‘Smaller companies are being ignored by the business and analyst community; they are slightly unloved.’ So said Guy Eastman, European investment director for Schroder Ventures International Investment Trust, in the Financial Times in mid-May. According to him, the current poor stock performance of many small caps is making it harder for them to raise capital, and many are now becoming turnaround targets.
At least there are value plays in the small-cap pack. Romain Burnand, small cap fund manager at Paris-based Moneta Asset Management, is in search of ‘overlooked and neglected stocks which the market has undervalued’ for his new fund.
Other investors may hunt small-cap territory for superior growth potential or to diversify their portfolios. ‘Fund managers will shape their selection procedures to reflect the objectives of their fund,’ says Harry Nimmo, UK head of small caps at Standard Life Investments. But with so many small caps to choose from, how do managers narrow the field? Where do they begin their search?
Going in under the radar
As a starting point, many fund managers look at research provided by their own analysts or by sell-side firms. Analysts’ screening processes seek out companies that satisfy criteria such as earnings, market capitalization, price-to-book value, sales growth or the size of their potential market. ‘Our analysts use Holt or Quest screens to correctly identify companies and compare them within a particular sector,’ says Alex Tarver, market analyst and portfolio strategist at Fidelity. Models such as Altman’s Z-Score use various financial ratios to gauge a company’s underlying financial strength.
So step one for IROs at small caps: make sure your company’s current financial data is always readily available. Otherwise, you’ll be in stealth mode instead of appearing as a bright dot on a fund manager’s radar screen.
Of course, most companies get passed over in the screening process for reasons other than a lack of data – lack of convincing cash flows or earnings, for example. They may, however, still have a convincing story to tell. But how can you win the ear of investors? Several channels are open to small cap IROs who want to put their companies on the map. Step two, then: enlist the help of the sell side.
‘We often depend on stockbrokers to draw our attention to emerging small caps, arrange meetings with management and so on,’ says Nimmo. ‘Most companies that have come to the market have a broker. The IRO should leverage broker contacts in the fund management community,’ adds Tarver, referring to the UK corporate broker model. His comment could apply equally to US companies that leverage their investment banking relationships to reach institutional clients.
When analyzing small caps, Tarver explains, Fidelity often talks to a company’s local broker first, since they usually have an informed opinion and will have developed a relationship with management.
One US fund manager advises IROs to ensure their companies participate in trade conferences and target analysts who might be interested in covering them. ‘IROs should know who the small cap portfolio managers are, and try to reach them through sell-side analysts who know the fund management community,’ he explains.
It’s a tactic that has worked for Italian pharmaceuticals company Recordati. ‘When targeting analysts and investors, we identify specialists in Italian small and mid-cap companies as well as industry specialists,’ explains CFO Fritz Squindo. ‘Our roadshow is organized by our brokers who will identify investors interested in this kind of company and arrange meetings with them.’
IROs at small caps shouldn’t be shy about contacting analysts and investors directly. ‘As a former sell-side analyst who used to call tons of clients, I am not against companies calling me,’ says Burnand.
Bob Powers, VP of IR at New York’s Paxar Corp, tells of his experience: ‘Two of our analysts arrived via their own screening processes. The third we targeted aggressively.’ That third analyst found himself the object of fierce attention when Paxar’s targeting provider suggested his firm.
‘Being in a niche industry, comparability is difficult, so I spend a lot of time with analysts and potential investors to help them understand our business,’ continues Powers. ‘That way they can better formulate their queries when they meet with management.’
‘Contact between IROs and analysts is a two-way thing,’ Tarver adds. ‘The IRO can bring certain insights about the company – within the boundaries of disclosure rules – while analysts may be able to tell IROs what opinion they have formed of the company and why.’ Once their interest has been aroused, analysts and potential investors expect full access to company management, and it is here above all that the battle to enlarge the investor base can be won or lost.
Meet the management
‘The single most important prerequisite for investing in any company is good quality management who not only are competent but can convince fund managers and analysts that they are competent,’ says Adrian McMillan, finance director at London-based independent analysis firm Oriel Securities. ‘Companies of all sizes face many challenges and it takes competent management to take the right decision often enough for the company to be successful.’ Hence IROs need to make sure executives are both available and committed to getting their message across.
Nimmo agrees with the importance of meeting management. ‘We want to know what they have done in their past lives,’he says. ‘Although we tend to build large positions, we will exit if management strategy doesn’t continue to convince us, or if there are fundamental changes in a company’s competitive position.’ McMillan confirms this mercurial outlook: ‘When an institution ceases to trust in the competence of management or simply ceases to trust the management, they will seek to exit PDQ.’
A healthy amount of trading in a company’s shares is also important for investors, who balk at building positions if liquidity problems threaten to make it difficult to sell. Liquidity may be limited by a low free float, for instance, if management or a founding family retain control. Or it may just be the company is not well-known to investors or the sector is out of favor. Low liquidity often means a wider price spread, too. ‘Small cap managers can take a long-term view, but they need to counteract low liquidity in their holdings by being sufficiently diversified,’ Fidelity’s Tarver adds.
‘Liquidity is an issue which isn’t going to go away for many small-cap stocks. Investors usually have to back management for some length of time,’ agrees McMillan. Recordati’s Squindo observes, ‘Liquidity is important for investors, both those who want to build positions in the company and those who want to be sure they can exit quickly.’
When building a position in a small company, an institutional investor often needs to spread purchases over a long period to avoid inflating the price. Likewise a large sell order, when the fund decides to exit, could cause the price of an illiquid stock to nosedive. A byproduct of illiquidity may be a higher cost of capital for the company due to the investor’s higher implicit risk (and hence higher expected rate of return).
Another anonymous US fund manager says his fund doesn’t place any formal limits on the company’s float or market liquidity. He explains, however, ‘We will take these factors into account in the context of upside and downside risk. When buying into relatively illiquid companies, we take more time to build a position in order not to force up the price we are paying.’
In Paxar’s case, the stock is fairly liquid for a small company with an average of over 100,000 shares traded a day. ‘Our level of liquidity gives investors a better opportunity to move into the stock without having to overpay and, if the circumstances of their portfolio change, they can exit without too much difficulty,’ Powers says.
Squindo notes how Recordati, which is still 56 percent controlled by the founding family, upped its liquidity by converting savings shares to ordinary shares in 2001, raising its profile in the investor community considerably.
Burnand suggests IROs can play a part in increasing liquidity by ensuring newswires such as Reuters and Bloomberg are kept up-to-date with events such as strategic partnerships or new products – while taking care that existing disclosure rules are observed. ‘Even press articles such as something about the construction of a new factory may draw investors’ attention,’ he says.
Far horizons
‘A lot of our [small cap] holdings reach 5-10 percent of the company, and this means we are effectively locked into our investments,’ Nimmo comments. ‘We generally have a long-term time horizon, depending on the risk/reward characteristics of the fund.’
Ultimately an investment house wants its small cap funds’ investments to grow large enough to be transferred to its large cap funds. Nimmo points to two such cases for Standard Life: Capita Group and Sage Group. They were included in one of Standard’s small cap funds in the early 1990s and both are now components of the FTSE 100.
Says Burnand: ‘We are obviously prepared to be long-term holders of stocks we believe in. Even unloved stocks are reacting to EPS changes. As long as there is a prospect for EPS growth, even low P/E stocks can increase in value. If the stock jumps to higher P/E because it has become part of a fashionable investment theme or a potential takeover target, that is an added bonus.’
‘Investors’ main concerns are our liquidity, our financial results and our products pipeline,’ says Squindo. ‘If Recordati continues to have a positive track record in terms of meeting our strategic goals, investors will continue to be interested.’
‘As Buffett and others have said, the patient investor will ultimately be rewarded, but you have to keep reminding yourself why you bought each company in the first place,’ Tarver concludes. Small-cap stocks can have the potential to deliver large rewards, but, as fund managers know, a smaller company may need more time than its larger brethren to build its business, execute strategy, and ultimately gain investors’ confidence. The IRO’s job is to mobilize all the available tools – including the sell side, management and the board of directors – to ensure the company doesn’t escape the attention of institutional investors.
Shine a light on me
‘Sometimes you notice companies because they supply larger companies that you already have in your portfolio. Other times, it may take an event to put a company under the spotlight,’ observes Alex Tarver, market analyst and portfolio strategist at Fidelity.
InVision Technologies, a Nasdaq-listed aviation security company in California, was one of the ‘unloved stocks’ bought early on by small cap fund manager Romain Burnand at Moneta Asset Management in Paris. Then, in the aftermath of September 11, before any increase in sales, investors piled into the stock. InVision’s share price soared from around $4 to over $40 then settled into a range of $20-35. The average trading volume multiplied by 500-1,000 times and is still around 20 times its level before the attacks.
Shortly after 9/11 Jordan Goldstein became InVision’s IRO. At the time, after a period of losses, the company was returning to break-even point and needed to ramp up capacity in short order.
‘When the investor community discovered our company and the specialized nature of our products, we were overwhelmed with inquiries about the size of our market, our projections and so on,’ says Goldstein. But to meet soaring demand as orders flooded in from the world’s airports, InVision needed to invest in new plant and staff. Frantic investor interest ensured that a secondary offering would be successful. Ultimately the company delivered on investor expectations – sales multiplied sixfold between 2001 and 2002 and continue to grow.
‘Noel Atkinson of Emerging Growth Equities was the first analyst to initiate coverage of our company in January 2002,’ says Goldstein. ‘We hadn’t started targeting analysts yet because we were in the middle of planning a follow-on offering and were already involved in discussions with our investment bank.’
InVision’s secondary offering was completed in March 2002. ‘Four banks aided us in the process – Merrill Lynch, Lehman, SG Cowen and Needham – and shortly afterwards analysts at the four began covering the company,’ says Goldstein. Since then four more analysts have added the company to their rosters.
