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Who the Cap Fits: Capitalizationism does not Pay

This week in Alrroya Aleqtissadiya, the United Arab Emirates (UAE) business and financial daily, I make a case for the portfolio merits of smaller cap stocks, which are often overlooked by investors.

Yes, you guessed right. There is no word like ‘capitalizationism’. You will not find it in the Merriam-Webster, Oxford or Collins dictionaries. I made that tongue-twister up. I was searching for a word to describe the discrimination that companies outside the stock market Premier League suffer from the media, brokers, analysts and investors. I came up with nothing. But the subject is dear to me and I did not want to abandon it for want of a ready-made name. So I improvised and cobbled that mongrel word together. Bear with me.

As the name implies, these stocks are primarily defined by their market capitalization. Due to differences in national markets, one country’s stock exchange’s large cap stock may be classified as a small cap in another, and vice versa. Therefore, I have selected a market capitalization falling in the lowest 25% on the listing exchange as an arbitrary normalization cut off. Every heuristic, like this bottom quartile categorization, will, by definition, be imperfect but it serves for our purposes.

Other than that, I would identify them by describing what they are not. They are not the companies you read about everyday in the Business Section, their CEOs are almost never invited to give keynote speeches at primetime conferences, they are rarely nominated for glitzy best-this-best that awards and their products and services are almost never advertized in glossy full page ads. Quietly going about their businesses and staying out of the news, these companies are the country cousins of the Stock Exchange’s red carpet stars, typically heard from only once a year, when they announce results then slinking back to their anonymity.

On the market, they have lower liquidity and as a consequence experience more volatility. To lock-in the self-fulfilling prophesy that these stocks are perennial shadow dwellers, they hardly receive equity analyst attention, making it even harder for them to exit the leap-of-faith category in investors’ portfolios. Compounding the challenge these stocks face, there is a dominant fallacy that the only type of research they require is on the individual companies themselves. Nothing could be further from the truth. To gain wider acceptance, both academic and sell-side research also needs to cover the broad category as a viable investment class offering competitive returns for the risks investors bear for buying them.

There are three compelling reasons why these overlooked stocks deserve a second look by investors seeking to improve their portfolio efficiency. These are beneficial diversification, secular potential and bargain opportunities.

But first, it is critical to disabuse one’s mind from the notion that a smaller capitalization equates to a shaky business model. This is untrue. Second, it is necessary to distinguish between, on the one hand, the investment policy segmentation constraints that limit the ability of fund managers to invest in these stocks for market based reasons, such as liquidity, index inclusion or free float, and on the other, objectively sanctioned analyst research on the surplus-cash generating potential of these businesses. Finally, the label ’small cap’ is not a verdict on the competence of a company’s management. In fact, the interests of most managers of these companies will be better aligned with those of shareholders as they are often still in the founding team-manager stage.

Since most investors’ predominant portfolio exposure is to larger-cap stocks, adding smaller capitalization stocks can improve risk diversification. In an October 2008 paper, Small/Mid Cap Investing: Thinking Outside the Small Cap Box (October 2008) – Goldman Sachs Asset Management, Goldman Sachs Asset Management advised clients that:

In any given market cycle, environments which favor large cap equities do not always favor small cap equities, and vice versa, therefore, having an allocation to both asset classes lowers overall volatility and smoothes investment returns over time.

An intelligent mix across the capitalization spectrum offers investors better protection from the bumpy ride that a turbulent economic environment brings.

Another point in favour of the smaller capitalization segment is that they are far more likely to have a specialized business focus. This permits investors the choice of self-determination regarding exposure to sectors of the economy where they see long term growth prospects. Generally, smaller capitalization firms pay greater attention only to niches where they have significant competitive advantages.

In contrast, much bigger companies are likely to chase diversified revenue streams just to stay on the same spot and maintain past rates of growth.  Moreover, a positive change in market share will have a more noticeable effect on these companies’ profitability than the same change in a bigger company.

Finally, because they enjoy less research coverage from analysts and lower ownership by big money managers, they are more likely to trade at attractive valuations. Typically, they trade at a discount to larger capitalization companies in the same sector. In a recent interview, Rob Feldman, portfolio manager of the Select Global Small Cap Fund – Fidelity International at Fidelity, the fund giant, pointed out that ‘they offer some of the best opportunities for purchasing mispriced securities at a discount, thereby increasing the return potential.’

When it is all said and done, smart investors are looking to balance risks with returns. Arguably, smaller capitalization stocks can offer just that homeostatic quality to a portfolio containing large cap stocks. Many of today’s stock market champions were once small cap stocks. Despise not the days of small beginnings. Invest without prejudice.

The original article can be read here on the Alrroya Aleqtissadiya website.

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