There was a bit of a storm kicked up in the investment community recently when Michael Burry, an investor profiled in the Michael Lewis book (and subsequent film) The Big Short. Mr. Burry was famous for his bets on the American sub-prime mortgage market in anticipation of the Global Financial crisis. This time he made another bold prediction, that major stock market indexes were overvalued, due to the pervasiveness of indexed investment strategies.

Mr. Burry’s beliefs are nothing new, in 1991 famous hedge fund manager Seth Klarman dismissed indexed investing as a fad, that “When it passes… the prices of securities included in popular indexes will almost certainly decline relative to those that have been excluded. When the market trend reverses, matching the market will not seem so attractive. The selling will then adversely affect the performance of the indexers and further exacerbate the rush for the exits”.

Mr Klarman’s views suggest that one would do well by searching for value outside stocks contained in major indices, something that Mr Burry agrees with; he believes that more value could be found in the small market capitalization space – which is less covered by the indexed funds that, in his opinion, have caused the overvaluations.

I don’t necessarily agree with their contention – even in the US, the home of indexed investing, indexers own less than 15 percent of the market, and globally they represent less than 5% of global assets.

Regardless, the majority of investment managers, both passive indexed, and active managers focus on only the top end of the market. In addition, traders of stock markets who use financial derivatives will see their short-term positions concentrated in the top end of the market (such as in our XJO index of the largest 200 companies, or in the American S&P 500 index). This also means that the largest stocks likely outperform to the upside on a bullish move – and underperform to the downside on a bearish move; as traders place bets on indexed derivatives.

Historically, the “small cap” space has been the realm of the growth investor – with each company selling a story of huge *potential* future growth. However, there may also be some underpriced, profitable companies that fit the mold for a traditional value investment, rather than a growth investment. By value investment, I mean a stock that appears undervalued relative to its current earnings, dividends, or by any other fundamental numbers.

To determine if something is underpriced from a value perspective, we look at indications like price/earnings ratios, dividend yields, current ratios, and price to book value ratios. Whilst many may assume that the best value stocks relative to these fundamental ratios would be found in the large, mature companies at the top of the market, that is no longer necessarily the case.

There exists an increasing number of stocks towards the lower end of the market, who are doing fantastic relative to their current market capitalizations, but who do not fit the mold for a “super growth” story that is usually required to get small cap investors excited.

Using some pretty basic quantitative screens, I’ve sifted through the smaller end of town – looking for those companies who post solid, consistent numbers relative to their valuations. Here is a bit of a sample of what I’ve been able to find:

These companies are delivering solid results today, they are paying solid yields to their investors today, and with a bit more analysis, they are companies that could be worth an investment today.

Let’s take a deeper look into a couple of their fundamentals:

CLH.ASX – Collection House Limited

Collection House describe themselves as a leading receivables manager, which means they are engaged in debt collection and debt purchasing. At their recent report in August they announced an increase in earnings per share of 16%. They are also paying a dividend of 4.1 cents on the 2^nd of October.  Net profit was also up 17%. The results saw CLH push significantly higher on the day, and the share price reversed some recent downwards movement. They collect a 56% margin on purchased debt ledgers (PDLs).

CLH has exposure in both Australia and New Zealand, as well a small exposure to the Philippines. Debt collection can also sometimes do well during cyclical downturns in economic activity.

GRR.ASX – Grange Resources Limited

Grange Resources produces iron ore pellets which are predominantly exported to China. They have been beneficiaries of the large increase in the Iron Ore price, but weaker production and an increase in costs has seen their profits decline in FY19; leading to a drop in their share price. Regardless, the results and dividend are extremely attractive relative to the current share price.

They are expecting production to increase again from here however, which could see an increase in profitability in the next reporting period. This could be a good stock to watch if you do believe iron ore prices will remain elevated.

NTD.ASX – National Tire & Wheel

National Tire’s share price was hit by a downgrade in 2019, but despite the downgrade, revenues and earnings were still materially higher than they were in the previous financial year. Now that the share price has come down, it appears to represent great value relative to current prices.

NTD is primarily an Australian based business with some operations in South Africa and New Zealand.

If you have any interest in discussing any of these companies, don’t hesitate to contact an Emerald advisor. We are also planning to soon run a Small Cap Analysis and Research subscription. If you have an interest in such a service and would like to be notified when it is available, please click here.