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Think Small

Finding Value in Small Cap Stocks

2024-02-14, Derek Nichol

As headlines focus on the alluring ‘Magnificent Seven’ and the S&P 500 Index becomes increasingly concentrated in a handful of companies, it can be easy to overlook the broad selection of publicly traded companies known as “small caps.” Market observers focused on the behemoths may be missing increasingly attractive value in the small capitalization area of the market.    


For most of the last 20 years, small cap stocks (as represented by the S&P Small Cap 600 Index) have traded at a relative premium to large cap stocks (S&P 500 Index), but this relationship has flipped over the last three years. Furthermore, the second chart shows that small cap stocks are currently trading at a 15% discount to their 20-year average valuation, while large caps are trading at a ~25% premium to their historical average.

Source: S&P Capital IQ

Source: S&P Capital IQ


There are many hypotheses for why a discount has emerged for small cap stocks. Part of the explanation has to do with the fact that the larger cap index has become increasingly concentrated. In the S&P 500, the top 10 stocks by weight represent 32% of the total market capitalization. Furthermore, as a group these ten largest stocks are trading at >25x forward price-to-earnings (as of year-end 2023).

The above helps explain some of the relative discount, but the fact remains that small cap stocks are still cheap compared to their own history. An explanation could be the generalized perception that small cap stocks are riskier than larger peers, driven by heightened economic sensitivity or that small cap companies are more exposed to inflationary forces and subsequent pressure on profits because of limited pricing power. An additional view is that smaller companies often rely on external financing with variable rates to supplement internal cash generation. External debt financing has increased in cost as interest rates have risen, implying lower earnings all else equal.


As can be seen in the chart below, for the last several quarters the QV Canadian Small Cap strategy has traded at an attractive absolute valuation of <13x forward price-to-earnings, a significant discount to its long-term average valuation. This translates to an earnings yield greater than 8%.

Source: S&P Capital IQ

We can look to Calian Group Ltd. (TSX:CGY) to get a sense of the strong value opportunities we are seeing. Calian provides diversified support services to businesses and governments across various areas such as healthcare, IT and cybersecurity. CGY trades at a forward price-to-earnings multiple of 12.8x which is a 23% discount to its own 5-year average historical valuation of 16.6x. This ~8% earnings yield valuation is attractive in the context of the company’s guidance for 8% organic revenue growth this year and margin expansion, leading to double-digit earnings growth and a ~16% return on equity. Notably, Calian’s diversified portfolio of service offerings, long-term contractual revenue and mix of government and commercial customers help to dampen its economic sensitivity and dispel this factor as a driver of CGY’s cheap valuation.

Perhaps then an explanation for the favourable valuation is that Calian faces a more expensive financing environment which will raise interest expenses and pressure earnings? The answer is no, as Calian has internally financed its capital needs for most of the last ten years (i.e. in a net cash position). Today the balance sheet is still relatively clean, with a Net Debt/EBITDA ratio less than 0.5x and limited ongoing capital requirements.

The company did face an operational issue in a recent quarter whereby it over-hired during a high growth period for its IT segment. As sales in that segment normalized, Calian needed to right-size its workforce to maintain proper margins. This was a swift restructuring, and not an event that we believe should be impairing valuation for long. We concede that, on the surface, Calian has what appears to be a disparate group of operating segments and may not be the easiest business to analyze. Perhaps that is reason enough for some investors to ignore this sub-$1 billion market cap opportunity, but we are happy to roll up our sleeves for an attractive combination of quality, growth, and especially, value.

All views and projections are the expressed opinion of QV Investors Inc. and are subject to change without notice. This Update is provided for informational purposes only. QV Investors takes no legal responsibility from any losses resulting from investment decisions based on the content of this Update.


Derek Nichol | Portfolio Manager, Equities

Derek oversees QV’s investment process and makes portfolio decisions for the global small cap strategy.