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3 Reasons Not to Invest in Small Caps

Investors in small capitalization stocks (small caps) are hoping that their suffering is finally ending. For the past several years, small cap indices have significantly underperformed large cap indices as overall market performance has been increasingly driven by a few massive companies. The Russell 2000, a US small cap index, declined over 5% in 2023 and generated a +17% 5-year return; a substantial gap to the 10% gain in 2023 and +69% 5-year return generated by the large cap S&P 500. European small cap indices have also been weak with the MSCI Europe Small Cap declining 6% in 2023 and generating an +8% 5-year return (in USD).[i] As a result of this significant underperformance, investors have begun expecting mean reversion combined with low valuations to drive outperformance for small-caps. In the past month, I have seen headlines like “Small Cap Funds Are More Promising Than They Have Been in Years”; “The Case for US Small-Cap Stocks”; “Big Value Available in Small Cap Stocks”.[ii] This optimism has also been apparent in conversations I have had as many investors I respect are excited for the opportunity in small-caps. However, even though most of my investing career has been focused on small caps, I think blanket optimism for smaller stocks is dangerous. Here are 3 reasons why I think it is a mistake to invest blindly in small caps: 1) Adverse selection is pervasive The burdens (regulatory oversight, competitive disclosures, quarterly reporting) often outweigh the benefits of being public for small companies. As a board member of a small, publicly-listed company, I have seen these challenges firsthand. Because of the unattractiveness of public markets, combined with significant availability of private capital, early-stage companies are going public later in their maturity cycle and small companies are going private more often. For example, the number of US-listed public companies has fallen over 50% from >8,000 in 1996 to 3,700 in 2023.[iii] As a result of these trends, the small companies that remain public are often those that do not have another option. In many cases, if a public company has remained a small cap for a long time, then it is reasonable to assume some fundamental flaw in the business that has prevented it from successfully scaling to a larger size. Simple compounding suggests that a good small company should eventually graduate from being a small cap. Because of this adverse selection, I am highly skeptical of any long-tenured small-cap unless I deeply understand why it is a public company and why its future will be dramatically different from the past (new management, new product, industry change etc.). 2) Businesses and management teams are worse It should not be surprising that smaller companies are generally weaker than their larger peers. As an example, at the end of 2022, 40% of the companies in the Russell 2000 were unprofitable and the S&P 500 has historically enjoyed double the profit margins of the S&P 600 (smaller cap).[iv] Smaller businesses are also more fragile. A $5mln unforeseen expense is a much larger problem for a company with $25mln in cash flow than it would be for most S&P 500 constituents. Compounding this impact from unforeseen expenses, smaller companies also have fewer attractive financing options during periods of duress. As a result, smaller companies face greater likelihood of a one-off event forcing a dilutive financing that materially impacts shareholder value. Smaller companies also frequently have weaker management teams. As ambitious people, it should not be surprising that CEOs tend to be higher quality at larger companies with more pay and greater resources. Furthermore, smaller companies often suffer from a lack of management depth, leaving them far too reliant on one or two key executives. The reliance on key personnel materially increases the risk of smaller public companies as outside investors will not receive any advance warning of their departure. Executive turnover can remove critical knowledge and irreplaceable skills, seriously wounding a small business. 3) Price discovery is unreliable Active investment depends on finding undervalued companies with the belief that market participants will eventually recognize and correct that undervaluation. However, recent trends have damaged the price discovery process in small caps. The increasing prevalence of passive index funds means that a large portion of a company’s ownership is not comprised of investors who have an opinion on a company’s fair value. At the end of 2022, passively managed strategies had increased to 46% of the US equity market, compared to 22% at the end of 2012. Furthermore, actively managed mutual funds have experienced $2.3 trillion of outflows from 2013 to 2022.[v] Companies with high passive ownership have fewer independent analysts assessing their value. Therefore, their share prices are more influenced by macro factors including investor risk tolerance, sector fund flows, and index inclusion. As a result, individual company share prices can often be buffeted by factors well outside of their control and any mispricing can take longer to correct. Small caps have been heavily impacted by these trends as they have the largest percentage of the company owned by passive investors.[vi] In small cap, this price discovery challenge has been exacerbated by the decline of sell-side research. As trading commissions have continued to decline, investment banks have invested fewer resources in quality research, especially for smaller companies with low trading liquidity. As a result, there are fewer sell-side analysts to help investors appropriately value small companies. As a result of this lack of price discovery, my experience is that small caps generate long periods of underperformance followed (hopefully) by massive outperformance over a very short time. This persistent negative feedback causes significant discomfort for most investors, even when their small cap investments end up generating strong returns. While carefully chosen small caps provide the potential for substantial returns, I believe it is critical to remember the structural headwinds that make this asset class difficult to invest in. A superficial approach to small cap investing is likely to generate a portfolio filled with subpar companies who remain undervalued longer than most investors are willing to wait. This is for informational purposes only and does not constitute investment, financial, or other professional advice. Nothing contained above constitutes a solicitation, recommendation, endorsement, or offer to buy or sell any securities or other financial instruments. The information above is of a general nature and does not address the circumstances of any particular individual or entity and one must evaluate the merits and risks associated with the use of any information. [i] Data from Bloomberg 10/25/2018-10/25/2023; 12/30/22-10/25/23 [ii] Barrons, 10/6/2023, https://www.barrons.com/articles/small-cap-funds-buy-3f836365; BNP Paribas 9/29/23- https://viewpoint.bnpparibas-am.com/the-case-for-us-small-cap-stocks/; ETFTrends.com 10/19/23- https://www.etftrends.com/etf-building-blocks-channel/big-value-available-small-cap-stocks/ [iii] https://www.cnn.com/2023/06/09/investing/premarket-stocks-trading/index.html; https://www.yardeni.com/pub/sprevearnmar.pdf [iv] https://am.jpmorgan.com/us/en/asset-management/adv/insights/market-insights/market-updates/on-the-minds-of-investors/is-there-an-opportunity-in-small-caps/ [v] https://www.ici.org/system/files/2023-05/2023-factbook.pdf; p. 22; 48 [vi] https://www.etf.com/sections/features-and-news/passive-funds-ownership-us-stocks-soars#:~:text=The%20report%20noted%20that%20stocks,midcap%2C%20value%20and%20dividend%20funds.

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