May 2024 Commentary

On Sunday, October 18, 1987, I was enjoying a late birthday
celebration with my family. The next day, our investment
team huddled around various transistor radios (back then,
computers were used only for Lotus 123), as the stock market
suffered its worst day ever. Our young team had successfully
shepherded nervous clients through the previous week’s 10%
decline but, to us, “Black Monday” was quite terrifying.
The S&P 500 Index fell 21% that day while the Dow dropped
23%, far exceeding Black Monday October 28, 1929, the
onset of the Great Depression (for Canadian readers, the TSE
Composite fell 17.3% through Oct 20, 1987). Thirty-seven
years later, there is still precious little evidence to support any
of the theories or claims on why the collapse occurred.
For most of its existence the investment business has been
driven by information. Those who had it hoarded and guarded
it. They tended to dominate the markets too, because good
information could be so very hard to come by. But the
inevitable march of time, alongside the growth and
development of information technology, has changed the
nature of investing dramatically. Statistical information is
now available to everyone instantaneously and is no longer a
competitive advantage.

Success is now driven by analysis – or, as noted in Dyson’s
quote above, “meaning”. It is also driven by investor behavior,
but that’s a topic for another day.

Howard Marks’ concept of second-level thinking is
particularly pertinent with respect to small cap analysis. It
emphasizes the need to go beyond surface-level evaluations
based on widely available information. Instead, successful
investing demands a deeper dive into the intricacies of
smaller companies. This involves understanding not just the
financial metrics but also the qualitative aspects such as
management quality, industry dynamics, competitive
positioning, and potential growth catalysts.

One of the common misconceptions in investing is the
emphasis on “reasonable value.” Valuation is inherently
inexact, but a reasonable sense of value is important in the
initial purchase, and ongoing maintenance, of any
investment. A longer thread of financial information can be
discerned from larger, more mature companies thus lending
themselves to a more definitive sense of valuation. However,
successful small cap investing is more about identifying
companies with the potential for sustaining long-term value
creation through consistent and scalable cash flow
generation.

Moreover, as we’ve written many times in the past, the role of
management cannot be overstated in small cap investing.
Analyzing management decisions, their track record, their
alignment with shareholder interests, and their strategic
vision for the company is paramount. Experienced and
capable management teams can navigate challenges,
capitalize on opportunities, and create significant
shareholder value over time that cannot be determined by
simply studying the financial statements.

Another unique aspect of small cap investing is
understanding the industry dynamics and market positioning
of the companies in question. Industries evolve, trends
emerge, and competitive landscapes shift. Conducting
thorough industry analysis helps identify secular growth
trends, competitive advantages, and potential risks that
could impact long-term investment outcomes.

Assessing the risk-return dynamics constitutes a pivotal
aspect of investment analysis, particularly within the small
cap domain. While diversification plays a role in mitigating
company-specific risks and sectoral fluctuations, significant
emphasis must be placed on the concept of “persistency” in
managing risk within small cap investments. Persistence
refers to the enduring success of a business, which in turn
fosters increased investor conviction. Moreover, persistency,
characterized by sustained financial performance, enhances
stability and supports continuing success over a long-term
investment horizon.

Small cap investing demands a multidimensional approach
to analysis – the “meaning” truly is expensive. It’s about going
beyond surface-level metrics and delving deep into company
fundamentals. This depth of analysis not only enhances the
investment decision-making process but also positions the
portfolio to capture the unique opportunities and potential
rewards offered by the dynamic world of smaller companies.