Small Cap TMT: Time for a Three Month Check Up

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In our piece “Small Cap TMT: The Idiosyncratic Method”, we made a case that a thematic approach to sector investing was particularly effective for small cap stocks, vs. traditional value or growth styles.  While stock selection based on association with important innovations is an intuitive truism to investors, it is difficult to capture using quantitative tools.  Our approach for assessing small cap opportunities employs two screens.  The first is a subjective categorization of each company based on its participation in seven areas of innovation that we view as the most important drivers of future sector growth.  The second is a quantitative screen based on the factors that have shown the best correlation to performance over recent history

Small cap TMT stocks continued to outperform large caps in 1Q11, touching historical levels in their relative valuation on most metrics.  While this broad TMT small cap outperformance certainly suggests caution, we also note that TMT small caps have tended to relatively outperform during other periods of economic weakness.  Moreover, we believe that the sector is in the midst of an unusually wrenching disruption from several paradigm-shifting innovations that are likely to remake the TMT landscape as thoroughly as did the PC-led revolution of the ‘80s.  Now, as then, well placed small caps will be big winners

We believe the current revolution centers on smart portable devices, 4G wireless, content delivery network architecture, cloud-based applications, on-line/mobile advertising, streaming media and energy conservation IT.  Screening the universe of 584 TMT stocks with market capitalization between $90M and $3B yields 246 names with at least modest positive exposure to these themes.  Collectively, these companies have grown sales at a nearly 12% CAGR over the past three years, vs. slight declines for the other 340.  Stocks in the growth areas have generated 1 yr returns 790bp higher than the others, and appropriately sport P/E ratios 50% higher at 18x.  Of course, choosing the right stocks is paramount in small cap, as the pronounced incidence of earnings surprises and the disproportionate reaction to those surprises yield a dramatically wider dispersion of performance vs. large caps

For small cap TMT companies, most traditional predictive metrics, such as P/E, sales growth, and return on equity have had small or counterintuitive correlation with relative forward returns, with PEG, and Free Cash Flow showing stronger, but still modest, relationships.  In contrast, large cap TMT stocks show stronger and more significant correlation in expected directions for most of these variables.  The idiosyncratic nature of small caps becomes more apparent as the market cap threshold for inclusion in the analysis is reduced.  Nonetheless, the positive relationship to P/E, sales growth and FCF yield affords a screening mechanism to augment our thematic categorization

Since February 8, the small cap TMT universe showed just 2.4% returns, below the tech components of the S&P 600 (+3.7%), the S&P 600 itself (+5.9%) and the S&P 500 (+2.5%).  The 243 stocks in our growth categories performed somewhat better, up 3.3% for the 3 months.  Amongst our growth drivers, 4G Wireless showed the worst returns over the period at (-5.0%), with Media Streaming (-2.5%) and Energy Conservation IT (-1.0%) off for the past 3 months while Cloud Computing (+9.5%) showed the best, followed by on-line/mobile Advertising (+8.9%), CDN architecture (+7.3%) and Smart Portable Devices (+0.5%)

In our initial small cap TMT piece, we generated a 25 stock model portfolio representative of our screening process.  The 3-month returns for this portfolio were 5.9% on an equal weight basis, well above the TMT small cap benchmarks.  Returns within the portfolio were widely dispersed, with the best performer, OmniVision Technologies (OVTI) up 27% and the worst, AXT (AXTI) off 31%.  Given a deterioration of PEG and FCF in the CDN category and the concern that appreciation in the theme has been driven by M&A discussions by a small number of firms at the high end of the cap range, we are reducing our exposure by one stock and increasing exposure to cloud computing.  With this adjustment in mind and assessing the individual performance of names in the model portfolio, we are replacing AXT with sapphire substrate company Rubicon (RBCN) in the energy IT category, Dragonwave (DRWI) with test equipment supplier Ixia (XXIA) in the 4G category, and CDN equipment maker Blue Coat Systems (BCSI) with consumer cloud application provider Ancestory.com (ACOM)

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