Small-Caps: The Competition for Capital
Ask the Experts: Best Practices in IR Outreach and Messaging for Small- and Micro-caps
During Nasdaq’s first-ever virtual Investor Relations Forum this June, we hosted a discussion focused on the challenges and push back small-caps face as they compete for capital. Our conversation covered how small- and micro-cap companies can overcome the market cap hurdle, differentiate their messaging, and target generalists and capitalization agnostic funds.
Here are some of the key takeaways from an interview conducted by Nasdaq’s Michael Spector, Managing Director, Listing Services, with Adam Epstein, founder of Third Creek Advisors, and Nasdaq’s Dan Romito, AVP, IR Business Development & Product Strategy.
Should small-cap companies target small-cap funds only, or should they be thinking about a broader pool of capital?
Dan Romito: Yes, but we have to take into account that the small-cap space is really ambiguous and broad. You're talking about companies that could potentially be as small as $100 million, all the way up to the upper threshold of the S&P 600, which is $2.4 billion. We refer to them as SMID-cap. So, you should be targeting SMID-cap investors. When you look at mid-cap investors—and I'll give a perfect example, we were looking at Royce and Associates. Seventy-five percent of Royce’s portfolio holdings have a market cap under $6B, and they position themselves, rightfully so, as a very mid- and small-cap-focused investor. In their respective portfolio, you have companies ranging between $150 million up to $9 billion.
The term small-cap is a little bit misleading because it makes you immediately assume that there's a very tight band of investors, when in fact, it's a fascinating exercise in behavioral finance, because to some investors, you might be a really big small-cap and to others, you're just a small mid-cap. Perspective matters the most. Our recommendation is to keep those pools for those companies $300 million to, let's call it $2.5 billion - $3 billion. You have to keep those thresholds very wide because subjective discretion is probably most incorporated within those respective portfolio constructions.
How important is a finely tuned investor targeting strategy for a sub $500M company? How should they think about finding the right type of investor?
Adam Epstein: Yes, it’s pretty important! What we know about small-cap companies is that they have very little time and very little in the way of resources to waste. I find that a lot of investor relations professionals, CEOs, CFOs…, and even board members, don't really understand the math. And when I say the math - there is an inordinate amount of time that's spent in this country, literally every business day by micro-cap companies, pitching their stocks to investors who are mathematically foreclosed. They are mathematically foreclosed from buying their stock in the open market. If an institutional investor, for example, needs to buy a million dollars of your stock, you can ask those funds, what their minimum position sizes are before you meet with them. If they need to buy a million dollars of your stock, they simply can't do it if your stock trades less than about roughly, let's call it a couple of hundred thousand dollars per day, not shares, dollar volume per day. That’s because they're only going to take 20 to 25 days of trading days to actually accumulate that position out in the marketplace. They never want to be more than about 10% of the daily volume. Because if you do that, you're just going to push the stock price up. And so, you can back out that math and get to that number, which is somewhere around a couple of hundred thousand dollars minimum per day. I think that a lot of micro-cap CEOs don't sufficiently appreciate that trading volume comes first from retail investors until such time as it's sufficient to permit institutional buying and selling. It’s really important, as small companies don't have a lot of time and resources to waste. You can't spend time telling your story to investors that are mathematically foreclosed from buying your stock.
Having said that, can a sub $250 million company with low trading volumes still attract a high-quality investor?
Adam Epstein: It's a great question. My answer, in two words, is 100% yes. If I were to add a couple more words, I would say some of the smartest investors I've run across are one-man shops that manage their own money and invest in market caps below $200 or $300 million. Your business model is to do extensive diligence into companies that institutional investors can't, and as I just said earlier, won't buy. In fact, I would submit that illiquidity not only doesn't scare those investors, it's actually a gift to them. And when I say it's a gift to them, what I mean is that they have smaller position sizes; they don't have to buy a million dollars. They have smaller position sizes and all the patience in the world. One of the biggest mistakes a micro-cap CEO can make is to underestimate the intelligence or savvy of these retail investors or one-man funds. Some of them are every bit as smart as the portfolio managers at funds that manage trillions of dollars.
Dan Romito: To piggyback off of that, we study the behavior of investors pretty extensively. The anecdotal and the qualitative that Adam just highlighted are very much supported by the data. If I'm interpreting the data, it appears that companies in this market cap range tend to “carpet-bomb” the world, so to speak, with their marketing efforts. In other words, they utilize, in a lot of cases, the law of large numbers. I'm going to talk to 100, and I'll close one or two. What we're finding is that there's an efficiency component that is missing. Your quintessential plain vanilla mutual fund takes about three to five meetings over the course of seven months before they engage, and by engage, I mean, take a substantial position - top 50 to top 75. In the small-cap realm, that three to five goes from six to eight, and that seven months goes to eight to nine months. What we're finding in our conversations, and what Adam touched upon perfectly, is that small-cap investors just take a longer time.
You have to also take into account that there is small-cap coverage. You can utilize the sell side, but from an economic point of view, it is not in any analyst’s best interest to place a disproportionate amount of attention on small-caps because the economic model simply doesn't make it profitable for them. There is no money in covering small-caps. What we find is that from a proactive standpoint, there is a common lag, not because of any deficiency, but just because it takes more meetings. And from a coverage standpoint, from an economic point of view, it's just not profitable to cover small-caps. You have to engage with a more interested tighter band of investors. Spend more time with them, and remain on top of them, which I know is a pretty tall ask, but that's what the data is telling us.
How should small- and micro-cap companies be thinking about hedge funds, and what role do they play in the ownership mix?
Dan Romito: Hedge fund is a really broad term. Unfortunately, I think, in some cases, hedge funds are immediately associated with traders. There is a big distinction between a fast money trader and a hedge fund. Right? Hedge funds do have trading strategies. But they also have a variety of other strategies that are relatively speaking, longer-term focused. The best thing for a small-cap, in my opinion, is to garner perspective. What does the competitive landscape look like not only in terms of performance but expectations? We found that hedge funds tend to be more blunt, and in terms of intelligence, a little bit more forthcoming of how you should engage and position your messaging. From an intelligence perspective, it's critical to engage with them. From a liquidity standpoint, they're obviously going to provide a liquidity source, which is beneficial. From a signaling standpoint, I think it's beneficial because if your shareholder base is consistently just being churned and burned, the market is inherently telling you something. It all depends on the person that's running the strategy. That's the contingency. The person matters much more, in any case, but this is particularly true with hedge funds.
Adam Epstein: Hedge funds are actually incredibly important to micro- and small-cap companies. There are two different discussions that exist in the small-cap ecosystem. One of them is trying to interest investors to invest in the open market, but then there's this little $30 to $50 billion marketplace that exists in the US where small-caps go to tap the equity capital markets for growth capital every year. In fact, that market is actually larger than the IPO market. It's the quietest $30 to $50 billion financing market that anyone's ever heard of, hardly ever covered in the New York Times or Wall Street Journal, but it exists out there. To be resolutely clear, there wouldn't be a small-cap market without hedge funds or special situation funds that are providing that $30 to $50 billion of growth capital a year. Hedge funds are incredibly important to the micro- and small-cap ecosystems. The other point that I would raise is something that I hear routinely from CEOs, CFOs, investor relations professionals, and sometimes board members as well. A lot of times, there is this notion that “hedge funds are just going to trade my stock, that they're not good investors.” “I want good investors,” meaning, “the investors that are going to buy my stock and put it over here and hold it for a long time.” So, good is “hold it for a really long time,” and bad is “people who are trading the stock.” My comment here is mostly focused on the $500 million market cap space and under since that's where most public companies are. If those companies don't have liquidity, there's definitely not going to be research coverage that anybody cares about because high-quality research coverage is inextricably linked to trading volume. Without that trading volume, you have no research coverage. Also, if you don't have liquidity in your stock, your stock is going to be really volatile in the $500 million market cap space and under. Volatility is going to make it harder for you to retain employees. It's going to make it harder for you to attract employees because their stock options are going to be all over the place. Also, if you don't have liquidity, no worthwhile company that you're trying to buy is going to want your stock as a merger consideration. Getting back to the liquidity issue, hedge funds provide that liquidity and particularly in that $500 million market cap and below strata, that liquidity is a lifeline.
What can small- and micro-cap companies do to differentiate themselves and stand out in a crowded field?
Adam Epstein: I'd say a couple of quick points. If you're a life science company, or a technology company, with technical products or services, and your market cap is under $500 million, do yourself a favor and get rid of all the jargon in your investor communications and speak in plain English about what you do. It will be a breath of fresh air to all of the generalists and opportunistic growth investors out there. That's number one. Number two, we all remember this adage, when we were kids that our parents kind of drummed into us that you should dress for the job that you want, not the one that you have. We used to say on the buy side that there are two different kinds of small-caps. One of them is really a private company that happens to have a ticker symbol. The other is “a real public company.” Fund managers can really see the difference between those two. If you're a micro-cap company, start adopting the best practices of companies in your industry that have a $750 million market cap when you're still a $250 million company. That's what I mean by dress for the job you want, not the one you have.
Will an investor overlook strong growth characteristics and performance if a company narrowly fails to meet its market cap requirement?
Dan Romito: Yes, it happens all the time. Having said that, market cap is more of a loose guideline than the gospel. The analogy I like to jokingly make is “market cap is the yield sign in the middle of a Montana highway, as opposed to a stop sign in the heart of downtown Chicago.” You know, it's not a major ordinance. There's exceptions all the time. If you're looking at the data, the market cap is somewhat a secondary consideration if you are within at least the 20th or 25th percentile of liquidity, margin and Return on Invested Capital (ROIC). The growth aspect there is important. With high growth within a small-cap, it's fascinating to look at the speed of mean reversion. The speed of mean reversion for high growth companies within the SMID-cap realm revert to the mean quicker. That means more of a downward pressure when you buy, so middle of the pack growth or even growth that is a little bit below the 45th percentile has a particular consistency with their capital efficiency and their balance sheet. In this case, market cap almost becomes a secondary, even a tertiary, consideration for that respective long-only manager.
If you’d like to hear more, you can find the full 60-minute interview here.