Small caps undervalued?

[bennycx]

Many of this board argue that there are more price inefficiency among small cap stocks compared to large caps as there are much less research analysts covering them. However in my experience most small caps I have looked at seem pretty efficient and only very few of them are truly undervalued (probably estimating 1 in 50). Furthermore one has to put in much more effort by sieving through thousands and thousands of small caps to find a gem in the haystack. Turning the typical argument around, if large caps are efficient due to hedge funds and institutions looking at them, wouldn't small caps be just as or more efficient as the only people buying them are small time value investors and insiders who actually read the whole 10Ks and Qs? Where do you find all these small cap undervalued stocks?

[Packer16]

I just look at my portfolio and most US names are small cap.  The only exceptions are GM warrants and Fiat.

 

Packer

[Guest Schwab711]

Interesting discussion. The 1 in 50 guess is probably really accurate. I'd bet at least 99% of all stocks are in a FV range at any given time (this 99% number changes dramatically depending on overall economic sentiment). So finding any undervalued stock should be a fairly rare occurrence (think of how many companies you filter out to find low-priced stocks).

 

It's not as if the majority of money in large caps is uneducated investors. Just small caps tend to be more likely to be misvalued (and thus, undervalued). Even if 1 in 50 small caps are misvalued (a huge difference from 1 in 100 large caps), that means there are at least 40-100 meaningfully undervalued companies at any given time under $1b market cap (and I'm assuming there are more overvalued than undervalued companies at any given time). There's just so many listed companies that the majority of stocks can be fairly valued and there's still numerous investing options for a value investor.

 

Edit: Somehow I do not own a single small cap stock. I have large, mid, and micro (small for OTC) currently.

[Travis Wiedower]

Turning the typical argument around, if large caps are efficient due to hedge funds and institutions looking at them, wouldn't small caps be just as or more efficient as the only people buying them are small time value investors and insiders who actually read the whole 10Ks and Qs? Where do you find all these small cap undervalued stocks?

 

To the first question, definitely not. I was recently talking to an engineer who has a sizable investment in a <$50M market cap company because he saw something about the company on the news, listened to a conference call or two and liked the story enough to invest. There are all kinds of ways that investors find out about companies. A small percentage of these do serious due diligence before buying.

 

To the second question, turning over as many rocks as possible. Investing blogs, VIC, this forum, other investors, screens, lists of insider purchases, etc. Lately I've been going through a list A-Z of every public company in Australia (obviously not all these are small caps but it gets the point across) in search of cheap companies I've never heard of.

[jawn619]

how many billion dollar market cap net nets do you see? I've found that markets are pretty efficient on most sizes, but as you get lower in market cap there are definitely more ideas trading at lower valuations.

[randomep]

how many billion dollar market cap net nets do you see? I've found that markets are pretty efficient on most sizes, but as you get lower in market cap there are definitely more ideas trading at lower valuations.

 

To add to Jawn's point. If you rate the cheapness of all stocks in the USA say, and plot it in a probability distribution function you'll get a normal distribution.  The tail at one end is what you are looking for.  Suppose one stock exists at the very end. What is the proability that stock is a large cap?  It is (all things being equal) no. of large cap stocks divided by total number of stocks. Say 1/2 the S&P 500 is large cap then it is 250/10000 or 2.5%.

 

It goes along the lines of Buffett saying he can make 50% with $1M capital.

 

[SpecOps]

Small caps also attract a lot of investors that don't think twice about value, and are more into momentum trading. This is especially true on the AIM of LSE. When a small cap's shares move up on decent news it is always a big move as momentum traders jump in. Conversely when stocks have no news for a while they just go unloved and often undervalued.

[KCLarkin]

The question assumes that any inefficiency in small caps is an advantage for smaller investors. Inefficiency usually means information asymmetry. My experience is that information asymmetry usually gives insiders and pros an advantage over small investors. Personally, I like to make bets when I have all the information (or at least the same amount of info as my opponent). Plus, I think this whole line of argument gives the EMH way too much credit.

 

I always approach small caps with skepticism based on Howard Marks' second level thinking. If everyone knows small caps outperform large caps and everyone knows they are inefficiently priced, how can they be under-priced?

 

My portfolio is almost exclusively $1B plus and I see no shortage of opportunities.

[oddballstocks]

The question assumes that any inefficiency in small caps is an advantage for smaller investors. Inefficiency usually means information asymmetry. My experience is that information asymmetry usually gives insiders and pros an advantage over small investors. Personally, I like to make bets when I have all the information (or at least the same amount of info as my opponent). Plus, I think this whole line of argument gives the EMH way too much credit.

 

I always approach small caps with skepticism based on Howard Marks' second level thinking. If everyone knows small caps outperform large caps and everyone knows they are inefficiently priced, how can they be under-priced?

 

My portfolio is almost exclusively $1B plus and I see no shortage of opportunities.

 

There are opportunities because professionals or investors with $5m or more in capital can't take advantage. There isn't enough liquidity.

 

Everyone knows this stuff exists, but few actually pull the trigger because of capital or a feeling of safety. I'd adapt the "no one ever got fired for buying IBM" to "no one ever got fired for only buying large caps". There is a significant amount of career risk to buying a small and unknown stock. No career risk by piling into popular trades.

[KCLarkin]

That is the theory but the facts don't really back it up:

http://aswathdamodaran.blogspot.ca/2015/04/the-small-cap-premium-fact-fiction-and.html

 

I'm not saying there aren't opportunities in small caps, I just don't think "inefficiency" is the reason they exist.

[randomep]

That is the theory but the facts don't really back it up:

http://aswathdamodaran.blogspot.ca/2015/04/the-small-cap-premium-fact-fiction-and.html

 

I'm not saying there aren't opportunities in small caps, I just don't think "inefficiency" is the reason they exist.

 

No, the reason to invest in small caps doesn't have to be inefficiency. That isn't the point when Buffett said he can make 50% with $1M. He said he can do it by "going off the map, way off the map".  The opportunities just have to be obscure, I have found all my gains are from:

 

1. really obscure stocks, by obscure it means that if I post it here, I will get 0 responses ( and I have done that), of course obscure stocks are almost always small caps

2. really weird contrarian thoughts (this generally applies to large caps)

[Pelagic]

I think a poker analogy works well for small caps. If you're a professional poker player you probably don't go and play for $5 or $10 bucks at the local casino, sure it might be fun but it's not really worth your time. Likewise, a fund with a couple billion in AUM is probably quite capable of finding deals in the small and nano cap space but it's not worth their time, they can't allocate enough to small cap ideas to move the needle. Just because a lot of posters here and on other value boards talk about small caps doesn't mean the market is saturated. Try telling the average investor you're investing in a stock with a market cap of 50m listed on the OTC and with a share price in cents, they'd think you're crazy, even if it's an amazing opportunity. Whether it's rational or not, people take comfort in either letting the "experts" invest for them or investing in things other people are investing in. Even on this board I have to tip my hat to those of you who find obscure companies and post them up as ideas and invest in them, blazing your own way in this business ain't easy since there is so much "conventional wisdom" regarding investing.

[KCLarkin]

I think the case for inefficiency in micro-caps and nano-caps is much stronger. Small caps (>300 M) seem pretty efficient to me.

[Packer16]

I think as you get smaller you get more potential for inefficiencies.  In the sector I look at there are quite a few firms with market caps from 80 to 300m that are pretty cheap.  In these same sectors I have rarely found anything as cheap with a market cap over a few billion.  I sold two of my largest cap stocks today as they were closer to fair value than any of my 80 to 300 million companies.

 

Packer

[dolce far niente]

I have found a few companies with cash at 80% of market cap or greater with negligible debt in Asia. Some have market cap = cash and small amount of debt. Most are below 50 million in market cap. But they have minuscule trading volume so it's hard to build a sizeable position for most fund.

 

I used to work for big mutual fund briefly and have a few friends in investment fund. They often apply rules such as market cap has to be at least XXX million or they have minimum trading volume. So there are enough inefficiency if you look at small cap stocks.

[Hielko]

I have found a few companies with cash at 80% of market cap or greater with negligible debt in Asia. Some have market cap = cash and small amount of debt. Most are below 50 million in market cap. But they have minuscule trading volume so it's hard to build a sizeable position for most fund.

 

I used to work for big mutual fund briefly and have a few friends in investment fund. They often apply rules such as market cap has to be at least XXX million or they have minimum trading volume. So there are enough inefficiency if you look at small cap stocks.

The flip side of that argument is that you don't need a lot of money looking at micro/small caps to remove inefficiencies. The market cap of all small caps combined is probably less than that of Apple.

[bennycx]

Problem with all these kind of "balance sheet" analysis where X% of market cap is cash and no debt is how the company is going to use the money. If it is a micro-cap it is likely that management is also the founders of the company - imagine if you were them what would you do? I would pay myself lots in salary to "extract the cash" while at the same time invest the cash in opportunities to build the business to make a name for myself. Find me a company where it is trading at market cap = cash AND where management is actively returning that cash to shareholders. That is the margin of safety I want to find

[randomep]

Problem with all these kind of "balance sheet" analysis where X% of market cap is cash and no debt is how the company is going to use the money. If it is a micro-cap it is likely that management is also the founders of the company - imagine if you were them what would you do? I would pay myself lots in salary to "extract the cash" while at the same time invest the cash in opportunities to build the business to make a name for myself. Find me a company where it is trading at market cap = cash AND where management is actively returning that cash to shareholders. That is the margin of safety I want to find

 

Well those companies are the companies that I like. And there are 4 possible things that the owner operators can do:

 

1. like you say they pay themselves egregious salary to extract cash

2. they try to expand the company and make a name for themselves

3. they sit on the cash and do nothing

4. they return the cash

 

4. - I have rarely seen, but one such owner told me that the IRS would scrutnize the company if they hang on to the cash and do nothing with it; the idea is that the IRS wants dividends paid out so they can get a cut; can someone confirm if this is true?

 

3. this is the common case, and I am ok with it because the companies that I invest in are also doing quite well minus the cash, I just expect to get the benefit from the cash either by payout or by higher stock price to reflect the cash

 

2. if that is the case is it really that bad? if you don't think the owner/operator is comptent then you shouldn't invest in the first place no matter how much cash

 

1. this doesn't make sense; lets assume the owner can do this because they own 60% of the shares of a $10M company, if he pays himself $1M bonus one year he'll get a tax hit, say his marginal rate is 40%.  His take home pay is going to be $0.6M and the market cap should correspondingly drop to $9M. So now the owner has $5.4M in company stock plus $0.6M cash or a total of $6M. If he didn't pay himself the $1M bonus he would also have $6M stock. hmmmmmm, looks like the only person that benefits is the IRS......

 

this is not to mention that the owner will no doubt face a lawsuit......

[Jurgis]

randomep, you tried to apply logic to life. you fail.  ;D

 

 

In reality, owner operators are not long-term rational. They do all kind of crazy stuff. Some out of short term greed (self-dealing), some out of ignorance or incompetence.

 

If you think this doesn't happen, just find some cash-rich micro cap companies and follow them for couple of years. You'll get enough material for a couple movies and a book. ;) Or even look through companies mentioned on CoBF.

 

IMHO, one of the most important skills in investing in micro caps is evaluating management. Although I guess that's important in large caps too, but in micro caps you have much less info. In large caps you can usually find various mentions, interviews, etc. For micro caps you might have to go and talk to management yourself.

 

There are people who can do this well. For me it's a crapshoot. I rather invest in companies where I know management is trustworthy even if I don't get as much upside. :)

[randomep]

randomep, you tried to apply logic to life. you fail.  ;D

 

 

In reality, owner operators are not long-term rational. They do all kind of crazy stuff. Some out of short term greed (self-dealing), some out of ignorance or incompetence.

 

If you think this doesn't happen, just find some cash-rich micro cap companies and follow them for couple of years. You'll get enough material for a couple movies and a book. ;) Or even look through companies mentioned on CoBF.

 

IMHO, one of the most important skills in investing in micro caps is evaluating management. Although I guess that's important in large caps too, but in micro caps you have much less info. In large caps you can usually find various mentions, interviews, etc. For micro caps you might have to go and talk to management yourself.

 

There are people who can do this well. For me it's a crapshoot. I rather invest in companies where I know management is trustworthy even if I don't get as much upside. :)

 

Well, now that I think of it I can see you are right in a large number of cases. Some owner operators are irrational or overly greed or incompetent. I've screened through a large number that have decent numbers at first but appear to be such after further digging. But as Ben Graham (or someone else said) it is pretty easy to detect such problems simply looking through a few years of financials. But to say it is a crapshoot for you, maybe you got burned a few times by not doing your due diligence. But once you do your due diligence some good owner operators will come up. Then I am sure you will pass :)

 

Some examples (and my memory for the exact facts isn't the best around):

 

- two really cheap HK companies, but gave up after reading that one is accused of bribary or something shady; another I think served some time in jail and was accused of threatening to break an employee's leg

- BH, the way Biglari comes across and they way he compensates himself, is a perfect example of an owner/operator who I'd stay away from. He is too hard to analyze; and seeing the lively debate on the BH forum its definitely a 50/50 risk reward, I don't invest with such crappy odds.

- IEHC, I've met the owner and his son, and I saw on their shop floor a 90yr old woman who worked there for 60yrs; I doubled my position based on that visit; I can't imagine a more trustworthy owner/operator; i wrote about my trip here http://bovinebear.blogspot.com/search/label/IEHC

- McRae industries, I met several of their family, they seem as american as apple pie; and I got the impression that they feel an obligation to their community, which I am not totally thrilled about, but they are not greedy self serving people; I am holding onto my position for now

- Installux: I'd like to visit them but it would be too costly going from US to france, plus there is no guarantee he'll communicate with me in english; but he does publish quarterly letters talking about his business, I get a good enough feel from that; I got a position

 

The latter 3 companies I've owned for at least 2 years, their stocks have done great, therefore their cash position relative to stock price has come down, exactly what I hoped for.....

 

Now as you elude to, with larger companies it is easier to read the CEO? is that so? Well I worked for John Chambers of Cisco, I so wanted to trust him, he had such good press, but it is all PR. I am surprised no one has called him the worst CEO over the last 15yr period of a major company.

 

I have seen so many other high profile CEOs that are all slick and polished, they are like politicians.

 

 

[Jurgis]

randomep,

 

Thanks for a thoughtful reply. :)

 

As I said, there are people who can deal with micro caps and their management well. And it looks like you are one of them. :)

 

Personally, I am not interested in visiting the companies and talking to management. So I'd rather put money into FFH/BRK/Liberty though these might offer lower expected returns.

 

Sure, there might be exceptions and I may buy microcaps. I never say never.  8)

 

I also agree with your point that evaluating big cap CEOs is wrought with risks too.

 

Take care.

[Tim Eriksen]

I think a poker analogy works well for small caps. If you're a professional poker player you probably don't go and play for $5 or $10 bucks at the local casino, sure it might be fun but it's not really worth your time. Likewise, a fund with a couple billion in AUM is probably quite capable of finding deals in the small and nano cap space but it's not worth their time, they can't allocate enough to small cap ideas to move the needle. Just because a lot of posters here and on other value boards talk about small caps doesn't mean the market is saturated. Try telling the average investor you're investing in a stock with a market cap of 50m listed on the OTC and with a share price in cents, they'd think you're crazy, even if it's an amazing opportunity. Whether it's rational or not, people take comfort in either letting the "experts" invest for them or investing in things other people are investing in. Even on this board I have to tip my hat to those of you who find obscure companies and post them up as ideas and invest in them, blazing your own way in this business ain't easy since there is so much "conventional wisdom" regarding investing.

 

Having focused on micro caps for more than a decade, only rarely has the share price been in cents. Most US otc stocks priced in the cents are crap.  Of course there are some exceptions where there was a low share price and share count.     

[bennycx]

Problem with all these kind of "balance sheet" analysis where X% of market cap is cash and no debt is how the company is going to use the money. If it is a micro-cap it is likely that management is also the founders of the company - imagine if you were them what would you do? I would pay myself lots in salary to "extract the cash" while at the same time invest the cash in opportunities to build the business to make a name for myself. Find me a company where it is trading at market cap = cash AND where management is actively returning that cash to shareholders. That is the margin of safety I want to find

 

Well those companies are the companies that I like. And there are 4 possible things that the owner operators can do:

 

1. like you say they pay themselves egregious salary to extract cash

2. they try to expand the company and make a name for themselves

3. they sit on the cash and do nothing

4. they return the cash

 

4. - I have rarely seen, but one such owner told me that the IRS would scrutnize the company if they hang on to the cash and do nothing with it; the idea is that the IRS wants dividends paid out so they can get a cut; can someone confirm if this is true?

 

3. this is the common case, and I am ok with it because the companies that I invest in are also doing quite well minus the cash, I just expect to get the benefit from the cash either by payout or by higher stock price to reflect the cash

 

2. if that is the case is it really that bad? if you don't think the owner/operator is comptent then you shouldn't invest in the first place no matter how much cash

 

1. this doesn't make sense; lets assume the owner can do this because they own 60% of the shares of a $10M company, if he pays himself $1M bonus one year he'll get a tax hit, say his marginal rate is 40%.  His take home pay is going to be $0.6M and the market cap should correspondingly drop to $9M. So now the owner has $5.4M in company stock plus $0.6M cash or a total of $6M. If he didn't pay himself the $1M bonus he would also have $6M stock. hmmmmmm, looks like the only person that benefits is the IRS......

 

this is not to mention that the owner will no doubt face a lawsuit......

 

I agree with you on 3. Some companies like these I invest too.

 

On 2. I usually mean they would invest in random new opportunities which might or might not work. This becomes like VC investing style and you can't predict what would happen so normally I would pass.

 

On 1. taking into account what I said above, that is why they pay themselves salary. Because they do not know whether their company would fail going into this "new" venture. By paying salary they can extract the cash. Normally they would also be selling stock/issuing stock to themselves at the same time but at a gradual pace in order not to spook the markets.