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By David Barr

The British pop band Dead or Alive had a huge hit in the mid-1980s with You Spin Me Round (Like a Record) on their album Youthquake. It’s a catchy little number.

Across the pond, the investment world is witnessing something else: renewed investor interest in small-cap stocks. They, too, are going in circles, with a long-awaited recovery in sentiment and capital inflows – albeit with slight fluctuations in August.

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After stagnating since the beginning of the year, the Russell 2000 Index recorded a gain of over 12 percent at the end of July. The Russell 2000 represents around 2,000 of the smallest listed companies on the US market. In Canada, there is the small-cap index S&P/TSX, which includes 246 companies.

Like all indices, including the S&P 500, they contain a grab bag of components of varying quality and profitability (or not). Studies show that only a small percentage of companies generate the majority of returns over the long term. For example, from January 1990 to December 2022, only 21 companies generated more than 64 percent of net assets in Canada.

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Due to the wide variation in the quality and profitability of smaller listed companies, this sector offers less efficient investment opportunities than the large-cap sector. Investors who passively follow the Momo – the current positive momentum – must therefore be aware that they are also buying a significant portion of companies that are not generating profits, potentially increasing volatility and capital risk.

There also appears to be a tailwind for experienced stock pickers. With interest rate cuts in Canada and the threat of a September rate cut in the US, smaller companies – often considered cyclical and riskier – are now beginning to wake up from their long-standing slumber.

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Compared to large- and mega-cap stocks, smaller stocks remain a bargain. The S&P/TSX small-cap index trades at about 10 times its forward price-to-earnings ratio, while the S&P/TSX 60 is at nearly 14 times. A reversion to the mean would give them a nice upside.

In addition, the change in the interest rate regime will provide welcome relief for the balance sheets of smaller companies that are more dependent on variable-rate or shorter-term loans and have suffered disproportionately from rapidly rising interest rates and reduced capital inflows in recent years.

For example, 30 percent of Russell 2000 companies’ debt is floating rate, compared to just six percent for S&P 500 companies.

The attractive valuations of these companies are simply too good to pass up, attracting the attention of private equity and venture capital firms that have a record $2.62 trillion in cash reserves that they could use for a gigantic spending spree.

Just after the halfway point of the year, there were already several high-profile acquisitions, including Copperleaf Technologies Inc., Nuvei Corp., Héroux Devtek Inc. and Sleep Country Canada Holdings Inc.

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Current prices have a built-in margin of safety that should appeal to value investors. At Berkshire Hathaway Inc.’s recent annual meeting, Warren Buffett (whose right-hand man and likely successor Greg Abel happens to be Canadian) told attendees:

“We don’t feel uncomfortable at all about investing our money in Canada. We have no mental blocks towards this country. And of course there are many countries that we don’t understand at all.”

We agree with Buffett. We also have no mental blocks when it comes to Canadian companies as we continue to see an attractive environment for them. Even with the recent positive developments, valuations are still very attractive on a relative and absolute basis.

Rather than viewing small caps as a short-term tactical investment, smaller, high-quality companies are an excellent long-term addition to a portfolio, provided investors can accept short-term volatility. Given the speed at which small cap markets can move, it is important to have an allocation to this asset class to fully exploit the long-term returns of small caps.

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One bright spot from the past few tough years is that it has allowed investors to invest their portfolios in higher-quality companies that trade at reasonable prices. While Berkshire has to limit its purchases in Canada to very large companies due to liquidity constraints, domestic investors can be more flexible and take sensible positions in a hand-picked selection of high-quality smaller companies.

David Barr, CFA, is CEO of PenderFund Capital Management.

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