Radio listeners in the late 90s were serenaded by a soulful Paula Cole asking “Where have all the cowboys gone?” In the song, the woman protagonist begins with dreams of a happy ending and a loving relationship, but quickly wonders where her John Wayne or Lone Ranger is. The song ends with acceptance of a daily life filled with chores and spousal trips to the bar.
Investors of today are asking a similar question in “Where have all the good small caps gone?” Small cap stocks were once an asset class full of hopeful companies that the market knew little about, promising above average returns for those willing to hold a basket of these stocks. The idea was first documented by Rolf Banz in 1981 and famously used in the 1992 Fama-French factor model.
Since that research, however, the outperformance of small cap stocks over large cap stocks has been non-existent. Below we show the ratio of small cap to large cap back to 1979. After a brief stint of outperformance in the early 80s, small caps have by and large underperformed large caps. This has left investors scratching their heads and wondering: where are the good cap small companies?
Source: Factset, Balentine
The literature on attempting to answer “why” the small cap premium has essentially disappeared is prolific. Instead of looking to add to the “why,” we attempt to answer the “now what?”
For investors seeking return premium in smaller companies, we highlight two potential approaches different than simply buying a broad basket of small cap stocks. The first of those approaches is an allocation to private equity.
Private equity is the ownership of private companies that seek outside capital and expertise to grow or reposition. That capital and expertise can be a venture capital manager, who for a minority stake in the company can help develop the product and roll it out to the market. It can also be a growth equity manager, who provides capital to expand operations or product lines. Or it can be a buyout manager, who looks to streamline operations of an older company to unlock value.
We believe investing in private companies versus public companies has two main advantages that can bring the small company premium to portfolios:
Companies can focus on the long-term versus just trying to hit quarterly earnings, and
Companies can leverage the talent and experience of the general partners of the private equity firm.
The typical private equity fund is 10 years in length to ensure these two things can play out. Private companies can invest in products and markets that do not need to show immediate return because they do not have to worry about their stock temporarily falling. General partners can develop a multiyear plan for the company and do not have to worry about investors demanding their money back if things are going slower than expected. This long-term approach can unlock value for which the impatient daily liquid stock market does not have tolerance.
We believe this is a main driver in why companies are staying private for longer. December 2020 saw Airbnb and Doordash both go public in the same week at $100 billion and $55 billion valuations. Microsoft went public at $777 million… Airbnb and DoorDash skipped the small cap arena altogether and debuted as large cap companies. All the growth that typically would have occurred in the public small cap space occurred in the private markets. Regardless of how good Airbnb and DoorDash are as companies, delivering a 2,805x return to public investors seems unlikely from this starting point.
Fast growing companies’ preference to stay private longer leaves the broad public small cap index in a pinch. According to Strategas, over 40% of small cap companies are not profitable. That is up from 10% – 15% in the late 1990s. It is quite possible the public markets have become a place for small caps to raise money as a last resort, making it crucial to be selective. This selectivity is our other path to consider for investors looking to gain access into good small cap companies.
Small Cap Managers
For those unwilling or unable to invest in the private markets, finding an active small cap manager who takes a private equity approach can be fruitful. This manager would look to take a meaningful stake in the public company to have a material influence at the board level. This is something that can only be done in smaller companies as 5% of a company like Microsoft with a $2 trillion dollar market cap is larger than almost all active funds.
The manager would have a long holding period for companies. To unlock value in public companies, managers need to be able to see a catalyst for change and then give time for that to play out. They need to not be worried if the company misses a quarterly earnings number, as long as they are working towards the long-term plan. Managers with short holding periods tend to be trading more than investing, and are unlikely to be able to unlock that value.
The manager would also be well-aligned. Be willing to invest in funds with reasonable lock up periods (1 – 4 quarters.) This alignment allows the manager to let his thesis play out without having to worry about investors running for the door after a quarter or two of bad performance. A low management fee and reasonable performance fee can also align the manager. This drives them to not gather assets, but seek true excess return, aligning themselves with investors.
A Happy Ending
While the woman in Paula Cole’s song never found her cowboy, we believe happy endings are still possible for investors seeking good small cap companies. Though buying a broad basket of small cap stocks may not give investors the premium they want, they may still seek these companies in the private markets or through a selective in the public equity managers.