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small caps. BIG OPPORTUNITIES?

Small caps are listed companies with market capitalisations of less than R1 billion. Given their size, they are often unknown and overlooked. And, as analyst WIM MURRAY explains, therein lies the opportunity.

Small caps can offer very attractive, long-term investment prospects. Nimbly sized, they enjoy scope to aggressively expand market share and develop new products. They have a long runway to grow profitability. Management can also use sensible acquisitions to add meaningful value to shareholders. 

In rare instances, we get to invest in undervalued companies operating in niche markets with few competitors. These small cap gems can generate exceptional long-term returns for early investors.

Because the large brokerage firms do not widely cover the small cap sector, company management are often generous with their time and eager to discuss their companies. Analysts willing to invest time and engage with management often achieve greater insight. This informational edge can help small cap investors profit from undervalued gems.

But small caps investing is an obstacle course with many pitfalls. As with all investments, the quality of company management is critical. But ethical and hardworking stewardship of invested capital is even more essential in small companies. 

A key feature of small caps is founders or managers with sizeable shareholdings. Skin in the game is unquestionably positive for minority shareholders. Except when combined with a sense of entitlement and contempt for corporate governance. Excessively generous bonuses or poorly disclosed related-party transactions could easily become the norm if not aggressively challenged.

Small cap stocks are often thinly traded. Building an investment holding may prove deceptively easy. But you must have the time horizon and temperament to marry the stock. When the sirens of deteriorating business dynamics sound, the dangers of poor liquidity become clear: selling is only possible at depressed prices. 

Price volatility therefore abounds for smaller companies. Meaningful dislocations between price and intrinsic value occur sporadically. For proof, look at the small cap index over the past five years to get a sense of how depressed valuations can become. The index has declined 36% in 2020 already and is down 50% over five years.

So how can investors benefit from the prevailing price opportunities while managing the key risks of small cap investing? Foremost is to be incredibly discerning. Illiquidity by its nature makes small caps long-term investment propositions. Rigorous analysis, high conviction and assessment of management’s quality and ethics are paramount. 

Investors must also clearly appreciate and stand willing to endure the inevitable price volatility. Moderate position sizing can mitigate the valuation impact and enable investors to tolerate bouts of volatility. 

At Foord, we strive to capitalise on attractive investment opportunities across the spectrum of the investable universe. Undervalued small cap stocks have consistently formed part of our investors’ portfolios. And they have, in the main, delivered outsized returns over very long periods. We are continually assessing the small cap opportunity set for our investors.

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