Small-cap stocks: Watching for mean reversion, technology diffusion, and the next inflection point

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We’ve also seen that past periods of large-company leadership are often driven by innovation, not unlike what we’ve seen recently with the “Magnificent Seven” and AI. In the 1890s, it was all about steel, oil, railroads, and banking, and investors just needed to own Federal Steel, US Steel, and anything with “Pacific” in the name. Fast forward to the Roaring ’20s, when telephones, electricity, and automobiles were the innovations of the moment and investors did well to hold stocks like Ford, Westinghouse, and American Telegraph & Telephone. Next came the post-World War II era and the dawn of commercial aviation and chemicals and plastics. In the late 1960s and 1970s, we saw the era of the “Nifty Fifty” stocks — the equivalent of today’s Magnificent Seven. Sears Roebuck was the “Amazon” of the day, revolutionizing the way consumers shopped. Kodak and Polaroid were the “Apple” analogue. There are other examples, including the dot-com era, but the point is that in each of these previous cycles, the innovation and technology spread beyond a small group of large companies and out to the broader economy fairly rapidly, so that smaller companies reaped the benefits as well.

With that history in mind, I think investors should be watching for signs of technology diffusion beyond the Magnificent Seven.

Adam: How will you be looking for signs of that technology diffusion within small caps?

Peter: Fortunately, there are better tools to help with that today than during previous innovation cycles. For example, job market data can be used to track the movement of talent to and from the larger companies currently benefiting from AI. It’s not about those at the level of, say, Sam Altman, but those one or two levels below him — these are often the key innovators at the big companies who have filed patents or written papers in their fields. Early in the innovation cycle, they want to go to the “Nvidias” of the world. But then you end up with hundreds of great minds in one place, and eventually they each want to pursue their own ideas. If you track their mobility, you often see them end up at VC-backed start-ups, which can eventually become attractive public small-cap companies, as well as at existing small-cap companies where innovators have more say in the strategic direction of the firm than at the larger companies. 

Adam: It’s not all about technology of course — small caps are a large and diverse opportunity set. From an alpha standpoint, what do you find typically differentiates the winners from the losers?

Peter: For me, it’s crucial to search for positive fundamental inflection points in a company’s business. Given the breadth of the small-cap market, which you noted, there are many potential drivers of such an inflection. They might include a change in a company’s strategic direction brought on by a leadership change; an increase in pricing power like those we saw during the pandemic, created by supply chain disruptions; or the launch of a new product or addition of capacity resulting from investments in the physical plant or the sales force. The key is identifying these shifts before the market does and, in my experience, using tools like data science makes a difference.

Adam: How might data science help you get ahead of the market?

Peter: Finding inflection points early requires being on top of what companies are doing and saying in almost real time. Given the number of companies, this “needle in the haystack” exercise can be challenging even for a fully staffed team of analysts. That’s where tools like our proprietary natural language processing techniques can come in. Let’s say, for example, that a company’s management team mentions adding capacity or launching a new product in a quarterly call. The question for investors is whether the management team is always talking about adding capacity and launching new products, or whether this really is something new and, therefore, a potential inflection point. With the right tools, it’s possible to rapidly search previous management comments and determine whether the latest comments truly stand out.

Adam: I’m often asked about two issues when it comes to the small-cap market: the use of leverage by some companies and the number of unprofitable companies. How do you view these issues?

Peter: Those questions come up frequently in my client discussions as well. On the subject of leverage, my first response is that it’s company specific — there is an appropriate level of leverage for every company, and for some, that level is zero. It’s also somewhat industry specific. I’m more comfortable with leverage in the financial sector, for example, where it’s part of the business model. And I’m a little more comfortable with it in, say, the industrial sector, where the businesses tend to be more sustainable, than in areas like consumer or health care, where a business might face greater obsolescence risk. Finally, I’d add that I don’t think the small-cap market overall is highly levered right now. Capital was cheap over the past decade, and it was easy for companies to improve their balance sheets and term out debt. 

In terms of profitability, it is true that small-cap companies, broadly speaking, are at a low point historically speaking. But I think this has more to do with the makeup of the small-cap market than any inherent profitability problem with small-cap companies. For example, in the 1990s, a large number of regional banks entered the US small-cap market, and, in general, they were very profitable companies. On the other hand, they weren’t companies that drove innovation in their industry — I doubt many of them filed any new patents.

Fast forward a couple of decades and we saw a shift in the small-cap market, with a wave of biotech IPOs. It’s abated in the last two years, but at last count, there were about 250 biotech stocks in the Russell 2000 Index. That means more innovation. Small-cap biotechs are largely clinical-stage companies, and that’s a business model that means losing money until drugs are approved and sales ramp up. But importantly, the balance sheets of these companies tend to be strong with healthy cash levels and little to no debt. So yes, the small-cap space has lower profitability right now, but also a lot more innovation than it did 25 years ago — and to my earlier point on technology diffusion, I expect there’s more to come.