The year 2023 saw significant stock market gains worldwide, but for anyone investing in European Small/Micro-cap, an invitation to the party was notably absent. Why bother trying to identify winners from thousands of small-cap stocks when you can simply invest in a few of the largest, best-known companies globally and achieve better returns?
For someone newly entering the investing scene in recent years, the question might be forgivable: „What’s the point of investing in small & micro-cap?“ With the emergence of the FANGs, then the GAFAMs, and now the Magnificent 7, who would want to invest in smaller, less-known, and often illiquid shares? Are the days of stock-picking over, and should we all just adopt a „Magnificent Seven“ portfolio? We strongly believe that the „Small Cap Effect,“ first documented by Fama & French in the 1970s, remains extremely important. Small companies can grow faster, tend to be less hindered by bureaucracy and inertia, and are often acquired by larger players seeking growth. As a result, the „small cap effect“ means that investing in small-cap yields significantly higher returns over time. In the 20 years since we launched The Argonaut Fund, it has returned 678% (net of all fees), compared to the benchmark return of 596%, and only +281% for the MSCI European Large Cap index.
Yet, at the moment, the disaffection for small/micro is on a scale we have rarely seen: small/micro, which traditionally sold at a premium to large cap for the reasons mentioned above, now sells at a DISCOUNT in terms of P/BV, P/E, and EV/EBITDA compared to their large-cap peers. Firstly, this is due to concerns that smaller companies are more exposed to rising interest rates and an economic downdraft – a conclusion that is only partly true given that many smaller companies in Europe are much less highly geared than their equivalents in the US. Secondly, there are justifiable worries about profitability and that small companies are more exposed in a downdraft. Here again, the worry may be worse than the reality: our universe of 1500 small/micro companies in Europe will probably see an overall drop in profits of around 10% in 2023, which is hardly a catastrophe, and at the moment, it looks like 2024 could see profits growing at least 15%. Either way, these concerns over the outlook for European small cap have meant that money has been fleeing the sector, and fund flows have been overwhelmingly negative for several years. By the end of 2023, all the money that had entered European small cap funds since 2012 has exited and gone elsewhere. This selling pressure has reduced many stocks to “bargain” levels: our portfolio is close to being as cheap as it has ever been, and there are many companies selling between five and ten times current year’s earnings… something that we have virtually never seen. And these are not “weak” or “sick” companies – balance sheets are strong, and business trends are generally favourable. Even if our earnings are too optimistic, then a company on 8 times earnings becomes a company on 10 times earnings… hardly a disaster.
At the moment, some companies are voting with their feet: frustrated with the fact that their stock prices have hit such low levels, every week and almost every day that goes by sees a few more companies taking themselves private – and almost always with a premium of at least 50% to the last traded price. One company in which we are a shareholder, and who is not normally very outspoken in reflections on their share price, said that their current valuation was so low as to be “insane”. The valuations are just too low, and so as a result, companies are going private… or selling out to private equity. We recently saw that a Swiss company we follow had spoken at a conference on the subject of “Why we decided to go private”. In the not-so-distant past, the subject might have been “Why we decided to go public”. Every time a company takes itself private with a substantial premium to the quoted price, this gives us what we like to call a “real-world” value to the business, rather than the value that has been attributed by an inefficient market. Certainly, over the longer term, this is not a healthy development, but with over 5000 quoted small-cap stocks in Europe, the sea is still full of fish.
We absolutely believe that our universe is full of bargains at the moment, but we are often asked “what will be the catalyst for the performance to change”. There are many possibilities: it could be new subscriptions into small cap funds (perhaps driven by new tax incentives as seen in the past), or more ambitious share buy-back plans, or private equity becoming more active in snatching up bargains. Or as above an increasing number of companies taking the decision to de-list. Most likely it would be a combination of several of these things BUT it is also worth remembering that during the GFC when small caps along with large caps took a heavy beating, between March and December 2009 while little had changed The Argonaut Fund rose 60% in 9 months. A reduction in the number of “forced” or constrained sellers is most important of all and a change in this dynamic can have a dramatic effect.
It seems to us at the moment that small/micro valuations are way out of step with reality, as is confirmed by the wave of public-to-private transactions. Whatever the next few months may bring, if you hold a portfolio of good businesses with solid balance sheets acquired at knock-down prices, then surely the risk/reward ratio is going to be in your favour over time.