This essay by Eric D. Wanger was originally published in a newsletter for the financial clients of the multifamily office he ran in Chicago.
March 31, 2008
If you’re very, very quiet, you can hear it, an entire universe of very small public companies crying out in the night: “Help us! Long Term Investors, come help us! Come buy our shares! We’re unloved because we’re small and cheap, because we can’t be margined or shorted easily. Many of our very small brethren are starved for cash or stuck without research coverage—but not us. We’re profitable, rapidly growing, or have great dividend yields. Many of us have cash-rich balance sheets with no debt. We’re the healthy ones. Our valuations are affordable for the first time in years. Long Term Investors come save us! Help us, Long Term Investors! You’re our only hope.”
This, my friends, is the Call of the Small. Long-investors should be greedily looking at small public companies in the U.S. Valuations have come in, timing is right, and the universe is generally unloved.
Valuations are Good
Valuations of very small firms are very good right now. Many have been dumped simply because their market capitalizations fail to meet some arbitrary limits. Silly? We think so. One way of measuring this is price to earnings ratios, the price investors are willing to pay for trailing (actual) or future (estimated) earnings. Despite earnings expectations coming down, forward P/E ratios on smaller public companies (Russell 2000) have come down significantly since the beginning of the year, more than the shares of medium-sized (Nasdaq) or large firms (S&P 500).
Small company growth is especially cheap. Some of our favorite small growers are firms like Amerigon (ARGN), ClickSoftware (CKSW), Cybsersource (CYBS) and Stratasys (SSYS). Patient long-term investors can buy the +20% growth of these cash-rich, debt-free growers for nearly half the price of only one year ago.
As prices come down, yields come up. Where can you get dividends (some north of 10%) from solid small companies—firms that are going to survive and thrive? Ituran (ITRN), Mortgage Financial (MFA), Redwood Trust (RWT) and Enerflex (EFX) are some of our recent picks. Financials? What? Yes, it’s true: Not all financials are created equal. We look at the balance sheets. You’d be surprised what you can find if you are willing to overlook the “smallness” factor.
The Timing is Good
It is popular to say that the current financial crisis is really about the repricing of risk. In our world that means that the “Equity Risk Premium” is being repriced. The ERP is an abstract concept which represents the amount equity investors demand to be paid (in the form of dividends or capital appreciation) above equivalently risky debt. (The CAPM formulation uses beta and the risk-free rate to compute ERP). The equity markets plunged during Q1 as equity investors demanded more reward for the risks they were going to take owning equities. Nowhere was this more pronounced than in the area of very small stocks. Small caps vs. large caps? Clearly, small caps have taken it on the chin.
The Space is Unloved
When a universe is hated, quality gets cheap too. Very small company stocks are clearly hated right now. And despite the prejudices against this asset class, many of these companies are cash rich, will continue to grow well and even pay dividends. Some of them represent extraordinary values trading at PEG ratios well below 1 and P/E ratios below 10 times. But it is definitely the time to look for high-quality, solidly growing small public companies. Remember, the time to invest is when they are cheap, not when they’re expensive!
Now is the time for the Long Term Opportunity Fund to put money to work. It’s the right time to answer the Call of the Small.
Do you hear it? Above the hue and cry of unemployed investment bankers hawking apples and pencils on the streets of Manhattan—it’s not some Steve Martin comedy routine, go ask Alice, it’s the Call of the Small.