January 2023 Commentary

Bad predictions are the norm in the investment industry
though, to be truthful, forecasting things in the future is
not limited to investing. In the 1980’s, as cellular phones
were becoming a reality, AT&T asked McKinsey, the
world’s top management consultancy, to estimate the
future market size for this product. They estimated the
mobile phone market would approach 900,000 subscribers
in the US by the year 2000 – the actual number was more
than 100 million.

But occasionally, a comment is made with a basis in history.
The recent Howard Mark’s memo, “Sea Change”, is one of
those rare opportunities to gain some insight on history
with application to the newly forming market cycle ahead.
Marks’ contention that accelerating inflation curing 2022
to unexpected and dangerous levels marked the end of
four decades of declining interest rates which culminated
in a recent zero interest rate policy (ZIRP). As such,
investment strategies that worked best over those years
may not be the ones that outperform in the years ahead.
That, in summary, is his sea change.

We’ll go one step farther. Again, based on history, we
expect the small cap market will outperform large caps
over the next few years. In our analysis of the US markets,
there have been five major corrections in the past thirty
years. In each case, coming out of the market trough and
up to the next market peak, small cap investments
provided much better returns than large cap investments.

Why?

Small-cap stocks and large-cap stocks react differently
coming out of a market trough. Typically, as small-cap
stocks have outperformed to the prior peak, valuations
tend to be higher resulting in a steeper decline through to
the trough bottom. At the peak, with valuations higher
than large-caps, the correction in small caps is sharper and
steeper.

In general, as small-cap stocks tend to be more sensitive to
changes in market conditions, they can experience larger
price swings – both up and down, as mentioned – compared
to large-cap stocks. This can result in potentially higher
returns for small-cap investments during market
recoveries. As market conditions improve and investor
sentiment turns positive, increased demand for small-cap
stocks result in a continued rise in stock prices.
As the market cycle (out of the trough) lengthens,
increasing demand for small-cap stocks also increases their
valuation spread to large-cap stocks. Inevitably, as the
cycle peaks and begins to decline, investors gravitate to the
relative stability and safety of larger companies. At the
ensuing trough, smaller caps reach more deeply depressed
valuations. The cycle is then set to begin anew.

This investment cycle has been proven time and again. Yet
investors, particularly in Canada, tend to shun small cap
investing. Again, why? Unfortunately, some of the
fearfulness comes from our own industry – the definition
of “small cap” is wide-ranging, from the very micro and
very illiquid, to cash-poor growth-at-any-cost disasters.
Humans are instinctively risk averse. We tend to overpay
for insurance and shy away from large but uncertain
opportunities.

High-quality small cap companies fall into the latter
category. They’re often founded by entrepreneurs with a
passion for their business and, invested alongside
shareholders, are therefore shareholder friendly. They
provide exposure to emerging industries or disruption to
old industries. And finally, they’re frequently overlooked
by analysts and investors seeking to identify undervalued
companies.

Think of it this way – all great large businesses began as
entrepreneurial small companies with a penchant to do
something different. Coming out of a trough is a multi-year
opportunity to find and invest in great high-quality small
cap businesses while their valuations are decoupled from
their growth fundamentals.