January 8, 2012 – Small Cap TMT: Time to Stop Feeding the Bear
Small cap investing in TMT has been a bear. Since launching our small cap model portfolio 2 years ago, the TMT components of the small cap S&P600 have underperformed the tech components of the S&P500 by 640 basis points, while our model portfolio has further underperformed the small cap benchmark by 170 bp. In comparison, our large cap model portfolio has outperformed the S&P500 TMT components by 813 bp. Our small cap investment premise, selecting stocks balanced across the subsectors most likely to exploit opportunities being created by the comprehensive paradigm shift underway in the TMT sector, has been hamstrung by several structural factors. First, we believe that tightly controlled user platforms – i.e. iOS and Android – and massive cloud computing operations have concentrated the TMT opportunity toward a handful of mega-players, thwarting the ambitions of small cap challengers. Second, the mix of small cap TMT companies is skewed toward lower growth and commoditized categories. Third, an unusual proportion of the small cap universe is now composed of declining, formerly large cap companies, consistent with our thesis of an industry sea change. Finally, dysfunction in the IPO market has kept many of the most innovative small companies private. Looking ahead, we do not expect these conditions to change. Given this, we are reducing our small cap model portfolio from 25 stocks to 15 and will no longer look to balance the selections across subsectors.
Small cap TMT has broadly underperformed relative to large cap, and our model portfolio has underperformed the index. We initiated our TMT small cap model portfolio in February 2011. Since that time, the TMT components of the S&P600 index of small cap stocks has underperformed the large cap S&P500 TMT components by more than 639 bp. Our small cap model portfolio has underperformed the rest of small cap TMT by 170 bp since inception, while our large cap portfolio has outperformed large cap TMT by 813 bp since its May 2011 launch. In review, we have drawn the conclusion that the small cap TMT universe has been structurally disadvantaged by the sector sea change now playing out, and that the structure of the model portfolio – 25 small cap stocks balanced across several growth themes – is not well suited to the investment environment.
The once-a-generation paradigm shift underway in TNT is concentrating opportunity toward large cap change leaders. The changes that we have predicted and documented over the past three years – the rise of portable platforms, wireless networks, distributed cloud data centers and cloud-based applications – largely reward scale and architectural control, driving much of the business opportunity to the advantage the large cap companies leading innovation. In contrast, many small cap face significant market barriers and cost disadvantages.
The small cap universe is relatively heavy in slower growth business categories. There are 170 TMT stocks with market caps greater than $3B, with 82% rated as well positioned for growth. In contrast, only 73% of the 333 TMT stocks in the $300M to $3B cap range belong to subsectors that could be labeled as growth, with nearly half of those companies either subscale cloud service providers or makers of commodity hardware for growth end markets. The average large cap TMT stock delivered 13.9% revenue growth over the past three years while the average for small cap TMT was just 12.7%, an unusual reversal relative to longer history and in defiance of the oft-quoted law of large numbers.
The weak IPO market has kept successful innovators out of the public market. Part of this is a consequence of the dearth of TMT IPOs. From 2003 to 2008, 215 TMT stocks came public, compared to just 104 over the past 5 years. The financial crisis and the controversial Facebook IPO overhang the market, with well-regarded new paradigm players, like Twitter, Pinterest, Square, Craig’s List, and others, remaining private as their assumed valuations continued into the large cap range.
The small cap universe is unusually burdened with formerly large cap companies that have fallen from grace. Of the 333 stocks in the small cap TMT universe, 72 IPOed during the past 5 years, 166 breached the $300M lower threshold from below, and 48 dropped below the $3B upper threshold from above. The population of fallen angels is high, although not nearly so high as after the collapse of the 2000 Internet bubble, but the influence of formerly large cap stocks like AMD, FSLR or ZNGA is unlikely to reflect well on small cap growth.
We are reducing our small cap portfolio to 15 constituents from 25 and will no longer seek to balance the selections across subsectors. Reflecting on our small cap model portfolio, too many names are there for balance rather than for conviction. In many growth categories, such as cloud hosting or mobile device software, scale advantages make attractive small cap candidates difficult to find. In this context, we see mobile device components, differentiated cloud applications, security software, and capital equipment to have the richest opportunities for small cap companies.
OpenText, 3D Systems and Comvault now exceed our $3B upper threshold and Ancestry.com is now private – these stocks have been removed from the portfolio. In addition, we are removing on-line marketing firms Responsys and Constant Contact, both of which focus on advertising models that are being squeezed by mobile platforms. Glu Mobile has performed poorly in a mobile gaming business in considerable flux. EZ Chip and Volterra are smaller players selling fairly commoditized solutions for embedded networking and device power management, respectively. Neither has distinguished itself during several quarters in our portfolio. Finally, we are removing Itron, which we believe has considerable promise, but in a business – smart meters for electric utilities – that is far afield of our research focus.
For our full research notes, please visit our published research site.