Coiled Tight: Smaller Firms Poised for Outperformance

Money Bizwiz Team
3 Min Read

The Future of Value Investing: What Cannot Be ETF’d?

At the Ben Graham Centre’s 2024 Value Investing Conference in Toronto, Jason Zweig, a veteran columnist for The Wall Street Journal, posed a thought-provoking question in his keynote speech: “What cannot be ETF’d?”

Zweig highlighted the challenge faced by active investors in competing with passive exchange-traded funds, known as Mr. Market. To truly outperform, portfolio managers must focus on areas that cannot be easily packaged into an ETF.

According to Zweig, the key for active managers lies in what he termed “left tail things” such as size, liquidity, marketability, and popularity factors, particularly prevalent in small-cap companies.

The potential for generating alpha in the small-cap space is incredibly high. While these companies may be included in ETFs, passive investing in this segment is not the most effective strategy for long-term alpha creation. Portfolio managers need to develop expertise in navigating this market.

Understanding the Landscape

In the United States, small- and micro-cap stocks have trailed large-cap stocks for nearly a decade, primarily due to shifts in institutional allocations towards private equity. While this trend has impacted the US market, the small-cap effect remains intact in other regions like the UK, Japan, Europe, and emerging markets.

In Canada, the small- and micro-cap space has experienced a bear market, leading to outflows from small-cap-focused funds and subdued M&A and IPO activity. However, recent performance signals a potential turnaround.

Opportunities in Small Caps

Despite the challenges, small-cap stocks present a target-rich environment for savvy investors. Factors like improved balance sheets, increased cash flow metrics, and a resurgence in M&A and IPO activity could serve as catalysts for a re-rating of the sector.

Approaching the small-cap sector requires an active investment strategy, where in-depth research and understanding of individual businesses are essential for success. Embracing potential risks and embracing periods of underperformance are crucial steps towards achieving outperformance.

As Magnus Carlsen aptly puts it, “Not being willing to take risks is an extremely risky strategy.”

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