A reminder of a topsy turvy madness in small cap valuations

Here’s a small mind experiment. I’ve got two investments to offer you. They are almost identical in what they do and priced at a similar valuation, but the first (company A) is very profitable and spits off lots of free cashflow, while the second (company B) is losing money and requires constant cash funding through debt and share issues. Which company would you rather invest in? Clearly, only a madman would prefer to invest in company B. But I hope to show you that there are very many madmen around…

Quality & Value — uneasy bedfellows

Any rational investor should prefer investing in higher quality companies to lower quality companies. So he’s likely to bid up the price of higher quality companies to a premium valuation, while lowering his bids on the lower quality companies to a discount. In theory this is the way the market should work.

In order to investigate whether the theory holds true I’ve created a few scatter plots using the Stockopedia StockRanks. On the horizontal axis I’ve used the Value Rank, while on the vertical axis I’ve used the Quality Rank. These ranks score every stock in the market as a percentile from zero (worst) to 100 (best). So the cheapest stocks have a Value Rank of 100, while the most expensive stocks have a Value Rank of 0. Each blue circle on the plot represents a single company, plotted along each axis according to its own pair of rankings.

If we plot Value against Quality for UK mid and large caps (greater than a market capitalisation of £350m) we see a picture emerge.

I’ve regressed a line on the above scatter plot to show the trend. It’s a weak trend, but it does back up our general thesis — that higher quality companies tend to be more expensive, while lower quality companies tend to be cheaper. The real holy grail in investing is finding high quality companies that are cheap (up in the top right corner of the plot), but the market is pretty smart and doesn’t give you too many opportunities there. In fact plenty of very successful value investors (such as Terry Smith of FundSmith fame, or the legend Warren Buffett himself) have learnt that paying up for Quality is one of the only ways to buy the best stocks in the market.

But I’ve only given you half the picture. What happens if we generate the same plot for small and micro-cap stocks with a market capitalisation of under £350m?

Amazingly, the trend completely inverts. For some reason better quality companies tend to be cheaper, while the junk companies tend to be more expensive … this is the complete antithesis of our theory!

How the madmen take charge

It seems that amongst small and micro-cap stocks the madmen have taken hold of the asylum. One might expect a cluster in the top left corner of the chart — as the highest quality companies should be at the most expensive valuations … but we find it’s an almost vacated area. The biggest cluster happens in the bottom left corner… where the very worst companies are given the most expensive valuations!

Why would this be? Well the obvious answer is that there are many more speculative shares amongst small caps. The AIM (Alternative Investment Market) has very many small energy and resources explorers, as well as many blue sky, pre-revenue tech and biotech companies. These companies tend to come with all kinds of promises, charismatic CEOs and stories of fantastic potential upside. They are in essence, lottery tickets. If you’ve ever bought lottery tickets you’ll know that they have a negative expected payoff, but you buy them anyway for that faint hope of a massive payoff. That’s the allure of story stocks for private investors. They end up bidding the prices of these companies way above fair value.

Chasing the grail

But there’s also a vague clustering in the top right corner of the small cap plot — where good, cheap companies can be found. Amongst small caps there has always seemed to be a greater opportunity to find the kinds of niche, forgotten wonderfully profitable companies that can become the stalwarts for long term investor portfolios. And for whatever reason, there’s often far greater opportunity amongst these small caps than amongst the comparable large caps. The stories of famed investors like Lord John Lee (read how he made millions from small cap shares) or hugely successful private investors like Leon Boros (read his strategy to become an ISA millionaire) bear this out. The kind of shares that these investors prefer often appear to be rather dull, steady stocks that most investors are ignoring. This may be why they present so much opportunity.

As ever, it’s worth reminding yourself of the basics, and ensuring that you too don’t lose your head amongst the baying crowd.

Written by Edward Croft, CEO at Stockopedia

Originally published at www.stockopedia.com.

Disclaimer: This content should be used for educational & informational purposes only. We do not provide investment advice, recommendations or views as to whether an investment or strategy is suited to the investment needs of a specific individual. You should make your own decisions and seek independent professional advice before doing so. Remember: Shares can go down as well as up. Past performance is not a guide to future performance & investors may not get back the amount invested.