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.

Eric has nearly 30 years of experience as a creative and entrepreneurial professional in roles ranging from general management, team leadership and project management to technical rolls in IT, software development financial services and law. He has run business units, managed teams and delivered projects for established global enterprises and as the founder of a number of startups. Over his nearly 30 years at work, his job titles have included Board Member (public, private and non-profit), President, Founder, Chief Operating Officer, Director of Research, Chief Investment Officer, Fund Manager, Software Developer, Securities Analyst, Web Designer, Systems Integrator, Investment Advisor, Fundraiser, Consultant and Attorney. As a software consultant, cloud based, mobile app software as a consultant to one of the world’s leading electronic medical records companies (Cerner). As Chief Investment Officer and Director of Research for a startup financial services firm (Wanger OmniWealth, LLC), he developed a proprietary, risk-based holistic reporting platform for wealthy families and a set of allocation models based on it. He has developed automated trading systems for equity and equity ETF's. Between 2002 and 2013, Eric served as a portfolio manager of the Long Term Opportunity fund (small/micro-cap equities), the Alternative Fixed Income Fund (blend of exchange traded and privately negotiated debt) and as the strategist and founder (with Ralph Wanger) for the Income and Growth Fund (multi-asset class dividend strategy). Eric was a senior investment analyst at Barrington Research Associates (Chicago) covering technology and business services. Prior to that, Eric was a software, communications, and technology analyst for the Edgewater Funds, a private equity/venture capital firm with over $1 billion under management. Before joining Edgewater funds in 2000, Eric worked in Silicon Valley providing consulting, training, and software development to early-¬stage firms. Between 1991 and 1996, Eric was a principal consultant at EDW, Ltd, a firm he founded to provide software development, training in rapid software development techniques (NeXT), and systems interoperability consulting services for large multi-vendor and distributed computer networks. EDW's clients included such companies as Fannie Mae, MCI, Swiss Bank Corp (UBS), Chrysler, Merrill Lynch, Apple Computer, Stanford University, and The Acorn Funds. Eric received his J.D. from Stanford Law School and is a member of the California Bar. He was co-founder and managing editor of the Stanford Technology Law Review. Eric was awarded a National Merit Scholarship in 1981. He holds a B.S. in Mathematics from the University of Illinois at Urbana-¬Champaign and received a Chartered Financial Analyst designation in 2005. Eric lives in Chicago with his three children and a fat English Labrador retriever named Casper. He enjoys classical and jazz piano, hiking and aviation. He is an instrument rated pilot. Eric serves as a trustee for the Acorn Foundation and is active at Chicago’s Museum of Science and Industry.

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