Look to small caps for big returns

It pays to find an undiscovered, undervalued company, but analyzing the fundamentals of every potential opportunity would take an incredible amount of time, much of it wasted.

It’s critical to apply filters on where you look for opportunities in order to make the best use of limited time and energy.

An efficient market is one where share prices accurately reflect a company’s true value and are therefore considered fair. By the same token, inaccurate company valuations and lack of information or understanding lead to unfair share prices and an inefficient market.

Small-Cap Stocks

Look for established and profitable companies under the radar of big investment firms and analysts because they don’t meet prescribed thresholds, such as market cap or company size.

These companies aren’t widely followed or fully understood by the market. Many small-cap stocks fall into this category.

Despite the fact they are relatively unknown, their impressive growth records, cash reserves and customer bases can make them a bargain haven for global players looking to expand product portfolios.

Small-Cap Contrarians

Being a contrarian investor means you swim against the tide of mainstream investment opinion. Narrow down the market by applying contrarian thinking to a particular industry or geographic segment.

The small-cap technology sector has been in the doghouse since the tech bubble burst in 2000, and unable to attract investors back because companies have had difficulty explaining their businesses to investors and regaining trust. That makes it a great hunting ground for potential opportunities.

That being said, momentum is once again building in the tech sector. Economic pressures and aging populations mean governments and companies are being forced to become more efficient and adopt high-tech software and infrastructure solutions to work smarter, not just harder.

Market data shows conventional money is now returning to the sector, but if the tech sector is on its way in from the cold, why should a contrarian stick around? Because the small-cap end of the technology sector still holds opportunities.

When a sector returns to favour, the money first flows into the larger, stable, bluechip companies first. In the case of the technology sector, these are companies we’ve all heard of—IBM, Google and Facebook.

Canadian Small-Caps

Let’s take two examples of small-cap Canadian technology companies. In each case, their intrinsic value was much greater than their market value since both were acquired at significant premiums to their share prices (see “Good returns,” below).

GOOD RETURNS ON CANADIAN SMALL CAPS

	Average share price prior to acquisition announcement*	Acquisition price	Return
Gennum Corporation	$6.97	$13.55	94%
Zarlink Semiconductor	$2.10	$3.98	90%

*For Gennum: average closing price from January 24, 2011 to January 23, 2012.

For Zarlink: average closing price from July 20, 2010 to July 19, 2011.

Source: S&P Capital IQ

Gennum Corporation (TSX:GND) designed innovative semiconductor solutions. The company sold cutting-edge products that enabled multimedia and data communication sharing with complete signal integrity.

Semtech Corporation (Nasdaq:SMTC) announced it planned to acquire Gennum Corp. in January 2012, and the acquisition was completed on March 20, 2012.

Zarlink Semiconductor Inc.(TSX:ZL) also designed semiconductors. Established in the early 1970s, the company went through a shaky evolution before emerging a successful manufacturer of communication and medical semiconductor technology.

As a result, it was bought by Microsemi Corporation (Nasdaq:MSCC) for $3.98 per share in September 2011. The acquisition was completed on October 13, 2011.

These examples clearly show the returns that come from ignoring crowded marketplaces and finding inefficient but promising pockets of the market.

David Barr, CFA, is the Chief Investment Officer of PenderFund Capital Management.