When fund managers discuss the quality of their investments, they often praise the high margins, the high return on capital, or how durable and competitive the business is, but in the small-cap space – where many companies are still in their early stages of growth – it can be hard to find a company with a track record that exhibits these characteristics.
Does this mean it is hard to find quality small caps? Well, according to two small-cap managers, not if you expand your definition of quality.
Gervais Williams, co-manager of the Miton UK Microcap Trust, said that certain quality small-caps can often demonstrate the same resilience as their large-cap counterparts during times of stress.
He said: “We believe the real magic comes in quality small and micro-caps, which typically respond more quickly to market changes than others.
“Specifically, their listed status means they can raise additional capital to take-over indebted, but otherwise viable, businesses. This not only keeps skilled teams together but can often deliver transformational cash surpluses on recovery.
He added that it should not, therefore, be a surprise that quoted small and microcaps have a history of delivering “premium returns” compared with the mainstream indices. Indeed, over the past decade the Numis Smaller Companies ex Investment Companies index has triumphed over the large-cap FTSE 100 index.
The small-cap benchmark has made 224.6% over the past 10 years, more than double that of the FTSE 100, which has returned 105.8%.
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Source: FE Analytics
When it comes to the definition of quality, in his experience, quality small-cap companies usually can be identified by their ability to deliver outstanding customer service.
“Typically, talented individuals need to excel in order to deliver outstanding customer service,” he said. “This is often related to a management team that strives to keep individuals unencumbered by bureaucracy so they can work together towards the common purpose.
“In short, these are businesses that appear to genuinely care about their customers.”
Williams added that pricing power in smaller companies was also a very important aspect to consider.
“Ultimately, a quality business tends to command a fair price for its products, so it remains profitable even through most downturns,” he explained. “This ensures they can continue to invest in improving products for the future as well as paying a commercial wage to their staff irrespective of the market conditions.”
Matt McGeary, who manages the Eagle US Small Cap Strategy, said that investors should expand their definition of quality beyond the traditional metrics and place a bigger emphasis on things like a company’s intangible assets.
Intangible assets include things like intellectual property, software, and patents – which are harder to accurately value than financial assets or physical assets.
To determine the quality of a small-cap company, McGeary said investors should ask: “Does this company have intellectual property? Do they have patent protection? Are there network effects that they benefit from in their business? Do they invest in their people and their culture?”
“The traditional stuff matters such as profitability, cash flow, return on invested capital – but I think you have to expand it to think about the intangibles. It's not just the companies with the highest return on equity. It's not that easy.”
When looking at data going back to the mid-to-late 1990s, he observed a “massive divergence” in how much investment was going into intangible assets versus traditional investments.
“A consequence of that is you have a lot of those investments go on the income statement, and not on the balance sheet,” he said. “When a company invests in this kind of stuff they're investing in their income statement, so it impairs their near-term profitability, but often you want that.
“It's not always the best idea to just pick out those companies that have the highest [return on investment] ROI, or the highest margins,” he added.
McGreary admitted however, that the US small-cap space can look like a very low-quality index with a low-quality group of companies.
He said: “If you look at the Russell 2000, more than 40% of the benchmark doesn't make money. That doesn't necessarily mean it's not quality, but there's just a lot of junk in there.
“If you pull out healthcare, technology and telecom – that 40% number drops down to about 15%. So you really have to sift through a little bit more.”
One example of a small-cap company that may not have high profitability today but is still desirable to McGreary is Duck Creek Technologies – a software company servicing the insurance industry.
“The US insurance industry is a pretty sleepy industry, a lot of times they're using mainframes and really antiquated architecture,” he said. “So these guys came in and they just offered a more modern, flexible and productive solution.
“They're growing extremely rapidly but they are not profitable - and we don't want them to be profitable right now. We want them to be investing in their sales force and continuing to invest in their products, because we think the opportunity is massive.”