Investing in Small Caps

In Spanish they are often called small capitalisation companies.

What is a small cap?

The classification is by market capitalisation (market cap):

Why can it be profitable?

Historically, small caps have had multi-year cycles: sometimes they outperform large caps and sometimes they underperform.

The current cycle, with more than 10 years of underperformance versus large caps, is especially long; at any time it could reverse and favour those who have selected well.

Market inefficiencies

• Little known: many have no analyst coverage, which creates more valuation inefficiencies.
• Liquidity: large investors often cannot invest because of size; the best opportunities tend to be more illiquid.
• Low free float: management teams often control a large share of the equity; in many cases they have no interest in promoting the share price in the short term.
• Secondary markets: many list on AIM (UK), BME Growth (Spain, formerly MAB) or OTC (US), with less oversight and more cases of fraud.

What to analyse

• Solid financial health and stable cash flow generation.
• Growth levers and competitive position (organic growth, market share).
• Some form of MOAT (unique product or service, or lower-cost operator).
• Management team: value creation, capital allocation, track record. Very important. Alignment of interests with shareholders, more so than in other segments.
• Auditor: preferably one of the Big 4 (not a guarantee).

How inefficiencies can be corrected

• If the company is quality, it will grow in market cap, with more liquidity and appeal to institutional investors.
• If it is undervalued, it may be subject to a takeover bid or tender offer / MBO by management to take the company private after having funded its growth.

Practical tips

Avoid small cap ETFs as a general rule

ETFs tend to give more weight to companies with higher volume (more liquid), not to those with the most growth potential; the most illiquid – sometimes the best opportunities – have very low weight.

Moreover, many indices include low-quality companies: in the Russell 2000 (the US benchmark) almost half of the companies lose money, compared with less than 6% in the S&P 500 or ~14% in the Russell Mid Cap.

The Russell 2000 concentrates many small companies that list mainly to fund losses through secondary offerings.

Avoid teams without “skin in the game”

The team should act in the interest of all shareholders; having “skin in the game” is almost essential.

Look for companies with expansion potential

One of the catalysts that often works best is expansion (new product or new region), whether organic (CAPEX + OPEX) or inorganic (acquisitions).

In early stages it may be a small % of sales; in the notes to the financial statements you can see if it is working. The market often takes time to reflect it in small caps until the share of sales is meaningful.

Pros and cons