Investing in small-cap stocks can be a rollercoaster ride.

Aside from their ability to generate outsized returns, Micro and small caps tend to be more volatile, experience larger downturns, and have lower liquidity than their larger counterparts. And it is times like now when the markets are unpredictable, that can reveal an investor’s true risk tolerance.

Overall, sentiment was quite negative towards equities during 2022 and has been this way again in the past month. In fact, a recent survey by JP Morgan suggested that people were shying away from equities altogether, with just 29% of clients planning to increase their equities exposure in 2023, the lowest in several years.

Moreover, it’s been a particularly tough time at the smaller end of town. For reference, the S&P/ASX Emerging Companies Index is down 24.3% over the past 12 months, and 26% from all-time highs in January of last year.

However, it is at this exact time that fortunes can be made. There’s a plethora of analogies that famous investors tout to help everyday shareholders withstand the natural vicissitudes of the stock market:

• The big money is not in the buying and the selling, but in the waiting
• In the short run, the market is a voting machine but in the long run, it is a weighing machine
• The short term is unknowable, but the long term is inevitable.
• And so on…

Those with enough experience and equanimity know that history is on your side if you’re a patient, long-term investor. So if you haven’t adjusted your allocation to small caps, now might be the ideal opportunity.

The stock market has good years and bad, but don’t let short-term dips shake your faith in the long-term trend: upwards. Despite this being a well-known fact, it never ceases to amaze us how many investors panic during so-called “bad” years.

Taking a closer look at historical share returns in the U.S. and Australia may provide some much-needed encouragement. Over nearly two centuries of research, it has been found that in the U.S., the chances of a positive return in any given year are at a solid 71%. Meanwhile, in Australia the statistics are even better.

During the 147 years of trading data available on Australian exchanges, the market has risen for 117 years and declined for only 30 years. That means 79.6% of the time, the market rises. While there may be a decline on average once every 5 years on average, it’s important to keep in mind that over the past 147 years, the market has averaged a return of 10.8% per annum, including dividends and share price growth.

And since the introduction of the Accumulation Index in 1979, the data points to an even stronger outcome. Over the past 43 years, the market has risen by an average of 13% per annum, despite some seriously scary episodes, including the 1987 stock market crash, the 1997 Asian Financial Crisis, the GFC, and the record-breaking fall caused by COVID-19.

Additionally, it’s worth noting that negative years – such as the one we just experienced in 2022 – are typically followed by a positive one. So, while the current state of affairs may seem grim, investing wisely now could pay off in the long run.

So, take a deep breath, and remember that despite the bumps along the way, the long-term trend of the stock market is upwards. Don’t let short-term fluctuations cause you to miss out on the rewards of long-term investing.

Negative market sentiment towards small-cap stocks isn’t purely related to the performance of the underlying businesses. So where does the selling pressure come from? For a start, larger funds and institutions are facing growing challenges to investing in small listed companies. As the giant super funds grow their funds under management by tens of billions of dollars, their ability to generate meaningful outperformance by investing in Australian small-cap stocks becomes increasingly tough.

The need to continually generate new investment ideas and implement those ideas encourages the biggest asset owners to focus on much larger companies. Additionally, as funds become bigger, they cannot invest in, nor continue to add to, positions in small caps in a meaningful size relative to their total portfolio. It is common for larger funds to invest hundreds of millions of dollars in one company. Most small caps don’t have the market cap to support these large investments – in order to buy a position large enough to make a difference in their fund’s performance, a fund manager would have to buy a significant share of a small cap company.

There have been multiple cases of institutions and funds unwinding exposure to small caps in the past two years (e.g. Rest Super). To adapt, some small-cap investment firms are rolling out mid-cap offerings as a means of staying relevant to their biggest clients.

This poses an opportunity for nimble investors who are able to identify and take advantage of these smaller investment opportunities.

Investing in small caps is appealing for several reasons, one of which is it’s a less efficient market. Compared to larger companies, small caps receive less scrutiny from analysts and investors, resulting in far less attention and potential undervaluation. This inefficiency in pricing means that there may be information about small caps that are not reflected in current stock prices, making them attractive to investors who are willing to do the research.

While micro-cap investing has been described as a “killing field,” we believe that there are compelling opportunities for investors who are willing to take a long-term view.

For example, Viva Leisure Group (ASX: VVA), recently reported record results and yet its share price sits more than 30% below recent highs. The Company operates health clubs (gyms) with 166 locations across Australia and owns the largest non-franchised health club brand in the country.

With H2 FY2022 providing the company’s first six months of uninterrupted trade for several years, H1 FY2023 has continued that momentum and generated promising performance. The following highlights show the business is performing very well:

• Operating earnings (EBITDA) exceeded all previous results, including all previously recorded full-year results
• EBITDA margin at 20.7% for the HY showed significant improvement, exceeding H2 FY2022 by 4.3%
• Revenue nearly doubled from H1 FY2022, with the start of CY2023 showing continued growth
• Highest net profit (NPAT) result ever recorded
• Strong Free-Cash-Flow generation, allowing the company to self-fund future growth
• Network membership now over 343,000 (growing organically each month), representing  2% of the Australian population aged between 15 and 69
• No sign of growth slowing due to current inflationary pressures.

The low valuation of Viva’s shares is likely driven by the stock being in ‘small-cap purgatory’ due to liquidity issues, but this is no restriction for the retail investor and we believe the company’s track record of execution makes it a compelling investment opportunity.

Another example of an unrecognised, profitable and steadily improving business is Clearview Wealth (ASX: CVW). Clearview has reported a strong financial result for the first half of 2023, with an underlying net profit of $16.3 million, which is 31% higher than the previous period. The growth was mainly driven by the life insurance segment, with a significant increase in premium income and new business. Clearview also plans to sell its managed investment business, which will result in a 40% stake in Human Financial Pty Ltd, valued at $16 million, and release $15 million of cash to strengthen its balance sheet.

Due to the strong performance, Clearview’s full-year underlying net profit after tax (NPAT) is expected to be in the range of $30 million to $32 million, excluding the Wealth Management NPAT loss of $2 million. This represents a 21-28% growth on the previous year. Clearview’s balance sheet is robust, with net assets of $476.7 million and an embedded value of $0.902 per share, including franking credits.

The company’s dividend policy remains unchanged, with a pay-out of 40-60% of underlying NPAT. The stock is currently trading at a 29% discount to its net asset per share, making it an attractive investment opportunity. With an expected earnings growth of over 20%, a price-to-earnings ratio of 11x, and a fully franked dividend yield of 4-5%, Clearview is also an attractive takeover target. The company’s strong performance and simplified business model make a takeover even more likely than in the past year when we first began covering the Company.

Investors should avoid falling into the trap of negative sentiment and instead take a closer look at the underlying businesses of their investments. Historical share returns in the US and Australia show that positive years follow negative years – the pattern is notable.

Investors should take encouragement from the wealth-building tendencies of quality businesses and remember that, ultimately, as businesses become more valuable, their share prices should follow.

Although the current mood of Mr. Market is unfavourable for micro and small-cap companies, it is crucial to keep in mind that market sentiment always turns and, when it does, small caps are likely to hit it out of the park.

Disclaimer: ASX: VVA​ and ASX: CVW are currently held in the TAMIM Portfolios.