The Value Shift to Microcaps

There’s a reason investing legends Warren Buffet and Peter Lynch got their start in microcaps. If the fundamentals are there, a small company will eventually have its day in the sun—and when it does the growth is often explosive.

It doesn’t take much to move the share price when you have a stock with an ultra-low market cap, a tight structure and little investment activity. And if you look closely, you can often see the signs before the moves start.

Increasingly, it looks like we’re entering this phase, as the “safe” large caps continue to not look so safe anymore, with many down over 30% YTD. The common advice to invest in stable blue chips isn’t as enticing as it used to be, whereas microcaps are looking increasingly attractive.

Changing market dynamics

Historically, the search for value has often focussed on premium large caps. This seems perfectly rational, as an established, large company is that way for a reason. They have proven products and services, often a strong moat, stable earnings and usually brand power.

These companies have been seen as unassailable in recent years; all an investor had to do was find one that looked to have a moment of being “undervalued” for whatever reason and hang on. But a lot of the success was also do to the monetary and investor landscape, as cheap debt flooded markets and technology allowed more and more investors to hop in.

What inevitably happened was a lot of money found its way into few well-known companies. The herd mentality of following each other into—and out of—investments was on full display. At the same time, passive investment funds kept buying these large companies to ensure the proper weighting in their portfolios. This created an impressive upward trajectory.

But at some point, an external shock was bound to show how overvalued these large companies are. We’re seeing that now with the tightening monetary policy, as stubborn inflation forces central banks to increase interest rates, taking away the cheap debt the market enjoyed a bit too much over the last decade and sucking money out of people’s pockets.

The search for value

To be fair, everything has taken a beating in the last year. But that’s the point, and the interesting thing is that we’re starting to see a divergence, as microcaps weather the storm better. The reasons are simple . . .

Cheap money is, at least for the next little while, gone. This is a much bigger deal than most realize as it was a large driver behind many of the tech darlings in recent years, who financed growth at all costs with cheap debt. At the same time, this is causing a lot of investors to look a bit more closely at fundamentals and value metrics.

And even with the recent declines, many hot stocks of the last couple years are still sitting on high, double-digit PE ratios and single-digit revenue growth. However, many microcaps are looking like absolute bargains.

What are microcaps?

While there isn’t a universal definition, a microcap is generally a company with a market capitalization of $50 million or less (although anything under $100 million is tiny). As this is the main requirement, there is a very wide range of companies that fall into this group.

The common critique is that many of these companies—about 90%, in fact—are not investible. There are a host of reasons, from a complete lack of a business model to a fad-chasing strategy and more.

However, the other 10% absolutely are investible. If you were to use our criteria for finding good companies in this space, you would see that there’s a growing number of companies that are in a very strong position and whose declines have been relatively subdued in relation to the larger market.

It may be that these small companies have simply gone down as far as they can. Or it may signify a new form of value asserting itself, as well as a simple reminder . . .

All big companies started small

This bears remembering because it’s as if we’ve forgotten that blue chip companies used to be microcaps.

As Peter Lynch notes in his book Learn to Earn, it has been more profitable to invest in small companies over time—because successful small companies of today become the Walmarts, Home Depots, and Microsofts of tomorrow.

In addition to the enticing promise that they may turn into a successful, large company one day, microcaps offer some distinct advantages:

They can grow much faster than large caps. They are, by design, small—meaning that when big money shows up it can move the stock price quickly, often resulting in many multiples of the original share price.

They historically outperform. Over the long term, smallcaps outperform large caps, although with much more volatility. This is especially true in high inflation environments, as the more established a company is the harder it can be to adjust for inflation.

They are undiscovered—especially in this environment. Microcaps have already seen their major decline. And now, they are presenting one of the best bull cases around. If you can find them.

Getting positioned

Unless we see a dramatic, sudden shift in the economic climate, we expect this opportunity to continue—and become even more apparent.

The secret is to make a move before everyone else catches on. While market fundamentals have felt missing in recent years, they have a way of re-asserting themselves. We are seeing this now, with the constant drawdown on large companies whose business model is dealing not only with the high inflation environment but the discovery that many of them are overvalued.

Meanwhile, there are good, money-making and growing microcaps out there that are well-positioned to take advantage of what could be a slingshot effect as value shifts from the large to the small.

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