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Canadian Value
Canadian Value
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Small Cap Valuations - Way Too High or Room to Run (Heartland Advisors)

May 06, 2014 | About:

Small-cap stocks have been on a tear for several quarters now. Even after their recent modest correction, price/earnings multiples (P/Es) have soared over the past year or so, rising above their historic average. This has led market observers to question whether these stocks can continue to generate relatively strong performance.

Conventional wisdom in this situation would be to shift assets away from small-caps, and reallocate them to other asset classes. The concept sounds reasonable, but is it well-grounded in fact? What is the state of small-cap valuations today? These questions merit a closer look.

What Can We Learn From History?

Small-caps’ recent performance is hardly unprecedented. Looking back to another key bull market, the run from 1975 through 1983, small-caps (as measured by the Russell 2000® Index) grew by a cumulative 980%—reflecting an annualized rate of 30.28% over the nine-year span.

We’re five years into the current rally—with aggregate returns of 150% and annualized gains of 20.08% over that period. History certainly isn’t guaranteed to repeat itself—but these figures show that more years of solid performance from small-cap stocks wouldn’t be out of line with what we’ve seen in the past. Small-cap bull markets can last a long time.

If history is a teacher, then it’s reasonable to compare conditions between the two periods as well. Does the macro backdrop point to more positive results? One answer may come from another factor giving us confidence in the outlook for small-cap stocks: The Financial Conditions Index (FCI), which many view as a predictor of future economic growth. It has also been useful for anticipating periods of stronger returns for small-cap stocks. (In the graph below, a figure of zero or below for the FCI indicates loose, or supportive, financial conditions).

We think the current accommodative environment could be constructive for future small-company equity returns, in much the same way it was during small-caps’ earlier bull run. We also think it’s notable that historically, such conditions have been positive for small-company stocks not just on an absolute basis, but also relative to other asset classes.

Taking a Look at Profit Margins

The spread between net profit margins for small- and large-cap stocks is historically wide. Typically, larger companies enjoy higher profit margins on average than their smaller competitors, thanks to economies of scale and other advantages that go with greater size. What’s unusual is for the gap to be so wide. At the same time large-cap margins are at or near peak levels, those for small-caps are well below their highs. This tells us that small-cap valuations today are not based on inflated, unsustainable levels of profitability. As well-managed small companies improve their margins—by putting underutilized assets to work and improving productivity, for example—there is room for their price multiples to expand as well.

In the current slow-but-steady economy, it can be difficult for bigger companies to achieve much in the way of organic growth from their existing operations. So to boost performance, they often seek to acquire smaller, faster-growing companies operating in complementary market niches. The higher net margins large-caps currently carry can help them to fund these purchases.

The announcement of a takeout—or even the prospect of one—can have significant, positive impact on the share prices of small-company stocks. So the current state of affairs for large-caps can be supportive of higher small-cap valuations going forward.

Focusing on Fundamentals

As active managers, we’re concerned with more than the prospects for small-cap stocks in general. We don’t invest in market averages—we buy and hold individual stocks based on a number of factors, using criteria aimed at identifying stocks that are not only relatively inexpensive, but also have a number of other characteristics that support future appreciation.

There’s quite a bit of difference among the valuation of stocks with higher-quality traits—such as strong return on invested capital (ROIC)—and those of lower quality. One way to see this is to first rank the stocks in both the large-cap S&P 500 and the small-cap Russell 2000® Indices by their ROIC, and break them into quartiles. The next step is to chart the median EV/EBITDA (Enterprise Value/Earnings Before Interest, Taxes, Depreciation and Amortization, an important measure of a company’s value as an acquisition target) for the stocks in each of these four groupings.

The results, seen in the chart above, were surprising, and a bit counterintuitive. Small-cap stocks with the lowest ROIC carried higher EV/EBITDA multiples than their stronger-ROIC rivals, and by a meaningful margin.

The upshot? Higher-quality stocks—which currently tend to be cheaper—might make sense for investors concerned about elevated valuations. Such a focus is part of Heartland’s long-term approach to value investing. In evaluating our U.S. small-cap portfolios, the Heartland Value Plus Fund and the Heartland Value Fund, against major market indices, their median EV/EBITDA over the last twelve months of 9.5x and 9.0x, respectively, are considerably more compelling than the Russell 2000® Index at 10.5x and the S&P 500 at 10.3x. It’s not just that there appears to be room for appreciation among high-quality small-caps in general; we believe our specific holdings are significantly undervalued relative to their intrinsic worth.

Another Way to Look at It

We’ve explored a number of reasons why we have confidence there is still room for small-cap stocks to run. But we make our living as fundamental stock researchers, not market seers. What happens if, despite this analysis, small-cap stocks—or even the broader markets and economy—come under pressure?

That very possibility, in our view, reinforces the importance of fundamental research and bottom-up stock selection while investing. We take heart in the fact that small-company balance sheets have rarely been in better shape: they’re carrying robust cash balances, and have kept debt under control.

In our view, this makes companies better-prepared to withstand the unpredictable turns that markets can take. Strong balance sheets can serve as an inherent form of risk management, particularly when combined with strong free cash flow. These are two qualities we look for when evaluating stocks.

Companies that keep a little cash set aside and pay down their debt don’t have as much money to fund expansion and pursue new, even speculative lines of business. So we won’t always catch the biggest wave in momentum/growth-driven markets, as we saw in 2013. We view this as a feature of our investment approach, and not a bug. It can also help keep us away from the stocks with the loftiest valuations and the furthest to fall.

In sum, while it’s true that small-cap valuations are meaningfully higher than they were at the start of the current bull market, we believe these stocks still have some legs. It’s reasonable to expect that the market will become more valuation-conscious, and focus greater attention on companies’ fundamental strengths. That’s an environment we believe allows research-driven, bottom-up stock selection disciplines—like Heartland’s 10 Principles of Value InvestingTM—to add value for investors.

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Canadian Value

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