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Small Caps: Adventures in Fundamental Research

How do you begin to research a company when so little information is readily available beyond a name and a set of regulatory filings? This is the challenge that defines small-cap investing, an asset class that invariably entails an adventure in fundamental research.

The superheroes of the stock market—mainly US corporations valued at or close to a trillion dollars—tend to dominate investment news and research. And yet little-known small companies—often based outside the US—that never generate a headline remain some of the most vibrant sources of innovation. If the biggest large caps sell the finished products that investors and consumers know well, small caps often occupy a small niche along the global supply chain, providing a critical piece of technology known only to its intended audience.

Watch to learn about the little-known Swiss company that produces a critical component for Tesla vehicles.

Because small companies solving esoteric problems usually aren’t well-covered by outside analysts or journalists, building a deep understanding of their businesses requires starting from scratch. For some investment firms, this lack of information means the foray into small-cap territory demands an entirely different way of thinking and working. But for Harding Loevner, it’s why small caps are a natural fit.

Our firm’s investment philosophy is based on the premise that we cannot forecast the direction of stock prices, but that through bottom-up analysis of the more durable aspects of companies we can identify the most exceptional among them. We look for strong competitive advantages, sound finances, and capable leaders, with the belief that companies possessing these attributes can be reasonably expected to produce superior growth and weather unforeseen events better than the average company, which will eventually be reflected in their stock prices.

Because small companies solving esoteric problems usually aren’t well-covered by outside analysts or journalists, building a deep understanding of their businesses requires starting from scratch.

For small companies especially, what this research process means in a practical sense is spending a great deal of time with engineers in manufacturing and R&D facilities, seeing the guts of machinery and the software that forms the mainspring of a company’s growth and competitive advantage. At times, our team has been the first to request a meeting with a small company’s management, never mind visit its factory. We must develop our own expertise—whether it be learning the ins and outs of recycling technology (to determine TOMRA’s role in meeting European climate-change directives) or the intricacies of atmospheric sensors (to understand why customers would choose Vaisala’s for their biolabs, air-traffic control, or space missions).

One challenge of investing in small caps is trying to ascertain whether a company’s niche is one that can provide growth for a very long time. Another is that the barriers to entry are far from assured. Small companies that don’t continually innovate risk ceding their competitive advantage to rivals, particularly when larger, well-capitalized companies take an interest in the same area. Our on-site visits and discussions with suppliers and customers help us gauge R&D initiatives and product launches to make sure that our companies are investing appropriately to protect their turf.

Watch as Harding Loevner portfolio manager Jafar Rizvi discusses why small companies are the unsung heroes of the economy.

Some investment firms keep small-cap teams separate from the rest of their analysts, a potential limitation to collaborating on bottom-up research. Our small-cap strategies are instead directly supported by Harding Loevner’s global research platform in the same way as all our other strategies. This helps us to understand small companies in the context of their broader industries and develop a more complete view of their supply chains and competitive position relative to rivals of all sizes.

Getting to know businesses and their managements intimately through a systematic process can also tip off investors to disconcerting traits long before routine financial reports do. For example, when the parking lot of one company that wasn’t yet generating free cash flow looked like a Maserati dealership, we suspected management had its priorities wrong and steered clear of the stock; it’s nearly worthless today.

Throughout my ten years managing the International Small Companies (ISC) strategy, most of the entrepreneurs I have encountered didn’t have ambitions of becoming the next celebrity CEO. Or driving a supercar. They mainly want for their businesses to be the best in their niche, and because of that, they tend to face less pressure to expand beyond those core competencies than large companies do. We consider such clear focus to be a hallmark of good management.

As a result, small companies can be quite skilled at what they do. Take Uno Minda, which produces automotive components such as alternate fuel systems used in electric vehicles. Years ago, the Indian company adopted Japanese techniques such as kaizen to supercharge its manufacturing processes and growth. Now, Uno Minda’s Japanese partners visit its factories to learn how to improve their own operations.

With so little of what small companies do visible to the outside world, they aren’t well-understood by markets—and may not be for some time. It requires investors to take a long-term view, another way in which small caps are particularly suited to our firm’s philosophy. But as much as we’d like to hold onto the best small caps forever, the bittersweet reality is that those are the companies most likely to move on from the asset class. Some get acquired. Others graduate out of the portfolio because they grow too valuable to fit the definition. (In just the last year, several of our ISC holdings—including Chr. Hansen, Dechra, EMIS Group, and Network International—have received takeover offers from strategic buyers or private equity firms.)

Some people enjoy covering the superheroes. But after getting to do both, for me there is nothing like the joy of discovering the greatest small companies most investors haven’t yet heard of.

What Is a Small Cap?

Different asset managers have different answers. For some, a small cap is defined by a rigid view of market capitalizations. For example, any company less than US$2 billion may be eligible for a small-cap strategy, and any company that eventually exceeds US$3 billion in market value must be sold. The trouble with using such blunt thresholds is that they fail to take into account a general increase in markets.

Other firms may set a market-cap limit for only the initial purchase. But this is how a “small-cap portfolio” can end up rather awkwardly holding lots of companies with lofty US$25 billion market caps.

Our definition says small is relative. It starts with the parameters set by the index provider MSCI, which considers a small cap to be any investable company that falls below the 85th percentile of market caps. We then consider the market cap ranges of companies in the MSCI ACWI ex US Small Cap Index (for our international strategy) or the MSCI ACWI Small Cap Index (for our global strategy) and their weighted average market caps relative to the index. This combination ensures that we steer clear of tiny, illiquid holdings as well as companies too large to fit the small cap label.

We like this approach because it allows for different ranges for different equity markets around the world, and because the most reasonable definition of a small cap is one that changes over time. What is “small” today would’ve been considered huge 50 years ago. When the international index launched in 2007, the largest members were valued at less than US$5 billion. Today, they are more than twice as big. Don’t be surprised if in another 50 years a US$25 billion company truly is a small cap.

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What’s Driving China’s Regulatory Transformation

On the surface, there are few precedents for China’s quick-fire regulatory changes, which over the past few months have transformed everything from e-commerce and education to health care and real estate.

One can only speculate on the reasons for this synchronous timing, but one possibility that stands out is the confluence of the five-year policy and leadership cycles in China. This is the first year of the 2021-25 Five-Year Plan, but more importantly, it is the final full year before the top 200 or so members of the Central Committee of the Communist Party of China are selected at its National Congress in October 2022. It bears remembering that those politicians are similar to counterparts elsewhere in facing challenges that have diverted them from other priorities. They spent the first two years of their terms coping with escalating US-China trade tensions, and just when “normal order” loomed after the signing of the Phase One trade agreement, COVID-19 hijacked everyone’s lives. Only recently have they gotten a chance to work on much-delayed goals.

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Too Much Information

In the late 1950s, in his book Common Stocks and Uncommon Profits, Phil Fisher recommended making investment decisions based on “scuttlebutt,” the kind of information an investor could get by asking around. This entailed tracking down and interrogating customers and competitors, employees, and former employees. Doing research, in the sense of gathering evidence and analyzing it to reach a conclusion, was hard work, but enabled analysts committed to such intellectual labor to obtain an edge over their competitors simply by having better, and more complete, information.

Indeed, when I started my career in investing in the late 1970s, obtaining even basic financial info about a German car company still required going to Germany and knocking on the company’s door.

Now gathering information no longer takes much effort. We are deluged by floods of data—not only the details of prices, volumes, margins, and capital investments of individual companies, but also highly granular data about credit card receipts, numbers of cars in parking lots, or words used in media reports. These new, “alternative” sources of information have briefly given some stock pickers a slight edge in predicting short-term stock price movements. The informational advantage provided by such data is but fleeting, however; once this data is commercially accessible to everyone, the advantage disappears. Thus, even for the short-term investor, information gathering itself no longer provides a lasting edge.

For long-term investors, the relationship to information has changed even more fundamentally. You no longer need to seek information; it finds you. Your job, rather, is to act as what Lou Gerstner, the former CEO of IBM, called an “intelligent filter”—determining the information that is important and ignoring data that (in the case of the investor) doesn’t help you forecast cash flows and estimate the value of a security.

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Out of Our Minds—From the Beginning

People who know a little about the history of our firm sometimes credit us with being ahead of our time. When we set out 30+ years ago we made an early decision that we would only invest in stocks of high-quality companies capable of growing revenues and cash flows over long periods of time, and then only when we could purchase them at reasonable prices. Mind you, this was two years before Eugene Fama and Kenneth French proposed their three-factor model incorporating value, and more than a decade before Cliff Asness’s seminal work on quality or the conflicting studies on the long-term premium provided by growth. So, we weren’t thinking of these aspects of our process as “factors,” or permanent sources of returns, in the current sense of the term. We thought they were merely sensible principles, based on our own beliefs about the markets, that would give us the best chance of achieving the above-market returns necessary to satisfy our clients and sustain our fledgling enterprise. Considering we had left well-paying jobs to stake our futures on these ideas, there were probably some people who thought us out of our minds. And, in a sense, they were right.