Small caps get big returns

While you can be richly rewarded for unearthing an undiscovered, undervalued company, analyzing the fundamentals of every potential opportunity can be extremely time consuming.

Therefore, it’s critical for value investors to apply filters and screens on where they look for opportunities in order to better allocate 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 hence an inefficient market. Most value investors focus their search on inefficient parts of the market.

Here are two of the ways to take advantage of inefficient markets:

• look at small-cap stocks, or
• be a contrarian investor.

Small-cap stocks

I 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.

As a result, 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 make them a bargain haven for global players looking to expand their product portfolios.

Being a contrarian investor means you swim against the tide of mainstream investment opinion. I narrow down the market by applying contrarian thinking to particular industry or geographical segments. In other words, I buy out-of-favour stocks at discount prices. And then I cover my ears and block out the headlines.

Small-cap contrarians

The small-cap technology sector is ripe with opportunities. The 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. It’s for these reasons I find 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. It took five years for the NASDAQ to rebound to around 2,800 from its post-boom low point of 1,100 in October 2002. However, it took less than half that time for it to rebound after the October 2008 crisis—from around 1,270 in March 2009 back to 2,800 in April 2011.

But if the tech sector is on its way in from the cold, why is the contrarian in me still sticking around? Because the small-cap end of the technology sector still holds opportunities. As the NASDAQ Composite shows, technology has been ignored for a very long time.

The general trend when a sector returns to favour is for money to flow 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.

As the share prices of these companies rise with increased interest, investors begin to look at mid- and small-cap companies to find the next big winner.

Canadian small-caps

Let’s take two examples of smallcap 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.

It had also won multiple awards for advances in high-definition broadcasting. 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 found itself the target of an unsolicited takeover by Microsemi Corporation (Nasdaq:MSCC) in July 2011 for $3.35 per share.The Zarlink board rejected the offer and invited bids from other potential candidates. Microsemi increased its offer to $3.55 and the Zarlink board eventually accepted an offer of $3.98 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. Currently the majority of capital is flowing into asset classes offering high yield and low volatility, which is putting pressure on prices.

David Barr, CFA, is the Chief Investment Officer of PenderFund Capital Management, a value-based mutual fund company in Vancouver. He also runs the top-quartile ranked(GlobeFund) Pender Small Cap Opportunities Fund.