The Case for Buying Small Caps Now

NVIDIA

Across the shows: 41 speakers in other episodes, 31 bullish and 11 bearish calls, past 30 days

• Simon Evan-Cook · Downing Fund ManagersBearish

  Nvidia is amazing but cannot grow 50 times from here, so mega-cap growth returns are limited.

  Simon contrasts small companies, which can grow 10, 20 or even 50 times, with Nvidia, which he calls amazing but says cannot grow 50 times from here. He says the maths is impossible. The argument is that mega-cap AI leaders have limited upside from current levels, which supports the case for small caps.

  “Whereas, obviously, a company like NVIDIA, amazing as it is, shouldn't be able to grow by 50 times from here.”at 4:40

Zotefoams

• Stuart Widdowson · Odyssean CapitalBullish

  Zotefoams is an undervalued asset-backed growth story; Odyssean bought at about 60% of real asset value.

  Stuart says the company makes foam using nitrogen, which makes it inert, and it has a very high UK market share of about 85%. The assets are well invested and largely fully depreciated, with useful life to around 2060, so it can pass on inflation without much reinvestment. A management improvement story is under way, with a relatively new CEO and finance director who are incentivised to perform. It is growing, including new capacity near Nike's factories in Vietnam. The stock trades at about 11 times earnings and EV/EBIT of 8-9 times. Book value is materially understated: the Croydon site's insured and replacement value is a multiple of its book value. Odyssean bought at around 60% of real asset value.

  “We think we've probably got in at around 60% of the real asset value. It's a growth story, and we bought in very cheap.”at 27:08

Neuberger Berman Group

• Simon Evan-Cook · Downing Fund ManagersBullish

  Neuberger Berman's emerging market value managers are exceptional; their fund rose during the AI sell-off.

  Simon's firm has bought the emerging market value fund run by Juan Torres and Vera German at Neuberger Berman. It was one of a handful of funds that rose while the market fell during the AI sell-off in July. Simon takes this as evidence the fund delivers when it is needed, which is why he calls the managers exceptional.

  “Juan Torres and Vera German, who are exceptional emerging market value fund managers. We were lucky enough to get into their fund in July when they were one of a handful of funds that went up when the market was being dragged down by the AI”at 37:26

US stock market outlook

• Stuart Widdowson · Odyssean Capital

  Buybacks and M&A now more than offset small-cap outflows, so small caps may be near the end of their clearing phase.

  Stuart explains that when a sector is out of favour, open-ended funds face redemptions and become forced sellers. With no buybacks or M&A, this puts pressure on small caps, so illiquidity works against investors. He says buybacks and M&A are now more than compensating for the small outflows. Good news is creating positive share-price momentum, so illiquidity has started to work in investors' favour. Some holdings are up 100% this year, and he believes small caps are near the end of the clearing phase.

  “What we're starting to find actually is buybacks and M and A is more than compensating for small outflows.”at 15:53

• Stuart Widdowson · Odyssean Capital

  Developed-market small caps are among the cheapest assets globally, and UK small caps have rerating upside if valuations revert.

  Stuart argues that small caps generally, and value small caps in particular, are very cheap worldwide, and that developed-market small caps are among the cheapest assets in the world today. He says the UK is an outlier within that cheapness. If investors believe in reversion to the mean, there is still upside on rating. He cites Simon Evan-Cook's Research Affiliates-based analysis, which suggests post-inflation forward returns from developed small caps could be very attractive over the next ten years.

  “Developed market small caps are some of the cheapest assets around... Quite small caps are cheapest assets around in the world today.”at 19:03

• Simon Evan-Cook · Downing Fund Managers

  US mega-cap growth has exhausted its return potential; small caps can deliver inflation plus 5-7% nominal.

  Simon cites Research Affiliates' forward-return work, which uses valuations to infer expected returns in a similar way to weather forecasting. US mega-cap growth, which did best over the last 10 to 15 years, has used up its potential return because valuations are so high. European, UK and US small caps have not over-delivered but have delivered sustainable returns, and there is no reason they cannot keep delivering inflation plus 5-7%, which is roughly 9-11% nominal. A good fund manager could add one or two points. This gives asset allocators a respectable alternative when equities look expensive and bonds look compromised.

  “there's no reason to think that over the next ten years that they can't keep delivering you inflation plus five, six, 7%.”at 21:10

International equities

• Simon Evan-Cook · Downing Fund Managers

  UK small-cap value has been the best long-run asset class since 1955, and great managers can add to that.

  Simon agrees with a value explanation for the small-cap effect and cites Dimson and Marsh data for the UK back to 1955. The best asset class over that period is small-cap value, which he has seen in his own career. He says a talented manager in that segment is worth holding on to, and gives Alex Wright's Fidelity UK Smaller Companies Fund as an example, which was the best UK fund over ten years of his management because of market inefficiencies and skill.

  “the very best asset class you can be in is small cap value. And I've certainly seen that in my time, small cap value over long periods smokes everything else.”at 22:54

• Simon Evan-Cook · Downing Fund Managers

  UK small caps stay downtrodden despite M&A; they should rebound once active UK funds finish selling.

  UK small caps are seeing M&A activity but still trade poorly because peer active UK equity funds have been selling the small caps they hold. Simon argues that once the last of those funds has sold, very little should be needed to reverse the move, so the group should start rising.

  “the market is still downtrodden, and that's because of the peers on my side of the fence who have been busy selling their UK equity, active UK equity funds that hold the small caps. And at some point, the last one of those will have left.”at 35:31

• Stuart Widdowson · Odyssean Capital

  Global small caps, especially value small caps, are very cheap, with rating upside if valuations revert.

  Stuart says small caps generally, and value small caps in particular, are very cheap around the world. He notes the UK is an outlier within that group. If valuations revert to the mean, there is still upside on ratings, although he adds that each circumstance is different.

  “small caps generally, particularly value small caps, are very cheap. UK is an outlier within that. If you believe in reversion to mean, there's still upside on rating.”at 39:45

Asset managers, brokers & exchanges

• Simon Evan-Cook · Downing Fund Managers

  Small, new funds tend to outperform early on because they are nimble and managers are hungry, but rising fixed costs deter launches.

  Simon argues that large funds usually became large because they performed exceptionally in their early years. Small funds can buy smaller companies, which large funds cannot, and the smaller-company market is less efficient, so managers can find overlooked companies that grow many times over. New funds run by either younger, hungry managers or experienced managers breaking away from red tape and risk departments often do well early on. Once a fund grows, its CEO starts to care and pushes for benchmark-hugging, which can restrain style. Fixed costs of running funds have become more onerous, so a fund now needs more money to be viable, which he regards as a shame and a barrier to new entrants.

  “those big funds only really got big because in their early years, they smashed it out of the park.”at 3:35

Europe's economy

• Stuart Widdowson · Odyssean Capital

  Odyssean has been bearish on domestic UK companies for a long time, so it invests in international firms headquartered in the UK.

  Stuart says Odyssean has been very bearish on UK domestic companies for some time. He is not a fan of the corporate environment or the broader economic conditions around them. The firm therefore focused on finding international companies headquartered in the UK rather than betting on the UK economy, which he says has proved a good thing.

  “We've been very bearish about the prospects for domestic UK companies for some time.”at 14:40

Private equity

• Stuart Widdowson · Odyssean Capital

  Higher debt costs make take-privates harder to justify, so private equity poses less risk to small-cap public markets.

  Stuart argues private equity used to find it easy to take UK companies private when debt was cheap. Now that the cost of debt is much higher, that is much harder to justify. He therefore sees less risk from private equity, though not zero. He says the bigger issue is that interesting niche market leaders are not recognised by the UK stock market and get bought by trade buyers.

  “I think where the cost of debt is now, it's much harder to justify taking companies private. So I don't see so much risk from private equity.”at 32:16

IPOs, M&A & deal activity

• Stuart Widdowson · Odyssean Capital

  Once flows stabilise, small caps should rerate enough to make IPOs viable again; trade buyers are already buying.

  Stuart says some interesting niche global market leaders in the UK are being bought by trade buyers because the stock market does not recognise them properly, and this year's M&A shows this is happening. He thinks that once flows have stabilised, what is left should rerate, probably to a point where IPOs make sense again. There are also many assets private equity needs to sell, and the next buyout wave will not work, so IPOs may become a good exit again. He describes himself as short-term concerned.

  “it will probably re rate to a point where IPOs make sense again and there's so many assets that private equity needs to sell.”at 33:30

AI bubble & tech valuations

• Simon Evan-Cook · Downing Fund Managers

  A rotation out of concentrated AI stocks into neglected value stocks can happen without an economic crash.

  Simon points to 2000, when market concentration was similar. UK funds, mostly equity income funds with valuation discipline, bought boring companies whose prices rose as tech sold off, and about 50 such UK funds rose in that bear market. He argues that if the sell-off is a pure rotation rather than an economic event, a war or something worse, there is no reason money cannot move from the concentrated AI stocks into the neglected parts of the market.

  “So if it's purely a rotation rather than economic event or a war or something worse, there's no reason, I think, that movement of money out of the massive concentration in AI stocks into all the stuff that's been neglected for three years can't happen as well.”at 39:25