Small Caps: Adventures in Fundamental Research

By Jafar Rizvi, CFA | May 23, 2023

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

By Lee Gao | November 05, 2021

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.

As policymakers picked up where they had left off, they found themselves facing stakes heightened by the pandemic: stagnating incomes, weak consumer confidence, and a growing demographic crisis as birthrates continue to decline. These challenges may have accentuated their top priorities, ones that have been repeatedly highlighted in official policy statements over the last few years: innovation, rule of law, culture, the environment, and social harmony.

The fact is that ever since Deng Xiaoping initiated the initial series of capitalist overhauls in the 1980s, China has undergone multiple periods of reform. These changes cut a wide swath across economic activity and drastically curtailed certain targeted sectors. They were painful in their time, creating mass unemployment and fueling social discontent. Ultimately, they laid the groundwork and helped sustain several decades of nearly uninterrupted growth.

Previous reforms were far less visible to foreign observers because they barely touched the companies widely held by global investors at the time. For example, the coordinated supply-side reforms of 2015, undertaken in part to reduce chronic pollution, shuttered roughly one-fifth of China’s steel capacity (equivalent to Japan’s entire steel output) in under two years. Air quality improved dramatically, while bankruptcies almost tripled as many marginal producers were killed off. But not many foreign investors owned marginal steel producers, preferring to own faster growing companies such as Alibaba and New Oriental. Likewise, the anti-corruption campaigns that began in 2013 may have ushered in a more sustainable business environment, but they were terrible for liquor makers, whose products had become popular high-priced gifts to lubricate business deals and lobbying efforts. Kweichow Moutai, producer of its fiery namesake liquor, saw its sales growth plummet in 2014 and 2015, but the company was not nearly as widely owned externally as Tencent is today.

Much of the focus of late has been on one policy priority: common prosperity. Redolent of China’s collectivist past (the term was first used by Mao in 1950), the phrase frightens some foreign investors who are unsure which companies’ prosperity will be sacrificed at the altar of the commons. Yet policymakers have been clear: their focus is on growing middle-class disposable income, not “robbing the rich to help the poor,” according to Han Wenxiu, executive deputy director of the General Office of the Central Financial and Economic Affairs Commission. This overt aversion to a European-style welfare model may seem contradictory for a party that still pays lip service to its Marxist roots. But the reality is that China systematically underinvested in education, health care, and other social spending—especially in rural areas—as it sought to catch up economically with more developed economies. Until now, policymakers have done little in the way of redistribution; indirect taxes, which generally serve to widen income inequality, still represent two-thirds of fiscal revenue. With China coming into its own, we should expect its practices to converge with those in more advanced economies, including some form of income and wealth redistribution.

To my mind, these regulations are reminiscent of the US Progressive Era of the late 19th and early 20th centuries, epitomized by Theodore Roosevelt’s Square Deal.

In practice, the government’s targets for common prosperity—judging from recent policies and the detailed roadmap for its first pilot program in Zhejiang, the richest province in China and home to Alibaba—are education, health care, and housing. In these pivotal areas, structural impediments have exacerbated inequalities over time, producing a set of challenges that would be very familiar, for example, to residents of California. One of the more draconian national policy shifts, which recently consigned much of the private after-school tutoring business to the non-profit sector, does not go as far as South Korea’s complete ban of private tutoring in the 1980s.¹ In each country, the reforms were designed to ease the burden on parents who spend up to thousands of dollars each month coaching their children on how to pass exams. (To put this cost in perspective, the Chinese city with the highest average annual per capita disposable income in 2020 was Shanghai at $11,000.) Likewise, China’s recent online regulations covering antitrust, data security, and the safety of minors are similar to the concerns of consumer advocates everywhere.

To my mind, these regulations are reminiscent of the US Progressive Era of the late 19th and early 20th centuries, epitomized by Theodore Roosevelt’s Square Deal. It was not an easy time to invest and was marked by muscular antitrust interventions, the inception of a progressive income tax, and the appearance of the first federal consumer and environmental protections. Certain industries faced a permanently higher level of regulation with which they had been unfamiliar. But many companies thrived, and the reforms arguably laid the foundation for a century of growth that shaped the American economy into the largest in the world today, home to the largest number of globally competitive companies.

Structural changes of this magnitude will inevitably shake up competitive forces, buffeting the outlook for growth and strength of free cash flow generation for many businesses—but not all of them in negative ways. If China’s reforms succeed in improving middle-class disposable income while opening more opportunities for more people and still ensuring that the country remains a meritocracy, the government will have set the stage for more sustainable end demand for many industries. It’s a tall order, but one notable advantage enjoyed by Chinese policymakers today is the benefit of a century of hindsight observing which policies worked—and which did not—in the countries that have tried them.

Endnotes

This commentary is excerpted from the Harding Loevner Third Quarter 2021 Global Report.

¹The South Korean ban was ultimately overturned by the courts two decades later, though South Korea’s government has been adding new restrictions on tutoring ever since.

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Too Much Information

By Simon Hallett, Vice Chairman | March 03, 2021

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.

The fact that filtering information is the long-term investor’s task, of course, doesn’t prevent most from feverishly pursuing every bit of information they can about the companies they follow. Egged on by the 24/7 news cycle, internet chat rooms, and by data providers to know their companies in as much depth as possible, investors often seek to become experts in every aspect of each company’s business. It’s dubious whether this helps them make better estimates of what a company’s shares are worth. Instead, the evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.

The evidence suggests that, beyond a certain amount, each extra piece of information has zero marginal impact on forecast accuracy. The impact remains positive, however, on the investor’s confidence in their forecast.

In one unpublished study, described in Winning Decisions by J. Edward Russo and Paul J. H. Schoemaker, people who handicap horse races were asked to predict, based on increasing amounts of information, which horse would win a race. They found that, beyond a very limited amount of data, forecast accuracy did not improve with more data, but the handicappers’ confidence in their forecasts continued to grow with each extra bit of information.

Knowing more makes you feel better, in other words, but doesn’t help your decision-making. In investing, feelings and actual results arguably are even more disconnected. After all, feeling good about a decision is rarely a help in successful investing—to have a good outcome, an investment view must be different from that of most other investors, and standing apart from the herd almost always leads to discomfort.

Sitting on Our Asses

The job of an investment analyst, then, when forecasting a company’s business prospects and the price that should be paid for its stock is to distinguish between what is important—the signal—and what is useless noise. That’s what we do at Harding Loevner. Our “common language” is designed to guide investment collaboration by helping us focus on low-frequency signals that are important to a long-term investment thesis and avoid being distracted by torrents of high-frequency information that obscure the relevant underlying issues.

We recognize that our industry has an extensive tradition of emphasizing high-frequency signals to induce transacting. In the past, much of the revenue associated with financial services was transaction-based. Brokers were paid only when customers transacted (indeed, when I started my career, so were investment managers!). Unsurprisingly, brokers devoted great effort to stimulating customers to act. Customers responded as you’d expect them to—humans like action, not sitting still. Although the investment management industry has shifted in recent years to replace commissions with asset-based fees, there remains a popular expectation that a good investor will be active, including taking advantage of the most readily available and highest-frequency bits of information: stock price movements (both up and down).

Few investors, though, are able to capture any benefit from high-frequency signals. Our analysts don’t even look at stock prices until a company has been thoroughly researched and qualified as meeting our quality and growth criteria, its long-term cash flows have been forecast, and the fair value of its shares estimated.

Stock prices are much more volatile than the underlying qualities of the business they are supposed to reflect. Investors should remember the words of Charlie Munger, who said successful investing is a matter of “finding a few great companies, then you can sit on your ass.”¹ Of course, while we spend a lot of time following Mr. Munger’s advice, that doesn’t mean we are sitting still. We are constantly questioning our assumptions, testing our hypotheses, updating our information and, occasionally, as a result, changing our minds. Usually, though, ignoring the calls of those whose business model, if not entire worldview, revolves around urging you to move is the key to success.

Compounding the Effect

An investment process structured around the long term, and asking questions about long-term strategy not short-term results, will focus on a few fundamental signals that show a company’s progress in creating value for its shareholders. It will focus on competitive structure of an industry, and durable competitive advantages, rather than on the outcomes of the recent past. It will take what you’ve learned and use that to forecast a company’s investments in its business and the cash flows those investments should generate over long periods of time. Only then can you make an informed guess as to what a company is worth and compare it to what the market is inviting you to pay.

A process focused on the long term also recognizes the importance of compounding—that over a long holding period, even if you did overpay, the rate at which a company continually reinvests its cash flows will be a much more important contributor to your return. In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

In an era when information is so democratized, our one true edge is an ability to latch onto a few incremental competitive advantages that we’ve identified in a company, and allow the company to do its job over the long term and provide the power of compounding to our clients’ portfolios.

Humans invariably underestimate this phenomenon. Compound interest is one of the wonders of the world, yet few people understand how powerful it is. It appears our brains are designed to deal with linear, not exponential progressions.

If there was any doubt about our difficulty in intuiting the power of exponential growth rates, look at how unperturbed most people were a year or so ago when COVID-19 began spreading, first in tiny increments. People could not grasp what the impact of a very standard exponential growth curve could be until it was sloping nearly vertically upwards.

A long investment time-horizon also benefits from the long term being more predictable, despite being the sum of a series of short-terms. When some luck is involved, individual outcomes are unpredictable, but the rules of probability dominate as the number of independent trials and outcomes increase. The outcome of a single spin of a roulette wheel, a roll of dice, or draw of a card is unpredictable, but in the long run the house’s victory is as near a certainty as we can get in this world.

Our job is to turn the coins we toss into unevenly weighted ones, by being disciplined about the information we use, diligent in our research, and allowing the companies in which we invest our clients’ capital to do the heavy lifting for us.

Endnotes

¹Charlie Munger, Berkshire Hathaway Annual Meeting, 2000.

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Out of Our Minds—From the Beginning

By Simon Hallett, Vice Chairman | December 02, 2020

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.

Value: Patience as a Virtue

Though we are frequently characterized today as “quality growth” investors, the truth is we started from a place of focusing on value. We have always believed that, as Warren Buffet put it, “price is what you pay; value is what you get.” We also recognize that, while the two converge over time, it is impossible to predict when that convergence may occur. Over the years other value-focused investors have come up with various ways of coping with this unpredictability. Some implement value strategies by timing their purchases so there is not only a share price that implies a discount to underlying value, but also a “catalyst” to accelerate that convergence. Another group, among them followers of the father of value investing, Ben Graham, effectively puts a cap on their patience. They buy stocks trading at a discount to value, but if price and value haven’t converged after some period, they move on to another investment. We were young, figured we had time to wait, and saw no need to identify catalysts or impose a time limit for estimated values to materialize in current market prices.

Growth: In Case We Were Wrong

Investment managers with our very fundamental, bottom-up approach to investing spend much effort determining what a share in a company is worth. That entails thinking about a company’s addressable market, market share, the relative power of its suppliers and customers, volumes, prices, and margins, and making forecasts of those variables, and others, many years into the future. Given that we don’t know what will happen tomorrow, let alone several thousand tomorrows from now, these forecasts are never going to be terribly accurate. Once we translate our forecasts into estimates of the company’s future cash flows, we discount those cash flows to a present value using a discount rate. What that discount rate should be is also highly uncertain. At the end of the day, we gain a rough idea of what a share in a company is worth, but one subject to a very large margin of error.

Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.

We liked prospective growth because it can bail us out of those forecasting errors. When we buy a stock, the return we achieve over time will be a function of changes in estimates of its value (i.e., its earnings multiple) and in the growth of its earnings. Changes in the multiple come about through changes in estimates of future cash flows and, if not more important, changes in the rate at which you discount those cash flows. Cash flows are hard to forecast and future discount rates completely unpredictable. But we figured that if the valuation at purchase was too high and didn’t rise, if at least we had growth the investment would still generate a positive return.

Quality: The Element of Positive Surprise

Quality came into the process mainly as the way to control risk and boost our odds of success. Quality is related to growth in that a higher-quality company is more likely to make high levels of returns on its capital investments, and to have more growth opportunities in which to invest the cash it generates. But quality is also about financial strength and avoiding the risk of having to rely on a balance sheet that can’t withstand the vagaries of the economy, product cycles, or waves of competitive pressure. Finally, it’s about the ability of management to see opportunities and threats, and to deliver to shareholders the expected returns on growth opportunities.

Ideally, a company will exhibit a track record of such patterns and behaviors that extends across successive management teams—evidence of an enduring company culture that is hard to measure objectively but can lend some degree of confidence to our forecasts amid all the uncertainty. A high-quality company, in other words, is one which will tend to give us pleasant surprises. While we realized we would nearly always be wrong, outcomes can be better than forecast as well as worse. By focusing on high-quality companies, we believed we could skew the distribution of our surprises in the positive, not negative, direction.

Out of Our Minds

Thirty years later, our process has become more structured and systematic, and our methods more refined, but the essential relationship among the core aspects of our investment principles remains very much the same. So has our approach to tackling the intellectual challenges with which we wrestle to this day. Now, as then, we subscribe to a belief that it’s always better to get our thought processes, ideas, arguments, and however-partially baked notions out of our own heads and onto a page, where we are more accountable for them and others can help us make them better. We hope you’ll start looking to this space for more of what comes out of our minds.

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Out of Our Minds

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

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

What Is a Small Cap?

What’s Driving China’s Regulatory Transformation

Endnotes

Too Much Information

Sitting on Our Asses

Compounding the Effect

Endnotes

Out of Our Minds—From the Beginning

Value: Patience as a Virtue

Growth: In Case We Were Wrong

Quality: The Element of Positive Surprise

Out of Our Minds

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