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Feb 06, 2024

Is now the time for Small-Cap Outperformance?

Christina Siegel Malbon

Given small-caps’ significant recent underperformance, many are enthusiastic about their potential to outperform in the future. Is this an easy mean reversion call? Not so fast. In aggregate, small-cap indexes have a higher percentage of money-losing companies with more sensitivity to interest rates and economic cycles, making the outperformance call more challenging. In addition, the largest companies now have the highest free cash flow margins. For active stock pickers, we believe some of the best opportunities lie in the most profitable companies on a free cash flow margin basis, regardless of market capitalization. As the chart below shows, the highest free cash flow margin companies are also the cheapest.

Chart 1 Large-and Small-Capitalization Stocks...Empirical

Small-caps have underperformed their large-cap peers since 2016. But, according to Empirical Research, over the last five years, small-cap stocks that rank in the top quintile of free cash flow margins have outperformed the market by +4 percentage points per annum. Today, small-caps with the highest ranking in free cash flow margins currently sit at attractive valuations.

Large-caps have put up fierce competition due to the fact that they have large and sustainable free cash flow margins.  Some of the most dominant companies with the most attractive financial characteristics live in large-cap land. What stands out today is that the companies with the largest free cash flow margins are trading at a relative discount to lower margin peers, despite proven sustainability over time.

We see opportunities in both large- and small-cap. Our flexible, bottoms-up portfolio construction allows us to go where we see value outside of typical market cap constraints. In the large-cap category, Google (GOOGL), and Meta Platforms (META) are names that we believe are undervalued by the market, trading, at market multiples and in the top decile of free cash flow margins.

On the small-cap side, names like OneMain Holdings Inc. (OMF), Crocs Inc. (CROX), and Kosmos Energy (KOS) stand out as companies with strong cash margins and growing earnings. These names trade at just 7.0x, 8.1x, and 4.6x 2024 earnings, respectively. Each of these names play in different sectors, showing the diversity of opportunities across small-caps.

We don’t limit ourselves to market-cap parameters. As Empirical’s research shows, the opportunity to outperform exists within the names with the highest free cash flow margins.

Source: Empirical Research

Free cash flow (FCF) represents the cash that a company generates after accounting for cash outflows to support operations and maintain its capital assets.

The views expressed in this commentary reflect those of Patient Capital Management analyst(s) as of the date of the commentary. Any views are subject to change at any time based on market or other conditions, and Patient Capital Management disclaims any responsibility to update such views. The information presented should not be considered a recommendation to purchase or sell any security and should not be relied upon as investment advice. It should not be assumed that any purchase or sale decisions will be profitable or will equal the performance of any security mentioned. Past performance is no guarantee of future results.

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