Big Gains in Small Stocks
- Small and micro cap stocks surge during Q1, fueled by animal spirits and a social media buzz
- A look at how short-squeezes are not uncommon in the stock market
- Valuations are more expensive now, but ample private equity dry powder could yield acquisition activity among small stocks
- How macro factors could benefit small and micro caps
Meme stock mania
What a quarter it was for small and micro caps. Late January was the crescendo of the “meme stock” mania, during which GME & AMC became household-name ticker symbols. The enthusiasm was driven by a group of “Wall Street Bets” traders on Reddit who sought to take down the ‘big, bad’ hedge funds who had sold-short shares of these once lesser-known companies.
Short-selling
It’s not uncommon for massive short-squeezes to take place in the stock market. For background, a short-squeeze occurs when traders who sell-short a stock are forced to buy-back shares at an increasing price, often due to requirements from their broker. Taking a step back, short-selling is when a trader acquires shares, lends them out to other buyers, then seeks to re-acquire the shares before returning them to the broker. The short-seller ultimately benefits when the stock price drops – the difference between the acquiring price and the price at which the stock was returned to the broker is the profit or loss.
Companies like DryShips in 2016, Volkswagen in 2008, and even Piggly Wiggly way back in 1923 experienced the kinds of moves GameStop and AMC Theatres made earlier this year. It’s nothing new. Markets tend to repeat over time, or at least rhyme.
What’s different this time is that everybody has a smartphone and a free trading app. Traders ranging from high schoolers to the elderly could have participated in the meme stocks. And many probably did.
Broader implications
The GameStop and AMC Theatres story was indeed fascinating, but it impacts how the small-cap and micro cap stock indexes performed. The strongest stocks during Q1 were found in the micro cap space. It was almost “the smaller, the better” in performance by market capitalization (Figure 1). Large caps managed to eke out a gain over mid caps, however. As we noted last year in our Road to Recovery presentations, small stocks tend to outperform large stocks coming out of a recession.
Figure 1: Stock market performance by market capitalization (Finviz)[i]
The value of a skilled manager
Portfolio management is more important when investing in small caps and micro caps. Those companies tend to be less liquid, meaning fewer traders are buying and selling, and there is less analyst coverage. Think of identifying quality micro caps as trying to find diamonds in the rough, while large caps are like going to a museum to view polished gems. Everyone has access to Apple’s financial statements and their future plans, so it’s hard to find new valuable information among big companies. Within the small and micro-cap spaces, an analyst can dig to try and find the diamonds in the rough.
A skilled portfolio manager can more easily find stocks that may have been overlooked within the smaller space. Case in point, the Deupree James Microcap Strategy has been stellar in the last several years. Interested readers can see our entire performance history here.
A tougher environment today
So what can investors expect going forward? We still see small and micro cap opportunities, but the recent small cap surge has pulled-forward some return potential. As you can see from our updated chart below, both small and large cap stocks are tracking with their historical post-recession norms. This suggests that further gains are possible, but certainly the opportunities are not what they were last year.
Dry powder
A significant feature of the large cap stock market arena right now is that the big names (like Apple, Microsoft, Amazon, and Google – the trillion-dollar market cap club) are flush with cash. There is plenty of dry-powder for large companies to seek to acquire smaller issues. We also notice significant private equity money coming available for acquisition activity (Figure 2). Our investment strategies were able to benefit from corporate deals in the last several months.
Figure 2: Private equity dry powder (J.P. Morgan from McKinsey Global Private Markets Review 2020)[ii]
Monitoring macro trends
Finally, let’s turn to the macro environment. Interest rates have been on the rise during 2021. Small and micro caps could do much better than large caps if the trend persists. The large cap index is top-heavy and relatively overweight the Information Technology sector as of Q1 2021. Many of the companies in IT are also not profitable and thus have “high duration” as we say in the industry. Duration is how sensitive an asset is to changes in interest rates – when rates increase, high-duration stocks usually underperform.
Sector differences are important
Small and micro caps are relatively underweight IT and tilt more to the “value” sectors such as Financials and Industrials. Those are the sectors that have performed well this year.[iii]
Figure 3: Large Cap vs. Small Cap sector differences[iv]
Conclusion
When opportunity meets patient & skilled portfolio managers, investors stand to benefit. At Deupree James Wealth Management, we try to proactively position our clients for major market moves, and this recent surge has certainly been tremendous for our clients. While we are pleased with the results, we remain focused on the risk and opportunities our research is uncovering in the back half of 2021.
