APRIL 10, 2024: Why You Should Invest in U.S. Small Cap Equities
By Jason Crawshaw, EVP & Portfolio Manager at Polaris Capital
Imagine yourself in a casino. Bright, flashing lights, people gathered around tables cheering on their fellow gamblers. The excitement in the room is tangible and the thought of all the money that could be won is intoxicating. You amble around the casino floor, moving from slot machines to roulette tables, and everywhere you look there is an opportunity to win big.
What you likely do not see on your walk around the casino are warning signs about the potential loss, or downside risk, of playing these games; the odds are stacked against you. Those signs are tucked away, inconspicuous to most gamblers in the casino. To get a sense of the “edge” that casinos have, see the below chart for a few popular casino games. While some of these “edges” appear small, over time they add up to significant profits for the casinos and significant losses for gamblers.
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Source: Wizard Of OddsGAME HOUSE EDGE Texas Hold 'Em 2.19% Roulette (Double Zero) 5.26% Slot Machines 2%-15% Keno 25%-29%
One can draw parallels between gambling at casinos and investing in small-cap equities. Like the many games offered in a casino, there are thousands of small, publicly-traded firms across the United States and they all seemingly have the potential to make it big. Many of these companies promise that they have the next hot technology or the latest drug to cure a disease. On the surface, these companies seem like great investments that could generate attractive long-term returns for investors. However, like the games in a casino, there is much about these companies that do not meet the eye.
Many small caps, like many gamblers, make no money. In fact, based on Polaris’ proprietary small cap screen results from March 2024, only 15% of the 2,618, or just over 400 companies, were profitable and met Polaris’ stringent valuation metrics. (Source: Polaris Capital Management, LLC. Based on proprietary screens.)
The clear difference between gambling and investing in small caps is that analysts and portfolio managers can deploy bottom-up fundamental analysis to potentially weed out those companies that are losers and seek out quality businesses with solid balance sheets and sustainable free cash flow that trade at attractive valuations. These companies have true potential to grow.
Small-cap stocks are an inefficient asset class. Why? Small-cap stocks are very thinly covered by the street; while large- and mega-cap stocks attract upwards of 25 sell-side analysts, small-cap stocks are typically covered by no more than 5. Interestingly, over time less coverage of a stock results in potentially higher returns as it takes investors longer to learn about, and incorporate, new data into their models.
As an example, the returns of S&P 500 Index have, in recent years, been largely driven by the “Magnificent 7”. These companies are broadly held by retail and institutional investors and represent a large percentage of many indices; as a result, there are effectively few inefficiencies on which investors can capitalize. Less sell-side coverage in the small-cap space provides investors with opportunities to uncover fundamentally-strong companies that trade at a discount long before the news gets to the general public.
Another comparative value: Small caps have much lower liquidity relative to large- and mid-cap stocks. This lower level of liquidity creates volatility in the stock prices of companies, for which active managers can take advantage. (To be fair, it should be noted that this lower level of liquidity can lead to difficulty in exiting positions).
Finally, these companies benefit from what is known as the “small-cap effect” theory. In his paper published in 1981, Rolf Banz found that, using a 40-year data set, smaller companies have had higher risk-adjusted returns, on average, than larger companies when they are held for five years or longer. In 1992, University of Chicago professors Eugene Fama (Nobel Prize Laureate in 2013) and researcher Kenneth French expanded on this by adjusting the Capital Asset Pricing Model to incorporate size risk and value factors. They also found that small-cap stocks perform better over longer-term holding periods. In summary, industry greats have all come to the same conclusion: while small cap stocks carry more risk, they also have greater return potential.
Aside from their potential for outsized returns, owning U.S. small cap stocks comes with additional benefits. A diversified portfolio (replete with stocks across all market caps) is key to protecting on the downside while also capturing returns in various market cycles. During periods of economic growth and high consumer confidence, small-cap stocks tend to outperform relative to their large- and mid-cap counterparts.
Over the years there has also been a trend in private companies staying private for longer. In 1980, the median age of a company at its IPO was 6 years; in 2021, the median age was 11. Typically, more mature companies have well-established products, strong customer bases and defined growth trajectory based on past precedent; thus, the companies should be easier to analyze at the point of initial public offering (IPO). More and more small-cap companies are presenting as stable, well-managed organizations with a notable track record; those are more likely to succeed when venturing into the public arena.
U.S. investors often invest in U.S. small cap stocks, and with good reason. Small-cap companies typically focus on local markets when selling their goods and services, and are relatively immune to global market dislocations and currency fluctuations. Thus, a U.S. investor with local familiarity can well assess the actual fundamentals of the business, triangulate with suppliers/demand/channels, analyze local competitors and “kick the tires on the ground” to determine whether to invest in a company. Why is this so important… and often left to knowledgeable investment managers?
Small-cap companies take an extra level of “digging” before purchase, as only 15% of companies in this category are profitable (see above Polaris metrics). Additionally, the U.S. economy has tended to be at the forefront of innovation. Investing in attractively-valued U.S. small cap equities provides investors with opportunities to find innovative, faster growing companies and invest in them before they make it big.
Polaris’ definition of value is unique in an industry saturated with like-minded investors. Polaris boasts one of the longest track records in global value investing. This “go anywhere” approach, which seeks to capitalize on global market fluctuations that produce mispriced stocks with attractive, sustainable free cash flow, dates back to 1984. Over the years, this approach, which can invest across industries, sectors, and market caps, has proven to provide attractive returns with lower than benchmark risk.
What sets Polaris’ investing style apart from the many other firms that invest globally is its singular focus on sustainable free cash flow. We believe that companies exist to deliver cash to shareholders. To uncover these companies, Polaris incorporates a proprietary metric into its fundamental stock analysis known as maintenance cash flow. At a high level, maintenance cash flow is the cash that a company produces from its operations less any maintenance capital expenditures. Importantly, this metric is calculated in real terms, that is, after inflation.
Due to the proprietary way in which Polaris invests, it is important to provide an example of how a stock makes its way into a portfolio. Take, for example, Winnebago Industries, the iconic U.S. manufacturer of recreational vehicles (RV) and other products. The company appeared on our screens in 2019, following a 66% price collapse from the prior peak in 2017. This coincided with the decline in industry-wide RV shipments from 505,000 in 2017 to 406,000 in 2019.
While end market demand can be highly volatile and cyclical, the underlying industry dynamics were intriguing to us. First, the top 3 RV manufacturers own about 85% of market share in a highly-consolidated industry. Second, the company is really an assembler, designer and marketer of myriad brands, with suppliers providing most of the components. Lastly, Winnebago has a variable cost labor model that adjusts to volume, allowing the RV company to remain profitable even during the deep downturns.
While Winnebago historically had strong brand recognition, a new CEO arriving in 2016 from Toro set out to expand market share, increase the product range, and improve margins through the cycle. With the unexpected tailwind from the pandemic, resulting in new buyers seeking outdoor activities, total RV shipments rose to a record 600k units in 2021; Winnebago was a leading beneficiary, with 250% profit growth for the year.
But more impressive, in this most recent destocking downcycle where industry units are down 48%, the company managed to report a quarterly operating margin of 5%. Also, as manufacturing capex is modest, the company throws off a lot of cash flow. They recently provided mid-cycle guidance of roughly $350 million free cash flow at industry volumes of 438,000 units at the midpoint. This equates to a free cash flow yield of 16%, making for a stock price that is far too cheap for an admittedly cyclical, but quality business.
The Polaris U.S. small cap strategy provides investors with the opportunity to participate in the growth potential of domestic small cap companies, typically investing in stocks with a market cap of up to $5 billion at the time of purchase. The investment process for the strategy combines both quantitative and fundamental techniques. The strategy’s approach is primarily “bottom up,” searching for individual stocks with strong, undervalued cash flows, regardless of industry.
The strategy uses proprietary models to rank publicly traded small cap companies on the basis of value and to narrow the universe down to 200 to 400 for further consideration. The strategy supplements the screening process by performing in-depth financial and fundamental analysis. Risk controls are also employed to prevent the strategy from concentrating its investments in any particular industry sector.
Portfolio construction is an important consideration, especially when dealing with typically volatile small cap companies (i.e. Winnebago). First, we tend to add and trim positions to take advantage of the opportunities created by investors with a shorter time horizon. Furthermore, we integrate diversified companies across industries into the portfolio that help lower volatility, but leaving room for the likes of Winnebago with greater upside potential.
In an already inefficient asset class, our distinctive approach to investing in U.S. small cap equities separates Polaris from the crowd. You can bet on that.
This blog was penned by Jason Crawshaw, EVP and Portfolio Manager, in April 2024. Mr. Crawshaw joined the firm in January 2014 as an Analyst. In 2015, he became an LLC member and was named an Assistant Portfolio Manager in 2016. He was promoted to Portfolio Manager in January 2021 and was named the firm’s Executive Vice President in late 2023. Mr. Crawshaw is a generalist and conducts fundamental analysis of potential investment opportunities. He brings 20+ years of investment industry experience to the firm.
DISCLAIMER: Investments in small-capitalization companies typically present greater risks than investments in mid- and large-cap companies because small companies often have limited product lines and few managerial or financial resources. As a result, the performance of small cap strategy may be more volatile than a mutual fund that invests in mid- and large-cap stocks.
IMPORTANT INFORMATION: The views in this article were those of Jason Crawshaw as of the article’s publication date (April 10, 2024) and may be subject to change. Information, particularly facts and figures, are dated and in many cases outdated. Views and opinions of Jason Crawshaw expressed herein do not necessarily state or reflect those of Polaris Capital Management, and are not nor shall be used for advertising or product endorsement purposes.
Polaris Capital is an investment adviser registered with the Securities and Exchange Commission. For more information about Polaris, please contact us at (617) 951-1365 or at clientservice@polariscapital.com.
