Finding Hidden Value in Small Caps

The growing consensus is that small caps are overvalued. They have handily outperformed the S&P 500 over the past year and trade at a 40% premium to the large-cap index.

SPY 1 Year Price Returns Chart

SPY 1 Year Price Returns data by YCharts.

However, labeling the entire small-cap market overvalued is irrelevant for investors willing to search for undervalued stocks with asymmetric risk/return profiles. While there are currently the fewest publicly traded companies on American exchanges since at least 1990, a larger portion is comprised of small caps.

Moreover, this market (especially micro caps) remains highly inefficient and offers one of the greatest opportunities across global equity markets to capture alpha, or a superior risk-adjusted return. These opportunities may not exist indefinitely, though, as private equity increasingly takes advantage of the severe value disconnect.

So how do I take advantage of this opportunity?
The following suggestions should help.

First, investors should consider actively trading stocks, rather than passively investing in indexes. This is in part because an index invests in every one of its component stocks, whether or not they're attractive from a fundamental standpoint. This means the alpha earned from buying the few undervalued stocks is more than offset by the alpha "lost" from buying the many fairly or overvalued stocks. It's also worth noting that an often overlooked yet real negative aspect of index investing is that some of the best-performing stocks are never in the index in the first place or are only included after significant price gains.

Second, the issue of execution is even more important in small caps, given the generally lower levels of liquidity and wider bid/ask spreads. Investors sometimes lose miss out on gains when entering or exiting a position if they are impatient or fail to use advanced order types.

Third, focus first on limiting downside risk by looking for stocks with a margin of safety provided by a strong balance sheet, high cash flow, and similar factors.

Fourth, look for stocks with overlooked catalysts such as attractive takeover characteristics in a consolidating industry, an upcoming resolution of a lawsuit that removes uncertainty, breakup potential, or other opportunities.

Fifth, offset stock-specific risk by shorting a broad-based small-cap index such as the Russell 2000 (possibly via put options) or a larger peer.

Promising small-cap opportunities
Here are two examples of undervalued small caps.

Casino gaming supplier Multimedia Games is a great way to play the increase in spending that is expected to come since machine replacement fell to historically low levels. Its premium games provide a growing stream of recurring and high-margin revenue, as well as higher contract renewals. In 2013, revenue rose 21%, while operating income rose 117%, driven by high operating leverage and a growing installed base. Furthermore, its relatively small market cap, $73 million in net cash, and in-demand games make it a prime takeover target, given the history of industry consolidation.

Recreational-equipment provider Johnson Outdoors , meanwhile, trades at only 6.1 times EBITDA -- earnings before interest, taxes, depreciation, and amortization -- and has steady top-line growth, with margin expansion driven by high market share, a diverse product line, and strong customer loyalty. Moreover, the founding family runs the company with a long-term focus and has rewarded shareholders earlier this year by initiating a regular dividend. Net cash accounts for about 18% of the market cap, providing some downside protection.

Bottom line
Individual investors are more empowered than ever at the same time the opportunity to capture alpha in small caps is arguably at its peak. They should remember that gold is hardly ever found on the surface, though. Most of the time you have to dig.

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