The Small Caps to Ask Santa For

The human brain is the most complex structure known to us. However, it took shape in a time in history when our ancestors were busy trying to ensure their survival, not manage their savings. With that same tool, we now have to face decisions about our money, which have a very strong emotional component. Far from helping us, our brains have design flaws (behavioral biases) that greatly jeopardize rationality and good decision-making.

As a graphic example, now that the time for Christmas celebrations is approaching, let’s think about how human beings act when prices drop. If we see a website or shopping mall with a poster advertising sales, people will probably happily enter the stores looking for bargains at irresistible prices. That is a rational attitude. However, if these sales (price reductions) happen on the stock market in general, or some of its segments, we usually see investors running terrified to get out of the market.

In my opinion, if there is a niche with attractive discounts within global stock markets, it’s probably small and medium-capitalization companies (small and medium caps). The market capitalization required for a company to belong to this group varies depending on the region it’s located in; there’s no universal rule that sets the limit. For example, a company that would be considered small by size in the United States may not be by European standards.

The reality is that small companies have traditionally been considered an especially profitable group of stocks. There is a certain logic that small-sized companies generally have more facilities for growth than companies that have already had a trajectory to reach higher capitalization. In addition, from the perspective of active investors, who try to track the markets in search of opportunities, small-sized companies tend to be a lake that attracts a lot fewer fishers. Their stocks are followed by far fewer analysts and investors, so errors or inefficiencies in their valuation that we can take advantage of are more frequent.

Well, for a few months, we have been experiencing a very unusual market situation. For some time now the indexes that group small and medium companies in developed countries have been performing much worse compared to the indexes that reflect the share price of large companies. Throughout history, the norm has been exactly the opposite. Additionally, in terms of relative valuation, if we take a look at the multiples that link the share price of the companies with their profit, small companies have been trading with almost the highest discount since the eighties.

What is the reason? As is almost always the case on financial markets, it’s essential to exercise a degree of caution when assessing the causes of this situation. Among other things, this is because there could be more than one factor acting at the same time, which makes it almost impossible to assess to what extent each factor impacts the quotes. That said, we are indeed in a phase of withdrawal of liquidity from the markets, which could be affecting the stocks where liquidity is lower.

In addition, small company stocks are usually (and mistakenly, in my opinion) associated with greater risk. That’s why they may be more affected in periods of generalized anxiety, as has been the case this year. Traditional finances associate greater volatility in quote prices with greater investment risk, and the large majority of those who take part in the market have bought into this theory. Nevertheless, the real risk for us is the probability of having a permanent loss of capital in our portfolios, which increases, for example, when we enter unknown territory or depart from our analytics process.

If we find an undervalued company with an upward trajectory, we care little if that upswing is produced with more or less turbulence. What really concerns us is trying to avoid making a mistake in the most likely destination point, not seeking the path with the least curves. Let's remember that volatility is nothing more than a measure of the deviations in the price variations for a period of time. That is, if a stock drops by exactly 5% every day and, therefore, its volatility is zero, the market will think it is a very safe investment... Judge for yourselves.

In any case, whatever the causes of this anomalous situation may be, it seems that nothing has changed regarding the fundamental reasons (described above) that make this group of stocks an especially profitable niche for patient investors. That leads us to think that we may have a tremendously attractive opportunity that does not occur very often. That’s why our Christmas wish list, reflected in the first positions of our investment portfolio, seems dominated by companies like Borussia Dortmund, Unieuro, MIPS, IPCO, Learning Technologies, Global Dominion, Gaztransport et Technigaz, Technogym, or CIE Automotive.

Luis García Álvarez, CFA

Manager of the MAPFRE AM Behavioral Fund