CIO Insights 3Q2023

Our strategy follows an all-cap approach. This means that there are no restrictions regarding market capitalization [= stock price x number of shares outstanding] of firms we can invest in. Currently, roughly three-quarters of portfolio holdings fall into the mid- and small cap range (below USD 10bn). For comparison, only about ten percent of stocks fit the same category in a typical equity index such as the FTSE All-World Index.

The market price of many large- and mega-cap companies reflect high future growth or profitability expectations. Our valuation sensitivity usually prevents us from buying into such situations. We would rather opt for firms with lower expectations where we believe the potential for upside revaluation, using conservative assumptions, is compelling. Having said that, we ought to draw a distinction between size in the stock market versus size as a business. In fact, when we look at corporate measures such as revenues, capital invested, work force or geographic reach, the typical firm we have invested in is actually quite big. To illustrate, the median number of employees on our companies’ payroll is about twelve thousand, a substantial figure by any objective standard.

For this reason, we believe that the significance of market capitalization must always be put in context of specific business characteristics. For instance, asset-heavy firms such as those operating in telecommunications, utilities, capital goods, logistics or commercial banking face high recurring investments needs which are partly financed through debt. Thus, they support a large balance sheet of which the equity portion only partially accounts for its size in terms of total assets. Next, for companies active in cyclical areas such as energy and materials the market customarily keeps a lid on the capitalization range because it is fearful that sporadic recessions and a mature core business may stunt long-term earnings power. Still others may be hesitant to take advantage of additional business opportunities because they want to avoid the dilution of existing shareholders should fresh capital be necessary to finance the incremental growth. This is often the case where individuals or families are controlling shareholders. Finally, niche players producing highly engineered industrial components usually have a confined addressable market even if they are world leaders in their field. For example, made-to-measure parts that are used in the assembly of long-haul passenger aircraft may be bought by a handful of customers that virtually constitute the entire market.

Notwithstanding these challenges, there are subtle arguments that make it worthwhile to look at neglected mid- and small-cap situations. First, a muted growth scenario may satisfice to justify an investment at the current price. In other words, a company that generates a competitive return on capital and pays a good dividend may deliver a solid performance for shareholders over time despite less exciting growth prospects. Second, structurally difficult industry economics attract fewer incremental competitors, which leaves incumbents’ achievable earnings power undisturbed and predictable. Third, low embedded expectations may elicit a sizable upward adjustment in a firm’s stock price if it shows an unexpected improvement in profitability or business outlook. And fourth, a modest market cap may render takeover financing more plausible for an interested acquirer, even if a substantial premium to the pre-bid market price must be paid.

In conclusion, bargain hunting for hidden gems in the global equities markets makes sense both intuitively and empirically. This is true for all capitalization ranges but can be especially fruitful in the mid- and small-cap space. Here companies get less attention by the financial media, securities analysts and market participants, opening up potential for inefficient price setting. This relative obscurity and the opportunity it presents partly explains the oft-studied performance factor which academics call the “small-cap effect.” With the persistently high allocation to this market segment, the Fund is set to continue to take advantage of this formidable source of return.

Sincerely,

Gregor Trachsel
Chief Investment Officer SG Value Partners AG