Small-cap head fake

Deep in the trough, small caps poised for valuation re-rating

The second quarter was a head fake in small caps. As with other periods when top heavy indexes have driven returns, the last five years have provided another challenging environment for active management. The real question is: When will the trend reverse and finally become our friend? That friend has currently ghosted active managers.

Our small-cap universe has seen massive share price corrections as investors have stampeded out of non-index and small-cap names in favour of the relatively easy returns of index funds. And who can blame them? With 155% cumulative returns in the S&P 500 over the past decade compared with 89% in the S&P 600 or 66% in the Russell 2000 Index,¹ outperformance in small caps has been hard to come by.

The times, are they a-changing?

Over the last six months we have experienced a market that reminds us of the early 2000s and the dot-com market correction era. It is hard to find anyone who still wants to sell a small-cap stock. It looks like everyone who wanted to sell already has.

This creates an interesting point in time in the market cycle. With news flow in these in already-discounted and sold-off small-cap stocks, we are seeing companies with weak results not moving their stock prices much at all. Conversely the companies with positive results are trading up. Optimism appeared to have kicked in during July and early August. That was the head fake! We are back to the pre-summer trading levels of many of our key holdings.

While we don’t know when, we do believe the friend who ghosted us is getting ready to reach out and start another wonderful 5-10-year relationship. The historical relationship between large caps and small caps has moved to an extreme that dramatically favours the setup for small-cap for the next market cycle. This trend will be a friend to small-cap stocks again. The last time this happened was in the early 2000s following similar price appreciation and narrow concentration in a select few large-cap technology companies. The table below outlines the results we saw, with small caps going on an extended run compared to large caps, outperforming by an average of about 12% per year.

With small caps trading near trough valuations today, these companies are already priced for an uncertain environment ahead. The re-rating in valuation multiples we believe is a tailwind as risk appetite returns and new leadership emerges from strong companies. This is similar to early 2000-2005 period when companies that proved they can deliver profitable growth emerged as the long-term winners in small-cap technology. The following chart illustrates just that – with the yellow line showing companies that became profitable rebounding through 2003 and 2004 following an indiscriminate selloff in the early part of that decade.

The M&A cycle is another element to highlight with several deals announced recently. An example is H20 Innovations Inc. (TSX: HEO), which was taken private at a 68% premium to their previous closing share price. The largest shareholder rolled over their existing stake in the company while committing additional capital, bringing private equity and insider ownership to 45% and a 26% premium to their 52-week high. This company was not held in our portfolio but highlights the perceived value of the company to sophisticated and knowledgeable buyers – value that was not recognized in the current market. This is more of a take-under than a takeover and demonstrates the extreme valuation disconnect in today’s environment.

When we can buy businesses we want to own for the next 10 years at distressed valuations, I am very optimistic when I think about where we may be in 5-10 years with our new BFF.

Notes

1. Source: Capital IQ, as at 30 September 2023.

David Barr, CFA, is the CEO at PenderFund Capital Management and Portfolio Manager of several Pender funds, including Pender Value Fund. Sharon Wang contributed to this article. This article first appeared in the Pender commentaries. Used with permission.

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