Dotcom 2.0 for Small Caps…

Dotcom 2.0 for Small Caps…

13 Jul, 2023 | Stock Insight

Bank of America Merrill Lynch (BofA) recently published a research paper showing that small cap stocks are now trading at a 20-year low versus their large-cap peers. In fact, the only other time in the last 50 years that small cap stocks were this cheap relative to large companies was during the dot-com bubble surrounding the year 2000.

Is This Dotcom 2.0 for Small Caps?

They currently trade at a 30% discount to their-long term average, or for the finance nerds, 2 standard deviations below the average since 1979. Does this signal a huge opportunity for investors over the next few years?

Relative Forward P/E: US Small vs. Large-Cap

What’s a Small Cap Stock?

The definition varies a little between sources, but a small cap (short for capitalisation) stock usually has a market capitalisation (that is, shares outstanding times the share price) in the range of $250 million and $2 billion (for example, Forbes says $300 million as a minimum, whereas Investopedia says $250 million). It’s worth remembering that while this might be small for a company listed on a stock exchange (particularly in the United States), they’re still much, much larger than your local neighbourhood store. Many will have sales each year in the millions (or even billions) of dollars!

What’s So Special About Small Caps?

Some investors focus almost exclusively on small cap stocks, and for good reason. They are often underfollowed by the investment community and have very little ownership by large funds and institutions. Because they are so small, investors with a large amount of money (think superannuation funds or big money managers) can’t invest enough to make an overall difference to their portfolios. For example, according to its website, AustralianSuper currently has more than $230 billion in assets under management. Investing in a company that has a market cap of just $300 million would be just 0.1% of their total investments–and that’s if they bought the whole company!

Another factor is that large investors often get their investment research from the brokerage arms of investment banks, which don’t usually provide coverage of small companies. Investment banks make most of their money from debt issues, equity raisings and mergers, and small companies don’t do as many of these–certainly not of the size that interests the global megabanks.

Because there is less research and large investors often avoid them, small caps can often be bought a lot cheaper than the larger, more well-known companies. It can also be a great opportunity to find companies that operate in a small market niche but are highly profitable. (The largest companies are not always the most profitable or necessarily the fastest-growing, but they usually have big total addressable markets). Usually, small caps will be family-owned and/or family-run companies, they won’t have much debt, and will often pay a good dividend–to keep the other family members happy!

Are Small Caps Riskier?

One thing about small companies is that they generally have more customer and supplier concentration. Businesses often start out with just a few major customers or suppliers, and if the terms of these relationships change (the company loses a customer or supplier to a competitor), it can have a huge impact on the company’s financials. They are also more concentrated in geographic regions and have less product diversification. Large companies can have several different product lines and operate in different states, countries and even continents around the world.

It’s often said that there’s a reason that these companies are still small, which can sometimes be true. There may be a limit to the size of the market, the industry may be stagnant or declining, or management may have made some missteps in the past. These can all be said of larger companies too, though!

Small caps certainly are more volatile though (academics often equate risk and volatility, but this is a topic for another day). They are more sensitive to the economy and have historically outperformed larger companies in a strong economy and underperformed during recessionary periods. This could be a big factor in why they’re trading at such a big discount to large caps today.

Good Things Come in Small Packages

There’s been almost endless talk of a recession as central banks around the world have aggressively raised interest rates. Yet this hasn’t slowed the share market, which has remained “resilient” (finance speak for it hasn’t gone down). In fact, large (popular) technology stocks have been on a tear, with the Nasdaq 100 up more than 38% just this calendar year fuelled by the recent optimism about artificial intelligence. Small caps, on the other hand, have been left behind and are now the cheapest they’ve been in 2 decades. The reversal in trends was fast and furious after the dot-com bubble. Could this be dotcom 2.0 for small caps?

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