Ravaged small caps may offer opportunity

Small caps fell harder and faster than large cap stocks in 2008. In fact, the definition of small cap itself is in question as valuations have plummeted to extreme lows. Yet, history suggests small caps usually have good performance during the early stages of a stock market recovery.

A report released by Merrill Lynch on Tuesday outlined just how drastic the decline in the small cap universe is, by creating a rebalanced simulation of the primary small cap index, the Russell 2000.

“Given all of the volatility in the market and the sharp decline in stock prices, we took another look at what the Russell indexes would look like if they rebalanced based on January 31, 2009, prices,” wrote Steven DeSanctis, chief small cap strategist for Merrill Lynch. “We estimate the top end of the Russell 2000 should be below $1.5 billion, with the weighted-average market cap standing at $633.0 million. Stocks under $500 million should see their weight rise to almost 42% versus 35.3% currently, and stocks under $10 million should weigh in at 34.0% versus just under 28% currently.”

That’s a decline of more than $2.02 billion on the top end market cap of the index. The decline in market cap on the index member is even more staggering, falling from $59.7 million to $3.6 million.

In both Canada and the U.S., small cap stocks have fallen much farther than large caps. It’s precisely for this reason that some portfolio strategists are suggesting an incremental uptake in small cap allocations. Small caps tend to take a bigger beating on the way down, but have greater growth potential on the upside.

“We just had a due diligence [meeting] with our underlying small cap manager. He is seeing companies that are very solid from a fundamental basis and is seeing historically compelling valuations,” says Stephen Lingard, director of research for Franklin Templeton Managed Investments Solutions and co-lead portfolio manager for the firm’s Quotential Program. “These things get beaten down so much, lo and behold, they start being priced like an ongoing concern, and they get a bigger bounce in performance as you near the end of the recession going into the recovery.”

Lingard points out that data from the U.S. Ibbotson Small Cap Index shows that, in each of the last 10 bear markets, small caps have had tremendous performance on the six to 12 months coming off a stock market bottom.

In his view, it rarely has anything to do with the fundamentals of the companies in the small cap sector but, rather, with just how cheap their valuations are.

“Given how far things have fallen, you can have stocks in this sector trading at five times earnings, so as we get towards the end of the recession and the market starts to sniff a recovery, it’s not that these earnings will grow double digits again, but the stocks may trade at 10 times earnings growth. You can capitalize on that multiple expansion as investors anticipate better times ahead.”

Better times in small caps may still be at least six months off, points out Allan Jacobs, director of small cap investments at Sprott Asset Management and involved with the management of the Sprott Small Cap Equity Fund and Sprott Small Cap Hedge Fund.

Jacobs, the 2006 Morningstar Fund Manager of the Year and one of the country’s most respected small cap stock pickers says Canada’s small cap sector is facing exceedingly difficult conditions.

“At the end of the day, the credit crisis is getting worse by the day, and small companies need money. I think the credit crisis has had an even bigger impact beyond companies that need money,” he says. “When the risk premium on stocks goes up, people want to have more liquid stocks. Small caps aren’t illiquid, but they are a lot less liquid than large caps. I believe a lot of their devaluation wasn’t so much a flight to quality as a flight to much greater liquidity.”

Small caps have been faring much worse than the broader large cap markets for a number of years now.

“If you look at the last few years, the disparity is quite extreme. The small cap index is 10% behind the TSX Composite for [the last] five years — that’s 10% per annum,” he says. “The cycles of outperformance of small caps versus large caps have tended to run roughly every four to seven years. Historically, they have had quite long periods of underperformance and outperformance.”

Right now, Jacobs isn’t willing to say that small caps are about to hit an outperformance cycle.

“This is an extremely tough environment. To say the outlook for earnings is choppy might be an understatement for the first six months of this year,” he says.

There are flickers of better returns, particularly in the gold sector, which weren’t there at the worst of the downturn in the late fall. Jacobs says the run-up on gold prices has allowed large cap gold players to secure financing and pick off small competitors who have seen their valuations drop. He says some gold small caps could see 30% to 40% premiums being offered during an expected round of new mergers and acquisitions.

“You don’t have to be a gold bull to think it’s a good environment for gold stocks,” he says. “Costs for gold producers are falling, and valuations on some of the small caps got to very low valuations. Now you’re seeing a big catch-up. We’re seeing that sector outperform quite a bit,” he says.

Jacobs was able to pick up some very cheap gold stocks during the fall, which, in his view, were irrationally underpriced due to risk aversion. It gives him confidence that the broader market is overlooking value in the sector.

“I bought one gold stock at 8 cents a share in December. At the time, people started to question what’s wrong with the mine if it’s trading at that price. It hadn’t done anything different than the other companies,” he says. “People just assumed based on its price something was wrong with the mine. I find that’s the mindset when investors get bummed out. Now it goes up 50%, and the same people are saying it’s a good value, and somebody will likely take it over.”

Jacobs’s example points to how stock selection can be key to adding value to this area. It’s a reason that Lingard and his team chose an active mandate for their small cap exposure.

“Preference is with an active manager because they can protect better on the downside. Someone like Bissett Small Cap Fund has a very strong track record of capital preservation. In fact, we’re maybe being a little early in allocating money to that fund knowing that capital preservation is paramount to that mandate,” he says. “In the end, it may lag an index on the upside, but we’re happy to get even 70% to 80% of the upside, knowing that that protection is in place.”

Jacobs emphasizes that the small cap sector in Canada is a minefield right now. For the first time in his career, he actually has short positions in his fund.

“I’m 72% net long, which means I’m basically saying be careful. Don’t be close to fully invested because there are too many potholes out there,” he says. “All small cap stocks are dirt cheap. There are many stocks down more than 90% that aren’t going to recover in a hurry, or may be out of business because their debt will kill them. You don’t want to be rolling the dice and buying those companies because things could be getting worse, not better.”

(02/18/09)