In his keynote address on the Ben Graham Center Value Investing Conference 2024 in Toronto, he said: Jason Zweiga veteran columnist for , asked rhetorically, “What can’t be ETFable?”
Active investors are competing with Mr. Market, also referred to as passive exchange-traded funds, he explained. To generate meaningful alpha, portfolio managers must develop expertise in what cannot be packed into an exchange-traded fund, Zweig advised.
The goal universe for energetic managers is what Zweig called “left-wing things,” resembling size, liquidity, marketability and recognition aspects. These are the aspects inherent in small cap firms.
There is a variety of resilience within the small-cap space and we consider it is incredibly favorable for alpha generation.
While small-cap firms have ETFs, passive investing on this group is a suboptimal strategy for long-term alpha creation. Portfolio managers must develop expertise on this market segment.
In the United States, small and micro-cap stocks are left behind Based on the value returns of the Russell 2000 and S&P 500, the small cap effect remained intact within the UK, Japan, Europe and emerging markets over the identical period.
What explains the United States’ outlier status? Institutional allocations have shifted toward private equity and away from public markets. Global private equity AUM is predicted to grow to $8.5 trillion by 2028, with American firms leading the way in which with a compound annual growth rate of 11.3% Prequin.
Today, fast-growing small businesses have financing options that weren’t previously available to them. You can stay private for for much longer and live and grow inside the closed private equity community. Some of those firms may never be included within the Russell 2000. If they reach sufficient size, they will move straight into the S&P 500 or be sold to a different large private equity fund.
Canada within the highlight
In Canada, the small and micro cap space was in a bear market. Active small-cap-focused funds have experienced outflows over the past decade, M&A activity is subdued, and IPO activity is weak. Total public capital raising for technology in Canada last 12 months fell 88% from 2022 levels and 98% from 2021 levels.
This has created a negative feedback loop of capital flight and poor performance within the sector in Canada. In the primary quarter of 2024, we saw the primary signs of change: the S&P TSX Small Cap Index (7.9%) outperformed the S&P TSX Composite Index (6.6%).
Outlook for North America
Market valuations rose in 2023, which should entice some private firms to go public this 12 months or next. An improvement in IPO and M&A activity could be a positive tailwind for small caps, that are undervalued in each absolute and relative terms.
We see a goal-oriented environment in small caps. The lack of research and capital has left the sector wide open for smart investors.
Potential triggers for a re-rating will include improved balance sheets, higher money flow metrics and increased M&A and IPO activity. Tailwinds include the turning point in rising rates of interest, quality firms continuing to grow their business value and clean up their balance sheets, accelerating M&A activity to capitalize on discounted valuations, and a median return to historical valuations and sentiment levels.
The small-cap sector is best approached through an energetic investment strategy that requires expertise and a deep understanding of individual firms and their risk-reward characteristics for fulfillment.
However, any investor in search of to outperform must accept potential risks. One of those may very well be periods of painful unpopularity and underperformance like we have now seen within the small-cap sector since 2016. As Norwegian chess champion Magnus Carlsen said: “Not being willing to take risks is an extremely risky strategy.”
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