Why small caps can emerge 'bigger, stronger and more profitable'
He added: “GDI Integrated Services is looking to develop cleaning solutions for their janitorial business. Pollard Banknote is aggressively marketing their iLottery business to state run lotteries in the US. K-Bro Linen is looking to increase their market share with hotels and long-term care facilities for laundry services. These companies do not just want to reach their previous earnings peak, they want to quickly eclipse it and grow through the next business cycle.”
Walker said that the current environment has led him to dwell further on why small cap companies generally perform well coming out of a slowdown. He said the first reason is that multiples generally correct more for small caps than for large caps, meaning that, effectively, small caps tend to start the next cycle with a lower valuation on their normalized earnings.
The second reason is earnings growth. Walker said: “Small cap earnings tend to be more sensitive to the economic cycle and so are impacted more when things slow but also grow more during the recovery.”
The third is down to a rest in valuations, which allows companies to deploy capital on acquisitions at significantly more accretive returns. The benefits of this are similar for companies of all sizes but Walker’s experience is that they tend to favour smaller companies.
He explained: “In the case of Richards Packaging, a larger peer will not be looking at smaller, suffering dental distributors because it is not worth their time. They are looking instead for larger acquisition candidates which will be more impactful on their earnings. The set up for Richards Packaging is the ability to deploy capital now at valuations that meet their return hurdles which by themselves might not be overly material but when combined can be significant value creators.”