How to Pick Small Cap Stocks

How can stock pickers minimise the risks of smaller company investment, while still benefitting from long term growth?

Todd Wenning 31 October, 2013 | 9:55AM

Last week, I kicked off a monthly series on small-cap stocks for our US website and received enough interest from UK readers that I thought I would run a parallel series here on Morningstar.co.uk using UK company examples. The focus of the series will be identifying smaller firms that exhibit signs of possessing an economic moat—that is, a durable rather than fleeting competitive advantage—and are run by skilful management teams. This is a promising combination for any company to have, but it’s particularly attractive for smaller companies with long growth runways, as they have the ability to compound shareholders' capital at high rates of return over long periods of time.

Easier Said Than Done

Of course, it’s not a simple task to identify such companies at just the right time. Indeed, there are many "false positives" for enterprising small-cap investors to sort through during their research process. For an illustration of the concept, consider the following examples.

  • A company with significant short-term competitive advantages that may not be defensible in the medium to long term. As such, it may not possess an economic moat. Apparel retailers, for instance, are often found in this category—as fashion trends shift, some firms enjoy a temporary advantage only to lose it when the next trend emerges.
  • A company that has an economic moat, but whose advantages are slowly being eaten away by able competitors, resulting in less attractive long-term returns on capital. 
  • A company that has exhibited strong growth in recent years or has a valuable franchise, but may be nearing the end of its growth runway, with management struggling to extend it through new product launches.
  • A company that has an attractive business model but is led by poor capital allocators who have consistently made value-destructive investments that limit the company’s long-term potential.  

Any of these four examples could result in a disappointing long-term small-cap investment. As such, a simple screen for shares that fit certain financial criteria - robust return on equity, profit margins, and so on - isn’t enough, and it’s only the first step in a thorough research process. After all, screening data shows only what happened in the past, and investors of course need to focus on what the future may hold. 

Furthermore, as the head of Morningstar's stewardship methodology, I’m particularly interested in how well small-cap management teams allocate shareholder capital. That’s because, unlike with large companies that require massive expenditures just to move the needle, even modest capital allocation decisions by small-cap executives can have a meaningful effect on a firm’s results. Specifically, we want to identify management teams that are making investment decisions that could establish an economic moat or enhance an existing economic moat. 

Moats and Stewardship Matter

Over the longer term, we think the strength and sustainability of a company’s competitive position within an industry plays a major factor in a share’s returns, dictating whether the firm is able to consistently generate returns above its cost of capital and create shareholder value. By employing Morningstar’s economic moat framework to our research in this article series, I hope to better separate bona fide opportunities from the false positives that we’d be more likely to encounter without the framework. 

To illustrate, Morningstar analysts have identified commercial printing company,  De La Rue (DLAR) as a small cap share with a wide economic moat (our highest moat rating), which we believe is derived from its reputation and skill in producing banknotes and security documents. Governments, for instance, face significant switching costs (e.g. counterfeit costs, etc.) when considering unproven vendors to print highly-sensitive materials like banknotes and passports, leaving few companies with the requisite track record to win large contracts. De La Rue's 200-year history and status as the world's largest commercial currency printer with customers in 150 countries makes it arguably the leading name in this select group. Its scale efficiencies also allow De La Rue to print currency at a discount to what it would cost individual countries to print their own currencies, while earning itself a good return on capital.

As Warren Buffett wrote in the 1994 Berkshire Hathaway shareholder letter, "Over time, the skill with which a company’s managers allocate capital has an enormous impact on the enterprise’s value." If we can identify small firms that possess durable competitive advantages, have healthy financials, and are headed by skilful capital allocators, then we might just find a few companies that can generate significant long-term returns given their ability to compound shareholders' capital at a high rate.

De La Rue, staying with the same example, has been awarded a Standard Stewardship Rating by Morningstar analysts, meaning that the firm's management's capital allocation decisions in recent years have had a net neutral effect on shareholder value. The ideal combination is a firm with an economic moat and Exemplary Stewardship - a rare combination, indeed - but De La Rue would certainly not be considered a "false positive" and is an attractive share at the right price.

A Worthy Journey

Despite the potential pitfalls of small-cap investing - the extra share price volatility, companies with less access to the capital markets, and so on - an individual investor with a long time horizon, a calm demeanor, and an eye for finding well-run businesses can have a distinct advantage over large money managers in this arena. One reason is that institutional investors are limited in their ability to purchase meaningful stakes in a small company without affecting the company’s share price or taking an unwanted large ownership position. Another reason is that because institutional investors and analysts naturally pay less attention to the small-cap space, there’s more opportunity for individual investors to exploit potential mis-pricings. In other words, individual investors should look to exploit their small-cap advantage when it's appropriate to their financial plan.

I’m looking forward to highlighting some hidden gems in the small-cap space, and I hope you find the series a valuable addition to Morningstar.co.uk's regular features. If you have any questions along the way, please feel free to contact me here.

Todd Wenning does not own shares of any company mentioned.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
Rating
De La Rue PLC395.00 GBX-2.47-

About Author

Todd Wenning

Todd Wenning  is an equities analyst with Morningstar.

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