Scoring BIG in SMALL Caps (Pt. 2)

The Ying & Yang

The ‘Ying’ to the fundamentally driven analysis & the ‘Yang’ of companies within the Small Caps Universe, are financial metrics and quantitative factors. These facets, for example a company’s key financial ratios, are used to understand a company’s current financial position and can also serve as strong predictors for short-term performance, profitability, operational efficiency, equity returns, solvency and liquidity. In a much broader heading, these insights are categorized into company growth, company health and earnings characteristics.

It must be noted, that financial ratios^[1] and other metrics do not have any immediate or absolute implication(s), rather, it is through the process of selective comparison, either against past performance, other companies or industry averages, that the meaning behind the number is obtained. Relative performance is a key indicator of a Small Cap company’s short-term success, and when coupled with a fundamental analysis of its catalysts, products, management etc., can provide an extremely robust investment thesis.

The Realm of Small Cap

Key methodologies used to take advantage of such quantitative factors is to keep a lookout on percentage growth of earnings and revenue. In the realm of Small Cap, an unfamiliar investor may seem to speculate that a company’s balance sheet will contains unusually large amounts of debt, with obvious negative earnings. It is vital to understand that none of these are downside risks, the only red-flag present here, is the possible chance that these ‘negative’ earnings are showing no signs of recovery or growth. The key as to why the returns of many small-cap companies are abnormal and tend to out-scale the returns or much larger competitors is the presence of a ‘turnaround’ in negative earnings – a period which consists of negative earnings growth, after which the earnings begin to increase. It is this key factor which contributes to the extremely high returns of small-cap companies, thereby in some ways, making sense in chaos and providing motives to invest into this risky (yet to an extent reasoned) game.

Investors should note however, it is a combination of fundamental and macroeconomic factors, which may catalyse the turnaround in earnings. These may consist of national economic relief, completing acquisitions or equity raisings, or simple management decisions which have led to positive earnings growth.

The different types of ratios can provide insights into a company’s profitability, liquidity etc., all of which are categorized into either company growth, company health or earnings characteristics.

Common ratios in the profitability heading consist of:

1. Operating margin = Operating income / Net Sales
2. Return on Equity (ROE) = Net Income / Average Shareholders Equity
3. Useful to measure management’s success in utilising its equity.
4. Net gearing = Net debt / equity

Common ratios in the liquidity (useful for mainly mining companies) heading consist of:

1. Current ratio = Current assets / current liabilities
2. Operating cash flow ratio = Operating cash flow / Total debts

As the economy begins to strengthen once again, investors should be willing to go all-in when it comes to investing in Small Cap companies. The combination of a long-term investing thesis, backed by valuations and fundamental analysis provides a strong premise behind investing in small cap companies.

^[1]: See https://en.wikipedia.org/wiki/Financial_ratio