The cheapest, least-loved asset class in markets today is small-cap stocks. There are reasons for this, but not good ones, and I think investors avoid small companies to their detriment.
The main reason that small issues are shunned is that investors have gotten bigger. By investors, I mean professional money managers. Mutual funds and hedge funds have a tendency to grow and merge as the asset mananagement industry matures and consolidates.
What happens when a fund gets bigger? It has to buy bigger stocks. A 5 per cent stake in a $50-million company can have a big impact on a small fund's returns. But a billion-dollar fund won't waste its time on a $2.5-million stake in anything. Even if that stake doubles, the position would only create a half point of return for the fund. It's not worth the fund manager's time, and he or she is unlikely to buy a larger percentage of any one company.
Retail investors used to buy a lot of small-company shares, but they, too, have changed their patterns. More and more of them buy index funds or exchange traded funds (ETFs) these days, and not many of them focus on small caps.
Private equity funds used to routinely swallow small, promising companies, but private equity isn't as trendy as it was a few years ago and, again, the funds have gotten bigger. So small– and micro-cap company shares languish even if the businesses grow and thrive.
Ironically, these companies are often especially cheap precisely when they shouldn't be–in uncertain times. There's very little economic growth in the world, and that appears to be the new normal. Even China and Brazil are slowing down. This means that large multinationals–ones that major indexes are made of and the ones the big funds and ETFs buy–will be hard pressed to grow their revenues and profits. Alcoa is unlikely to gain market share. Big banks like TD or CIBC can do little about the cash-strapped Canadian consumer and the cooling real estate market. IBM probably won't invent something everyone needs or wants (Apple still does that, but even that mighty company is showing signs of maturity).
When people say that we need economic growth to drive up stock prices, they're speaking largely about big caps. Small, nimble companies can thrive even in a slowing economy. They can introduce new products or services, or they can carve out niches in mature markets.
Take three examples that I own and know quite well, all of which trade on the TSX Venture Exchange.
Toronto-based Symbility Solutions Inc. (formerly Automated Benefits Corp.) makes software for insurance claims adjusters and has a very promising technology. The company only has about 15 per cent of the North American market, but it is clawing business away from bigger players in the industry. Its shares also appear to be a bargain–analysts who cover the company have price targets that are as much as double its recent market prices.
Loyalist Group Ltd. operates English-as-a-second-language schools across Canada. ESL for foreigners is an established industry, and it's growing, but not by leaps and bounds. Loyalist, however, is a consolidator. It's expanding at triple-digit rates, and its share price surged over the summer.
The energy business is also mature, but pockets of it are growing at astronomical rates. Athabasca Minerals produces aggregates in booming Fort McMurray, the oil sands capital, where demand for gravel and sand is enormous. The company's sales are growing at healthy double-digit rates.
Yes, these three companies are penny stocks–or close to it. But they're not like most penny stocks. They're all profitable or close to profitable, have solid business models, are easy to understand and have high levels of insider ownership. They're not junior resource or tech plays that have low probabilities of making it.
In my view, if you pick your small caps wisely, you'll do much better than the major indexes in the years to come.
Price-to-earnings ratio (trailing 12 months): 11.7
Softchoice is in transition from mostly selling other companies' software to generating recurring revenue from its own products–the holy grail of business models in technology. The stock is changing hands at about seven times its forecast cash earnings for 2013 and has generated very high total returns. Something has to give: Either the returns will fall, or the share price goes up. Bet on the latter.
90 per cent Growth in second-quarter revenue (year over year)
Entrec is a little company with a fleet of very big trucks and trailers that haul around giant pieces of equipment in the oil patch. It's already one of the largest independent heavy haul and lifting operators in the area. The oil sands are still attracting tens of billions of dollars of investment every year, so there's plenty of growth potential. What's best is that you get that growth at a value price. Back up the truck.