Small caps ‘indiscriminately sold down’ & undervalued, study finds

Quality small capitalisation companies, despite many possessing superior earnings profiles to large companies, have been “indiscriminately sold down”, leading to a significant undervaluing of these stocks, new research has found.

The research, authored by Melbourne-based boutique fund manager ICE Investors, has shown that higher quality small caps have been oversold relative to large cap companies, leading to the share value discrepancy.

A small-cap stock is generally defined as a public company whose total market value, or market cap, is about $250 million to $2 billion. Many of these companies – though not exclusively – are emerging, and often fast-growing, start-ups. A significant number, however, are also mature, well-established businesses with strong underlying financials.

Whilst ICE acknowledged that small cap stocks, in the main, have “significantly underperformed large companies in recent times” (particularly with the dominance of high-performing bigtechs or FAANGs/MAMAAs), quality small cap stocks, when viewed apart from the broader small cap market, show significant potential for value growth.

According to ICE Investors managing director and portfolio manager Callum Burns, the high-quality half of companies within the ASX/S&P Small Industrials have equivalent or better earnings growth profiles compared to the S&P/ASX 100 Index.

“Notably, the paper finds that earnings growth, debt levels and profit margins of these companies compared to the S&P/ASX 100 Industrials are typically more favourable.

“Therefore, the large underperformance of this quality group of small companies since 2022 versus large caps stocks is unjustified,” he said.

The methodology of the research paper, The Small Cap Dislocation, separates companies of the ASX/S&P Small Industrials into two halves: one half consisting of higher-quality companies with superior earnings growth, profit margins and debt profiles, and the other half consisting of lower quality companies.

Five quality categories were defined in the research: ‘best franchises’, ‘solid franchises’, ‘typical company’, ‘below average company’ and ‘challenged and/or loss-making’.

The ASX/S&P Small Industrials Index was chosen as the control group to focus on the underlying drivers of small companies.

Portfolio manager Mason Willoughby-Thomas said the earnings growth in the higher quality of the ASX/ S&P Small Industrials is superior to that of the same quality categories in the Top 100 and superior to that of lower quality companies, whether in the Top 100 or Small Industrials.

“This suggests for the higher quality categories in the Small Industrials Index, the underperformance of this group since the start of 2022 is not justified,” Willoughby-Thomas said.

Furthermore, he said, “the median quality small cap franchise has better earnings growth, slightly lower debt levels and slightly higher profit margins than Top 100 companies”.

“In contrast, earnings growth in the lower quality half of the Small Industrials is materially inferior to that of the same quality categories in the Top 100.”

According to ICE portfolio manager Roger Walling, the research concludes that the more challenging investment environment has unsettled investors, leading to an investor retreat to the perceived safe harbour of large cap stocks and indiscriminate down-selling of small caps.

“This sell-off in quality small companies has opened up very attractive buying opportunities for shrewd investors prepared to do the work and unearth quality companies with robust earnings growth, good profit margins and low debt levels,” he said.