Opportunities abound in the small- and mid-cap space
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The field of small- and mid-cap equities is a great hunting ground for growth companies in the early stages of their life cycles, says Phil Taller, senior vice-president, investment management with Mackenzie Investments, and lead portfolio manager and head of the Mackenzie Growth Team.
“Long term, it’s been a great space to look for investment opportunities,” he said. “You can find great innovative, high value-added companies that ultimately have the potential to become much larger.”
Taller said the current economic environment is favourable for small-to-mid cap companies due to upward earnings revisions, a potential rise in mergers and acquisitions, aging demographics and rampant infrastructure spending.
“There are a number of tailwinds that could arise for small companies in the future,” he said.
Taller said merger-and-acquisition activity is expected to rise as large companies struggle to achieve organic growth in the current market.
“There are times when larger companies who are pushed to find growth in their own businesses will often look for smaller companies to acquire,” he said. “I think there’s been a bit of a pause, in the last year or so. But I do think it’s possible that that picks up again.”
He cautioned that while investors with shares in the target company will often see impressive returns, acquisitions are difficult if not impossible to predict.
“It’s very much like lightning striking in any given portfolio,” he said.
More conventional opportunities for small- to mid-cap investments are found in sectors that are relevant currently: infrastructure, healthcare and communications.
“Small- and mid-cap companies are often the birthplace of innovation in technology fields,” he said.
He offered the example of California-based Dexcom, Inc., a manufacturer of continuous glucose monitors for diabetics. The company has focused on developing innovative products and services, and has steadily grown its free cash flow, profits and margins.
“Stories like Dexcom are our favourite kind of thing to happen: to find a good company and to ride it for a number of years,” he said. “It’s great.”
Similarly, California-based iRhythm, a maker of heart monitors, has developed new ways to capture and read millions of hours of cardiac rhythm data to diagnose atrial fibrillation. The analysis is assisted by artificial intelligence, another positive development for small- and mid-cap companies, he said.
While large tech players have the AI resources to mine and crunch data, they must negotiate access to the data of niche-industry players like Dexcom and iRhythm in the healthcare sector, and Washington, D.C.-based Costar Group in the real estate sector.
“We own a lot of companies who collect data about their sectors, where they have proprietary data sets that others do not have,” he said. “Even though we may not own the mining equipment, we own the gold.”
Taller also sees opportunities in the companies that crunch the data, like the mid-cap California-based software company Alteryx, which specializes in what is referred to as the “extract, transform and load” space.
“They can go to disparate systems and bring all the data together,” he said. “It’s very much a tool that can be used to democratize the analysis of data, and we think has a lot of high-value-added in business processes, where they can make things a lot simpler and a lot quicker.”
Similarly, mid-cap EXL Service is a business process outsourcer based in New York that’s added data analytics to its suite of products.
“Companies are coming to them, saying, ‘Here’s my data, here’s what I’m collecting.’ EXL has the domain knowledge to help those companies better understand their own data, and how to use,” he said.
There are headwinds too, Taller acknowledged. The high-interest-rate environment, for example, does not favour smaller companies, which typically have a harder time getting financing.
“It’s a lot easier for a large mega-cap to get financing. So, if you’re at all worried about their ability to finance or to cover interest costs, it is probably proportionately a little more of a concern for the small companies,” he said.
Inflation is a problem too, but less so for innovative companies with pricing power. He pointed out that the most persistent inflation in some areas tends to be service inflation, which is driven by wages. For some companies — especially those driven by intellectual property — labour is not a big part of the cost base.
“They either have some kind of technology or an innovation or trade secrets that make what they do hard to do,” he said. “And therefore, they don’t have labour as big part of the cost base. And they also have pricing power.”
Historically speaking, small- and mid-cap indexes tend to have an easier time climbing out of a downturn.
“They have often taken the brunt of the worries going into recession,” he said. “Coming out of it, they then do better.”
This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.