Are small-cap tech stocks mostly a dead end?
I'm an undergrad assigned to research small-cap tech stocks for a equity research class and I can't help but shake off the feeling that small-cap tech (software/IT) stocks are companies without much FCF growth potential or value underpricings. Given the massive economies of sale with software and its geographically agnostic nature, a tech company destined for greatness should capture its TAM quickly and get out of small-cap territory soon. There are also a lot of analysts and investors covering tech which should help the market discover inefficiencies. I know Amazon and Apple were once small caps and penny stocks due to various reasons but that was decades ago when the tech sector was growing.
Is investing in small-cap tech a losing game nowadays? If not, how would you go about discovering value in the sector?
Comments (46)
It's called "betting on which one gets Thoma Bravo'ed next".
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How does a small-cap tech company position themselves to get acquired by the likes of Thoma Bravo?
Don't have a sht product and not in declining markets
Sticky product that if you turn off the growth spend, TB can juice the cash flow
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Nope! Plenty of great companies are purposefully ignored by institutional investors because of their small market cap. If you manage a billion dollar fund, your average position size is multiples of a small cap's market capitalization. Would echo other comments on looking at PE buyouts for more case studies. Look at what happened in the trajectory of Magnet Forensics on the TSX this month. Sometimes acquisitions are from a bolt on perspective
Billion dollar fund, average position size even with a 10 position L/S concentrated fund would be $100mm. This as multiples of a small cap's market capitalization puts the companies you're referring to in what sounds like a micro cap stocks. Even if the fund is 1x levered you are still in micro cap territory. I typically think of small as LSD billions market cap. Do you agree or do you think my thinking is off?
What does "LSD billions" mean...?
Smallcaps are a great source of alpha because they are covered less than their larger peers, have a variety of funky anomalies (such as time of day effects) due to liquidity sourcing, and have a much broader set of corporate actions.
Large caps are largely macro and TAM -- they typically do not need capital and the only significant corporate actions they do revolve around buy backs and m&a.
Small caps have a much broader set of actions -- where and how will they raise capital? What's their balance sheet mix?
Don't end your analysis at "company doesn't have profits or FCF". Instead, ask yourself what the company would need to do in order to reach an attractive FCF or EBIT level (say target 20% RoE), and whether it has room in margins to do so or whether it still needs capital to build out product (in which case, expect share issuance or credit facilities!). I never exclusively covered small caps, but always found them to be a lot more interesting than large caps. I'm sure you will too if you give them a shot.
Quality quality post. I cover and love small cap tech, the dynamics are super interesting. Even more interesting in this market with the pivot to cash flow over growth.
The two points you cover hit the nail on the head. Essentially the first questions I get when taking around a company - (a) what takes them to attractive economics and (b) how much does it cost to get there.
I appreciate the wisdom! You mention that "Large caps are largely macro and TAM" but aren't smaller cap stocks on average hit harder in bad macro climates? Also why does the balance sheet mix matter more for small caps?
Regarding your point "ask yourself what the company would need to do in order to reach an attractive FCF or EBIT level (say target 20% RoE), and whether it has room in margins to do so", my fear that is that these small cap tech companies have exhausted their potential to do that or never had the potential in the first place, given the high investor interest in tech and their very high economies of scale enabling rapid and relatively cheap growth across vast geographies.
I mean that stock prices for large caps are more efficient, which means there are fewer anomalies or edges to grind out. Price discovery in small caps is limited by the depth of liquidity, which is quite shallow. Furthermore, small caps must take significant corporate actions to remain solvent through a crisis, which suggests greater variety in outcomes. For large caps, having a bull and bear care is usually good enough against consensus.
Because they have more default risk.
Don't be too quick to fear. Curiosity paired with healthy skepticism is the right attitude for any investor. If you think small caps are doomed to fail, what are the the few you think will survive?
can you elaborate on what you mean by time of day effects?
Isn't that hint good enough?
Interesting post. I think you have a great point that if TAM hasn't been captured quickly, there's often something wrong with the situation. A lot of companies die at Series A because they failed this test.
Two complications there IMHO as it relates to small caps:
1. The company made it to IPO, so at some point the tech was passing these tests. The question is then, were the late stage VC and IPO markets wrong about the tech, or is it possible the tech fell out of favor incorrectly because of a popular misconception around where the future is going.
2. In public markets, yesterday's trash can be tomorrow's treasure. Even if the market has correctly written off the company's prospects, multiples can get so cheap that it becomes a deep value play.
One way or another I think you do need to be able to identify a mistake being made by a lot of smart people. That might seem daunting, but I'm not sure I'd be comfortable with any investment that didn't have that feature.
Thanks for this response. I just have a couple thoughts/comments about them.
Regarding #1, I fear that due to the bull market over the past decade and the cheap liquidity flung at both private and public tech companies, the VCs and IPO markets made a lot of mistakes regarding the viability of many tech firms. Right now I'm not sure tech has felt a market rout, despite a lot of sell-off: Shareholders, activists, and PE are hard at work restructuring bloated tech companies, which are still pulling decent revenue for the most part.
How common is #2? There's no deep, lasting, tech rout as I mentioned previously and there's not a lot of tangible assets that ensure a good margin of safety. I feel like the market will still notice that undervalued tech stocks have good cash flow generation through screens, etc so there wouldn't be a lot of pricing inefficiencies in tech, as say, legacy industrials.
Agree with you on #1. Would quibble with you a small bit on how severe . . it's felt like a bit of rout sometimes. I won't have any good examples from small cap tech, but mega cap tech has certainly felt like a rout and I can only imagine small cap got hit harder no? Anyway in general I still agree, there's a lot of assumed viability simply because the tech ecoystem has put down so many roots that people can't imagine a large part of it vanishing.
As for #2 - I think the lack of tangible assets creates more potential for a stock to be sold down to a ridiculous level. So of course it's harder to underwrite because you don't have the tangibles to point to. But OTOH, if the tangibles were there, the traditional surface-level deep value crowd would grab the opportunity away.
But is it rare, yes I think it's pretty rare unfortunately.
Small-cap tech, or any tech for that matter, is mostly a losing game. A lot of companies are running on string line budgets to get products out and have no recourse. Discovring value in the sector is more about eliminating companies that don't really have a break through technology. I use to cover small cap tech, but I'll use some more well known names as an example.
1. First I'd say GoPro. When this when public in the early 2010s the stock went up to close to $90 a share (just looked, it was in the $80s for a while.). Then came crashing down and hasn't recovered. At the time people prob thought it would be more than it is, but really it was just a gimmick camera. Good for hardcore skiers, but its not an iphone, you're not buying multiple.
2. Same thing happened with Peloton. People were crazy about this company, the company was even high on itself, then everyone basically remembered its just an exercise bike.
So if you think about smaller tech companies, there's a small few that will take off, but most probably shouldn't even be public to begin with.
What do you think would be good sectors to explore for promising small-cap?
Promising sectors are more about where you competence lies, as Buffet would say. If you really understand healthcare or biotech, thats a good place; however, you have to understand the products. If you're in college you prob have a leg up on consumer products. I know companies like the energy drink Celsius (CELH) were a hidden gem, but had a good grass root start in colleges. Even companies like Domino's started small.
Small caps are also interesting because they usually have some sort of conversion or buyout that can be arbitraged. Joel Greenblatt discusses this in his book "You too can be a stock market genius", really its just about actually reading the financials.
tech is more than just consumer facing companies
How does one go about researching enterprise SaaS companies? A lot of them do the exact same thing (Cloud cybersecurity, marketing software and CRM, etc) and it's hard to see whether feature #433 of a large platform will materially affect cashflows in the near future.
I'd try to look for possible acquisition targets - times are rough and bigger companies should go shopping. But then I've never invested in public markets so could be garbage comment
Tons of alpha in small caps, particularly sub $1bn small caps in solid industries where research coverage has fallen away. You can make outsize returns in situations that would be extremely obvious in larger names. Also particularly in turnaround situations where a company has been left for dead for a while and has quietly improved its situation.
Out of curiosity, but if a small cap tech stock is in a non-niche industry, wouldn't it already have become a mid or large cap owning to the economies of scale of software? I feel like for research coverage to have fallen away implies the company was stagnant or not as promising as once thought.
they may be developing their products and/or gaining traction with customers. business is an iterative process where you try and learn for years before making it big. nobody goes from idea to billion+ valuation overnight.
Large caps are more dead end. They are past the pick of their growth. Apple is making the same phone for the last 5+ years with minimal changes. Google is providing the same search engine for more than a decade. FB is providing the same social network site which is now dying off due to popularity of new smaller companies. Amazon is still developing new capabilities, but how much more new things can it add?
The most exciting are some small companies working on AI and its applications, self-driving, etc.
Yes but I would argue that the large caps aren't quite as dead as your post suggests - these big tech companies have the money, infrastructure, and human capital to expand into promising new industries, like AI and self driving cars (they already have in fact), either organically or through acquisitions. Small cap. tech companies are less able to compete with these behemoths, who will capture TAM quickly.
Some replies to this thread have mentioned looking for small cap. tech companies who would make attractive acquisition targets for PE, however this seems to be a tenuous thing to bet an investment on?
good points.
No, of course not, but successful small cap stock investing can require the same amount of work, if not more, as large cap stock investing - so you need to consider whether you're able to invest enough in the stock to make it worthwhile.
If you invest $5m into a $250m company and the stock doubles, with a 20% performance fee you've generated the firm $1m revenue. What share of that $1m finds its way into your bonus? Your time may be better spent investing $100m capital in a large cap with 40% upside. The most valuable investment professionals get the big stocks right.
Putting less research effort into a small cap stock is a common mistake - if anything you're more likely to get blindsided in these names. Technical aspects like ownership, board & management, understanding the people involved are more important. Why is XYZ company considering a nonsensical merger? Because shareholder ABC with 40% ownership needs an exit because they lost money their other holdings, and figures the best way is to dilute first, then sell down (this nearly happened in one of my holdings just recently!). Not saying this doesn't happen in mid or large caps stocks, but it is less likely.
Thanks! I'm not clear on the last part about shareholder ABC - do you mind elaborating on what exactly they're doing and how they are profiting from getting the company to do a value-destroying merger?
The primary shareholder in small cap stock, with a seat or two on the board, wanted to exit. Selling on market would take forever without offering a substantial discount, and they probably considered a negotiated/private sale of their shareholding but found no buyers. So instead they pushed for a merger with a larger but inferior peer as it would dilute their ownership in the combined entity to a manageable size. Minority investors including myself had no wish to merge.
Fortunately, it didn't go ahead. Just an example, stuff like this happens. We got the raw end of deal in a small cap M&A transaction about six months ago, the stock was acquired but not all acquiree shareholders got the same price - I can't remember all the details why as it wasn't my stock.
Unrelated here but how do you have an ER class in undergrad? What's your degree, do you do BS Finance? I do BSc Economics in the UK and everything here is a galaxy away from useful stuff for recruiting and careers (unless you wanna work on an econ desk I guess, but even then I'm not sure how far your econ degree can teach you in that regard), so kids have to essentially do a double workload to study finance concepts for recruiting lol.
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