Small Cap TMT: The Idiosyncratic Method


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TMT investing has historically favored thematic strategies, as innovation repeatedly remakes the landscape in favor of those able to exploit the rapid pace of evolution in the sector.  This is doubly true amongst small cap stocks, as traditional value and growth metrics have been unusually poor correlates to forward returns for investors.  While these effects may appear idiosyncratic to quantitative models, they have fueled strong performance for stocks associated with in-favor themes.  In the course of our work, we have focused on smart portable devices, 4G wireless, content delivery network architecture, cloud-based applications, on-line/mobile advertising, streaming media and LED lighting as the center of a tectonic shift in the TMT landscape.  We believe that these areas may offer particular opportunity for small cap investors

We believe that current market conditions are benign for small cap TNT stocks in general.  Small cap valuations have been stable relative to large caps over the past year at a very slight premium to historical levels on most valuation metrics.  TMT small caps have also tended to slightly outperform relative to large caps during periods of broader economic weakness, a correlation that suggests conventional wisdom to the contrary may be misplaced

Moreover, overall small cap market valuations do not appear to drive individual stock performance.  Small cap companies are more thinly covered than their large cap brethren, yielding more earnings surprises, bigger earnings surprises and more pronounced market reactions to surprises.  This contributes to a much wider dispersion of returns for small cap TMT stocks than for large cap.  The obvious implication is higher rewards for sharp stock picking for small cap investors, with significantly higher first quintile performance of small caps even during stretches of large cap outperformance at the mean

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

Of 543 publicly traded TMT companies with market capitalization between $90 million and $3 billion, we have identified those tied specifically to the 7 areas of disruptive innovation called out in our research.  Collectively, the 208 companies in these categories have delivered returns more than 1000bp higher than the remaining 337 over the last 12 months.  Of these, the 27 companies associated with CDN architecture have delivered 56% returns, with smart portable devices, LED lighting, and on-line/mobile advertising each over 40% and 74 cloud computing companies averaging better than 35%.  Average sales growth was best in smart portable devices and 4G wireless, while LED lighting companies enjoyed the highest P/Es, followed by media steaming and cloud computing

Screening these companies by P/E, sales growth and FCF yield suggests a lists of candidate companies positioned in high potential opportunities and that exhibit statistical characteristics historically associated with superior returns.  Using these screens, we have selected a model portfolio of 25 small cap TMT stocks.  While we do not specifically recommend these stocks, they are representative of small cap investment choices that we believe are appropriate in the current environment

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