With large capitalization stocks leading markets over most of the latest three- and five-year rolling periods, it is no surprise that small-cap and micro-cap stocks have lost some luster in the eyes of institutional investors. That said, we should remind ourselves why small– and micro-cap stocks make excellent long-term investments. Smaller companies have provided better returns than larger companies over the long-term. Exhibit 1 displays average market capitalizations of companies*broken down by deciles and their associated returns from 1926 through 9/30/2018.

*Center for Research in Security Prices (CRSP) data used in the analysis Source: http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html 

At first glance, the rationale for investing in small companies can be somewhat counterintuitive. Typically, smaller companies:

• Are less profitable

• Have lower market valuations (as a multiple of sales)

• Are followed by fewer analysts

• Are prone to more volatility

With this in mind, let’s review the mechanics of how small companies can unlock tremendous value over time—but let’s start with some of the challenges small companies face in the short-term.

First, the key profitability measures for small companies are generally less robust than their large-cap counterparts, primarily because they do not benefit from the same economies of scale in areas such as purchasing, labor, benefits and costs of capital. To illustrate this point, observe the disparities in operating margins among large-, small- and micro-cap companies in Exhibit 2. The Russell 1000®Index operating margin is nearly double the Russell 2000®and triple the Russell Microcap®Index. As the diagram points out, small companies struggle to achieve the profit margins of their larger compatriots.

The second challenge facing small companies in the short-term is valuation. As one might assume, the more profitable the firm, the higher its valuations are as a multiple of sales. In general, small companies have lower valuations compared to those of large companies. Observe the differences in valuations between large and small companies in Exhibit 3. It is clear that markets pay a higher price for revenue generated by large companies than for those of smaller companies.

With these two strikes—lower margins and reduced valuations—how can investors expect better returns from small company stocks? To begin answering this question, consider the life cycle of a small company. They start out small and, if management is on target and strategies are sound, revenues grow over time and profit margins increase—as do their valuations.

This is the source of valuation expansion that long-term investors seek. As a company’s stock moves from micro-cap to large-cap, its enterprise value-to-sales ratio increases from 1.2 times to 2.5 times —more than a 100% valuation increase. A great example of this phenomenon is Nike. In 1985, Nike stock was valued at 0.35 times sales. By 2018, that ratio increased to 3.5 times sales. As the stock moved from small cap to large cap stock (reflecting the growth of the company), Nike’s margins and valuation increased, much to the delight of its investors.

Organic growth is not the only path to realizing outsized gains. We need to keep in mind that large companies strategically buy small companies for what could be described as “valuation arbitrage.” Put another way, large companies purchase small companies to realize an immediate increase in revenue-based valuations. For example, let’s assume Acme, Inc., a large company, is valued at an average of 2.5 times revenue. Acme buys Bizco, a small company, for a 30% premium to the average valuation of 1.4 times revenue (or 1.8 times revenue). When this occurs, Acme makes an immediate valuation arbitrage by simply rolling Bizco’s revenue onto their balance sheet, resulting in nearly a 40% valuation gain on revenues. This illustrates that acquisition (as an alternative to organic growth) can be a path for small companies to realize long-term gain for investors.

Another hidden reason why small- and micro-cap companies offer more long-term opportunity is coverage. The average company in the Russell 1000 Index is followed by 26 research analysts, while the average company in the Russell 2000 Index is followed by just eight—and some of those are merely statistical ranking services. Why is this an opportunity? Lack of coverage when companies are young means they are free to make bold moves and big strategic pivots without the scrutiny of analysts questioning their every motive. As those management decisions translate to growth, small companies are gradually pulled into the analyst spotlight. While that increase in coverage may throttle some of the early-stage boldness, the enhanced visibility attracts more investors, bringing needed capital that fuels further growth. As such, lack of coverage helps a small company in its early stage and the onset of coverage helps the company in its latter stage.

Finally, the inherent volatility of small stocks offers investors a long-term advantage. On a day-to-day basis, small- and micro-cap stock performance can swing significantly in either direction. While many short-term investors shun that kind of volatility and risk, firms like Pacific Ridge Capital understand that riding the volatility wave is a necessary component of growth. That’s where stock selection based on solid fundamentals comes into play. The risk is counterbalanced by experience of successfully choosing companies that make it to the other side of up-and-down growth. When combined with the factors we’ve discussed—better margins, better valuations and more coverage—small stocks begin to look very attractive as a long-term investment. 

Investing in small- and micro-cap stocks may not seem like a timely investment in today’s capital market conditions, but the virtues of these companies are timeless. At Pacific Ridge Capital Partners, we believe small- and micro-cap companies have a perennial place in any institutional portfolio. The current environment presents a good opportunity to add or increase allocations to these asset classes. We welcome the opportunity to discuss the advantages these securities can bring to you.

Sincerely,

Pacific Ridge Capital Partners

The firm maintains composites on both its strategies. The Small Cap Value Composite incepted on August 1, 2010. The Micro Cap Value incepted on April 1, 2007. All returns greater than one year are annualized. The performance results of the Micro Cap Value strategy includes accounts managed at another advisor. The Firm maintains a complete list and description of composites and a presentation that complies with the requirements of GIPS® standards, which is available upon request by contacting Peter Trumbo, Chief Compliance Officer at (503) 886-8972 or Peter.Trumbo@PacificRidgeCapital.com. The portfolio statistics are shown as supplemental information only and complements the full disclosure presentation (fully compliant GIPS presentation).

About Pacific Ridge Capital Partners

Pacific Ridge Capital Partners is an employee-owned firm. We generate our own investment ideas using fundamental analysis and bottom-up stock picking. The investment team applies a consistent, patient and disciplined process that results in low turnover and stability. Our proven philosophy has performed well over many investment cycles and it is the consistent application of this strategy that makes Pacific Ridge unique. 

The principals of Pacific Ridge Capital Partners are invested along with our clients in each of our strategies. 

PRCP Small Cap Value – Our Small Cap Value strategy generally purchases stocks in the bottom three-quarters of the Russell 2000® Index. This smaller capitalization segment has a large number of underfollowed companies, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 75 and 110. 

PRCP Micro Cap Value – Our Micro Cap Value strategy generally purchases stocks in the Russell Microcap® Index. This segment is widely underfollowed, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 50 and 80. 

We believe these market cap segments offer great potential returns and additional diversification for our clients.

For further information about Pacific Ridge Capital Partners and our investment strat- egies, we invite you to contact Tammy Wood via email at Tammy.Wood@PacificRidgeCapital or by phone at (503) 878-8502. 

Disclosures 

Pacific Ridge Capital Partners, LLC (“Pacific Ridge”, “PRCP”, or “the Firm”) is an employee-owned investment advisor registered with the Securities and Exchange Commission under the Investment Advisor Act of 1940. The Firm was established in June 2010, and has one office located in Lake Oswego, Oregon. Pacific Ridge claims compliance with the Global Investment Performance Standards (GIPS®).

Sources: Pacific Ridge; FactSet Research Systems (“FactSet”); and Russell Investment Group (“Russell”) who is the source and owner of the Russell Index data. 

The current annual investment advisory fees for the portfolios managed in the Firm’s Small and Micro Cap Value strategies are 1.00% and 1.50% of assets, respectively. Returns for the composites are presented gross and net of management fees and other expenses and includes realized and unrealized gains and losses, cash and cash equivalents and related interest income, and accrued based dividends. The Firm calculates time weighted rates of return by geometrically linking portfolio simple rates of return at least monthly, with adjustments made for significant external cash flows. The composite returns are calculated by asset weighting the individual portfolio returns using beginning of the period values. All returns are calculated after the deduction of the actual trading expenses incurred during the period.

The information provided should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in our strategy at the time you receive this report or that securities sold have not been repurchased. It should not be assumed that any of the holdings discussed herein were or will be profitable or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. Past performance is no guarantee of future results.

Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the Firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.

The Russell 2000® Value Index measures the performance of the Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. For comparison purposes, the index is fully invested, which includes the reinvestment of income. The return for the index does not include any transaction costs, management fees or other costs.

The Russell Microcap® Value Index measures the performance of the microcap segment of the U.S. equity market. For comparison purposes, the index is fully invested, which includes the reinvestment of income. The return for the index does not include any transaction costs, management fees or other costs.

Returns and asset values are stated in US dollars.