Investors have long been fascinated by small companies.  From the historical “small cap premium” to the chance at a “lottery ticket,” investors recognize the potential return profile that makes the asset class so compelling. While the tantalizing ten-bagger looms large in the imaginations of investors, systematically identifying and harnessing real growth within publicly traded small caps over the long term has proven even more elusive. Why has the potential success of a small business been so hard for investors to measure? Have we been looking at the right things?

It is no wonder that investors keep trying to figure out small caps. On average, from 1926 to 2020, small company securities outperformed large cap stocks by nearly two percentage points per year. There is no free lunch in the investing world though, and during the past decade the tables were turned, with large caps outperforming small by nearly three points annually. So is it time for the cycle to turn, and for the sun to shine once again on small companies?

There are reasons to think so. Most importantly, the landscape for small cap investors has changed quite dramatically in recent years. The inexorable rise of index investing has resulted in a steep decline in research and analysis of individual companies. This trend increases market inefficiency, which creates more investment opportunities for those who are willing and able to conduct rigorous small company research.

The Rise of Intangibles

Over the long term, many of the classic quantitative investing metrics that are used to value securities in many asset classes have been shown to not work with small cap growth stocks. The nature and requirements of small cap research have fundamentally shifted since so much of the value and the determinants of future success of small, innovative businesses are now tied up in “intangible assets” that are by and large absent from financial statements under standard GAAP accounting.

Large corporations, of course, also possess intangible assets of value, but there is evidence that intangibles are relatively more important for small, fast-growing companies. Market participants typically do not initially understand these intangible qualities, which tend to be difficult to understand and measure, and it can take years for Wall Street to acknowledge their value in small, disruptive businesses. Therein lies an opportunity for an astute investor to uncover some investment gems.

Let’s take a closer look at what I’m talking about. To take one simple example, research and development is expensed on the income statement (i.e., it depresses short-term earnings) and it is not capitalized on the balance sheet, yet R&D (and resulting patents) is a lifeblood that is key to the future success of so many technology and knowledge-intensive businesses.

Such intangible qualities have a strong impact on results. For instance, a powerful brand means a company can pay its employees somewhat less, and such a company can keep less cash on the balance sheet because the firm will perform relatively well in lean times. Companies that meet this profile have greater flexibility and can invest in their businesses in ways that a company with a weaker brand cannot.

Thus, to analyze and appropriately value global small companies, investors need to quantify and measure multiple intangible assets like company culture, entrepreneurship and management, brand value and effective marketing, innovation and intellectual property, and customer and employee relations. Indeed, the value of (unmeasured) intangibles is so great that it often contradicts how stocks are categorized in style boxes. Traditionally, the price-to-book ratio has been used to distinguish between “growth” and “value” stocks. But if intangibles such as a powerful brand, valuable patents, and superb customer service are not being captured on the balance sheet, then perhaps a “value” stock is simply a mispriced growth company, and a “growth” company appears more like a value stock when the relevant adjustments are made to the financial statements.

How does one quantitatively measure the intangible characteristics that can vault small cap companies to the next level of potential returns? We can get a handle on these traits using big data and related tools. Through technology and artificial intelligence, we now have multiple ways of creating data sets that allow us to quantify intangibles that we once thought were too hard or impossible to measure for small cap stocks the world over. Examples: crowd sourcing employees to learn their level of satisfaction, analyzing sentiment on the internet to understand brand strength and customer service efficacy, accessing credit card receipts to obtain an early idea of ongoing sales, measuring employee turnover and tenure, examining R&D dollars to determine how the firm prioritizes innovation, and analyzing the impact of the founder on current operations through a deep dive into the evolution of business practices.

In sum, most investors are under-allocated to small cap securities at a time when the forces of innovation and disruptive digital technologies are powerful in small businesses.  Employing new technologies and strategies to measure and value the unique intangible characteristics that drive growth can open a world of profitable investment possibilities in small cap companies.

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