Where risk paid off, Part II: Small Caps

Traditionally, small cap stocks are hammered during a bear market and are almost always on the leading edge of a recovery. The precipitous rise in small cap stock valuations has been welcome news for investors across the board, and it doesn’t look to be slowing anytime soon, small cap strategists say.

Small capss tend to have more leverage, less liquidity and clearly a smaller market capitalization than large caps, which makes weathering a downturn difficult. As a result, investors tend to abandon the asset class in search of safety.

Since the bottom of the market, the Templeton Global Smaller Companies fund has posted a near 60% return, according to its manager Brad Radin. Radin was one of the key speakers at Franklin Templeton’s Outlook and Opportunities Forum in Toronto, stressing the message that, while things have come far, small caps still offer a lot of value.

“It’s been a wonderful time to be a good small cap investor. It’s been an unbelievably great four-month stretch. The Templeton Global smaller companies fund is up about 57% since March 9, while the overall the world small cap index is up about 19%,” he says. “It’s the asset class that tends to get the maximum lift as the bear market turns into a bull market. Interesting enough, the exact same thing happened in the last bear market that ended in March ’03.’03. The following one year, the world index was about 29% in the following one year, where as this fund was up about 58% in the following one year from starting at the bottom.”

Part of Radin’s out performance has to do due with the bottom up value discipline he employs. Radin looks for cheap companies based on what they are likely to earn on a normalized environment five years into the future. As confidence has returned to the market, many of these stocks have had farther to travel from the bottom.

He says that on average small caps, particularly value names in the space are still considerably cheaper than their large cap peers.

“Whether it is price to book, price to cashflow, price to earnings or dividend yield – if you take those valuation metrics, my fund is still 30% cheaper than the MCSI world index today,” Radin says.

While many investors are making a tactical choice to enter the asset class as a whole as recovery forms, he says the long term prospects to out pace large caps remains good.

“As to whether do you want to be in the asset class long term? The answer is yes. Smaller caps perform over the long term,” he says. “Academic literature shows small caps outperform over the long term. You get more than your fair share of out performance in the early days of the bull market. Over a ten year period ending roughly now, this fund has outperformed the large cap index by over 900 basis points before fees on average.”

The Canadian story

Radin’s fund is a bit of anomaly amongst Canadian fund offerings, considering it uses traditional value method and is distinctly global in its geographic nature and focuses on traditional businesses. The Canadian small cap landscape tends to have a very heavy focus on resource and materials.

For example, even within the same firm, Franklin Templeton, there is the Bissett Canadian Small Cap fund, which in it’s own right has had phenomenal returns in the last quarter – a nearly 37% return. The fund has 31% weighting to energy or energy related stocks. Again, the small cap space in Canada has seen a huge run-up as investors become more comfortable with the downside risk of the stocks.

“If you look at our portfolio, energy services and consumer discretion stocks are where the bulk of our exposure right now. The short term outlook for energy services isn’t great with natural gas prices being depressed and the exploration and production (E&P) companies not having the capital to invest replace and grow productions. The valuations we’ve seen on the companies has been more than discounted to include that outlook,” says Richard Fortin, a small cap analyst for Bisset Investment Management. “What we’ve seen [recently] is a bounce up the bottom. Our fund was down well north of 40% at the bottom of the market. A lot of these names don’t reflect the full intrinsic value of the business.”

Investors need to keep in mind the strong correlations that resource stocks have to commodity prices. Fortin says Bissett Canadian Small Cap Fund strives to keep a lower correlation to energy prices, but it still remains sensitive.

“Energy stocks certainly have a high correlation to energy prices. If I was to hazard a guess it would be well north of 50% and probably closer to 70%. Our portfolio on average has a 55% to 60% (correlation) towards natural gas production. Whereas our peer group would be 70% correlated to natural gas production,” he says.

The leverage problem

Leverage is a big X-factor to small cap investing from here on out. In the past, leverage was a necessary pipeline for many smaller companies to grow and consolidate. With tighter credit conditions for the foreseeable future, Radin says it’s his preference to avoid leveraged balanced sheets if possible.

Refinancing and debt risk is a major issue in small cap investing. There is no guarantee that a company will be able to refinance it’s debt in the near future.

“I have strong preference for companies on net cash on the balance sheet. I own some where more than three quarters for their market capitalization in cash. I have owned some companies that carry more debt than I would like too see. The decision to buy [a leveraged] stock really comes down to individual company by company analysis,” he says. “Those companies are okay because that debt doesn’t come due for another three or four years, or in other cases they are okay because the fundamental business is so strong and they can keep paying it down.”

He adds, “Leverage is a lot more important today, than it was two years ago. Before 2008, virtually no company went bankrupt. They could almost always rollover their bank debt and do a new high yield issue. No matter how leveraged they were, there was always more debt to refinance. Man did that change in 2008. The ability to refinance became really challenging. It’s become a far more important part of analysis today.”

(07/28/09)