doesn’t draw too much competition and there is still plenty of room for growth in an industry that has been relatively late to adopt the latest and greatest in software. A large fund manager can invest in something huge like SAP, giving it a tiny exposure to the theme. On the other hand, a small and nimble investor can back RPM Global and be fully rewarded if they are right.

3. The law of large numbers

One of the most overlooked laws in investing is what’s called ‘the law of large numbers’. Eventually, large companies get so big that they begin struggling to meet their growth targets, though that hasn’t stopped some companies from trying in the past. In any case, nothing can grow faster than the global economy forever.

Small caps typically have longer runways and that can be a good thing for investors. While they’re still small, they can grow and expand their operations more quickly and can, in some cases, bulk up through mergers and acquisitions. This means there’s a lot of potential yet to be capitalised on.

Take Australian tyre distributor National Tyre, for example. We bought this stock in 2019 at $0.40 per share. During the COVID crisis, National Tyre bought one of its largest competitors. In one attractively-priced acquisition, it doubled the size of the business and more than doubled its profits. Today, the stock trades at $1.50 (though we sold ours too soon).

Many large companies make acquisitions, but the bigger they get, the harder it is to find something that moves the dial, and that’s when many make mistakes.

4. Volatility is your friend in the stock market

Perhaps the most attractive aspect of the smaller end of the stock market is wild gyrations in share prices. Being well covered and widely owned by index funds, the share prices of larger companies tend to be a lot more stable. Not so in recent times. Facebook owner Meta recently saw its share price fall 25% after releasing its results, which was one of the largest falls ever seen in large cap land.

For small cap investors, moves of that magnitude barely rate a mention.

National Tyre’s share price halved after we first bought it, falling from $0.40 to $0.20 and rising sevenfold from there. And in the last 18 months, Fathom Holdings’ share price has been absurdly volatile, going from $10 to $50 and back to $12 again.

This sort of volatility scares a lot of investors. But for those with a longer time horizon, it can be of benefit. Along with a share price rollercoaster, Fathom has more than doubled the size of its business and is likely a better investment today than when we first bought it. You rarely see these sorts of bargains at the big end of town.

Volatility delivers opportunity

While we can’t speak for other active managers, we like the case for small cap stocks, especially at a time like this. In our experience, when markets are volatile, it can be a great time to find investments in quality businesses at reasonable prices. And if the outperformance managers experienced in 2021 suggests anything, it’s that the small cap space holds a world of untapped potential.

First published on the Firstlinks Newsletter. A free subscription for nabtrade clients is available here.

Steve Johnson is CIO at Forager Funds. Analysis as at 09 February 2022. This information has been provided by Firstlinks, a publication of Morningstar Australasia (ABN: 95 090 665 544, AFSL 240892), for WealthHub Securities Ltd ABN 83 089 718 249 AFSL No. 230704 (WealthHub Securities, we), a Market Participant under the ASIC Market Integrity Rules and a wholly owned subsidiary of National Australia Bank Limited ABN 12 004 044 937 AFSL 230686 (NAB). Whilst all reasonable care has been taken by WealthHub Securities in reviewing this material, this content does not represent the view or opinions of WealthHub Securities. Any statements as to past performance do not represent future performance. Any advice contained in the Information has been prepared by WealthHub Securities without taking into account your objectives, financial situation or needs. Before acting on any such advice, we recommend that you consider whether it is appropriate for your circumstances.