A Thought-Provoking Insight into the World of Small-Cap Investing
At the Ben Graham Centre’s 2024 Value Investing Conference in Toronto, Jason Zweig, a seasoned columnist for The Wall Street Journal, posed a stimulating question: “What cannot be ETF’d?” This question delves into the realm of active investors and their ongoing battle against passive exchange traded funds, also known as Mr. Market. Zweig emphasized the critical need for portfolio managers to identify and specialize in aspects of the market that cannot be easily packaged into an ETF in order to harness significant alpha.
- The Unexplored Universe of Left Tail Things
Zweig introduced the concept of “left tail things,” which encapsulate the unique factors like size, liquidity, marketability, and popularity associated with small-cap companies. These characteristics form the crux of what active managers must master to outperform the market and generate alpha. The tightly coiled spring of opportunity within the small-cap space presents a lucrative landscape for alpha generation that remains largely unexplored.
- The Lopsided Story of Small-Cap Stocks
In the United States, small- and micro-cap stocks have trailed behind their large- and mega-cap counterparts for almost a decade. This trend contrasts with the continued small-cap effect observed in regions such as the UK, Japan, Europe, and emerging markets. One of the primary factors driving this anomaly in the US market is the shift in institutional allocations towards private equity, diverting attention and investment away from public markets.
- The Canadian Conundrum
The Canadian small- and micro-cap space faces its own set of challenges, marked by a bear market trend, dwindling fund inflows, tepid M&A activity, and weak IPO performance. This unfavorable environment has perpetuated a negative feedback loop resulting in capital flight and sector underperformance. However, recent signs of change in early 2024, with the S&P TSX Small Cap Index outperforming its composite counterpart, suggest a potential reversal of fortunes.
- Navigating the Small-Cap Landscape
Looking ahead, the North American small-cap sector presents a fertile ground for investors attuned to the nuances of this market. From improved balance sheets to increased M&A and IPO activity, various catalysts are poised to fuel a re-rating of undervalued small-cap companies. This sector demands an active investment approach rooted in comprehensive business understanding and risk assessment.
In conclusion, the realm of small-cap investing offers a promising yet challenging landscape for investors seeking alpha. Embracing the inherent risks and fluctuations in this market segment is essential for unlocking its untapped potential, echoing the sentiments of chess grandmaster Magnus Carlsen. As we navigate the dynamic world of small-caps, a proactive and informed investment strategy remains paramount for success in this evolving market scenario.
