More and more investors are leaving small stocks out in the cold

Due to the growing importance of passive index funds, which shadow the price of a stock basket, the rules of the stock market are being rewritten. Smaller stocks in particular have to fight harder and harder for the attention of private and institutional investors. Will there be another turning point?

What the hell am I doing wrong? ' The notorious fund manager David Einhorn asked himself that question more and more in recent years, when he found that he was no longer able to achieve the same, high returns as before with his leveraged fund Greenlight Capital.

During the financial crisis, Einhorn became famous for his' short 'on the American major bank Lehman Brothers. In the summer of 2007, he was one of the first to realize that Lehman was taking immense risks with his exposure to the overvalued US real estate market. By betting on a fall in the Lehman Brothers share price, Einhorn earned millions of dollars. In 2008, the bank went bankrupt.

Until 2015, Greenlight Capital had an average annual return of 25 percent, but then the engine started sputtering. Much to his frustration, Einhorn found that the undervalued companies in which he invested were no longer rewarded for good results, while overpriced stocks - where the leveraged fund took a short position - kept rising. “A frustrating period,” Einhorn said about this last month an interview with Bloomberg news agency. 'I started to wonder why I still went to the office. '

Until he understood why the mayonnaise stopped working. Einhorn found that expensive stocks often remained expensive because they were blindly bought up by passive index funds. Those trackers or ETFs buy a basket of stocks in a certain index - for example, the S&P500 or the Nasdaq100 - and make no further estimations about the fair value of a stock. Conversely, cheap stocks remained cheap because they fell outside an index basket and were almost nowhere on the radar.

Megatrend

While Einhorn's conclusion deserves some nuance, it reflects a structural megatrend in the financial markets: active fund managers passive index funds are increasingly making way for passive index funds. At the beginning of this year, a new milestone was reached in this area. According to specialist market researcher Morningstar passive funds have surpassed active index funds as the most popular investment product for the first time. In the US, ETFs represent 50.02 percent of invested capital today, while actively managed funds remain stuck at 49.98 percent.

We sometimes refer to the rise of ETFs as the Taylor Swiftification of the stock markets.
- Wouter Verlinden (Value Square Fund Manager)

In Europe, this transition is somewhat slower, but with a market share of 27%, the importance of passive funds has also more than doubled in ten years on the old continent. “We sometimes call it the Taylor Swiftification of the stock markets,” says Wouter Verlinden, fund manager at the Belgian fund boutique Value Square. He manages a fund specialized in European small caps, listed companies with a smaller market capitalization.

“Thanks to streaming platforms like Spotify, we have almost all the music in the world at our disposal, but in practice, everyone listens to Taylor Swift. She can also sell tickets for her shows at any price,” Verlinden explains. “That's how it works on the stock market today: despite all the options, everyone buys just about the same thing.”

Worrying dive

This shift to passive funds has important consequences. “The flight to ETFs is to the disadvantage of small and medium-sized companies, because they are much less likely to be bought up by passive index trackers,” says Guy Sips, an analyst at the KBC Securities stock exchange. He specializes in small and medium-sized Belgian stocks. “In addition, invest especially private investors their money in passive funds, while those amateur investors are so crucial for trading in smaller companies. Especially for a relatively small stock market like the Belgian one, private investors are an important lifeblood. '

The flight to ETFs is to the disadvantage of small and medium-sized companies, because they are much less likely to be bought up by passive index trackers.
- Guy Sips (KBC Securities Analyst)

A dive into the trading volumes on Euronext Brussels provides a worrying picture (see table). For many small and medium stocks, the number of transactions is decimated in recent years. “At least over the past three to four years, we've been experiencing this drying liquidity firsthand,” says Verlinden. “I don't know exactly why, but the growing popularity of index trackers certainly has something to do with it.”

“As a result, smaller stocks risk ending up in a vicious cycle,” adds Degroof Petercam analyst Kris Kippers. “Illiquid stocks arouse less interest among investors, so the price lags behind. You often see that the company or the major shareholder is going to buy up the shares themselves, but as a result, the number of freely tradable shares falls even more. The end game is then a buyout bid to take the company off the stock market. In this way, great companies such as Resilux, Sioen and Duvel Moortgat have been around in recent years disappeared from the Belgian stock exchange.'

Especially for fund managers, sufficient liquidity is crucial to be able to invest. “It is important to be able to get in and out of a stock within a certain period of time, also in the interests of our customer,” says Rik Dhoest, who manages the Nagelmackers bank's European small cap fund.

“In some small companies, the market has dried up to such an extent that we can no longer trade without completely disrupting pricing. We have decided to avoid companies with a market value below 500 million euros. Initially, that threshold was 100 million euros, but that is no longer workable for us,” says Dhoest. “We still had participations in Belgian companies such as Jensen, but that is no longer the case. In my opinion, small investors can still benefit from it. '

In this way, the players in the market are adapting to a new reality. “We mainly look at the daily trading volume in a stock,” says Verlinden of Value Square. “As a small fund boutique, we are quite flexible, but a daily turnover of 200,000 to 250,000 euros on the stock market is still a minimum requirement.”

To illustrate: the lingerie maker Van de Velde - with a market value of more than 400 million euros - achieved a daily turnover of around 160,000 euros last week, in what following the annual results was still a fairly busy trading week. The food manufacturer What's Cooking, the former Ter Beke, is struggling to reach 15,000 euros daily turnover. Far too little, so to speak. investable to be for larger investors.

Index records

The success of ETFs, of course, has its reasons: the costs are much lower than with actively managed funds and often the return is even higher. Only 17 percent of funds actively managed in Europe have been able to achieve a higher return than a comparable passive fund or ETF over the past ten years, according to Morningstar figures.

In the US, indices such as the S&P500 and Nasdaq are booming setting one record after another, led by tech giants that are surfing on AI enthusiasm. The European barometers are also much to the delight of index followers. at a record price. At the same time, a lot remain stock pickers left with seemingly eternally underrated 'gems' on the Brussels stock exchange or elsewhere. Historically, European small caps have rarely been so cheap. (see graph).

“A bargain that remains a bargain is not a bargain,” Kris Kippers recalls old stock market wisdom. “Still, I wonder if we're not gradually approaching a turning point. The rise of ETFs over the past decade has been accompanied by an exceptionally good era in the financial markets. Outside the corona dip, passive investors have hardly experienced any financial storm. I think that active management will still prove useful in the event of a real shock in the financial markets.”

I assume that passive investors are also gradually beginning to question the sharp rise in valuations of the US tech giants.
- Rik Dhoest (Fund Manager at Nagelmackers)

Dhoest joins him: “I assume that passive investors are also gradually beginning to question the sharp appreciation of the US tech giants, which, due to their enormous market value, guide the performance of US and global index funds.” He is convinced that the cycle will sooner or later turn in favor of the small- and mid-caps.

This does not alter the fact that the situation is acute for many small stocks, given the languishing liquidity. “If that continues, even more companies will leave the stock market,” fears Guy Sips. “Although I am the last to encourage that, as an advocate for a wide range of great companies on the stock market.” He has some suggestions for resuscitating trading in the lower echelons of the stock market.

“Of course, it starts with good results. But smaller players must also dare to sell themselves,” says Sips. “Take a great company like Van de Velde. It may not always be fun to prank investors and repeat that they sell bras, but it is necessary. This keeps you on the radar of stock markets and investors. In the long run, that pays off. '

In that regard, the image technology group EVS is a nice example, says the analyst. “Two to three years ago, it was still a typical small company that was difficult to attract investors. But management has brought a transparent and consistent growth story and is gradually being rewarded for it. ' On the stock market, EVS is now at a market value of 500 million euros. “Every time such an important threshold is crossed, the company comes on the radar of larger investors and index funds. Then the flywheel suddenly starts turning in your favor,” says Sips.

Breaking the market

According to Wall Street veteran Einhorn, passive investing risks “breaking the markets” because “algorithmic and machine money” from those funds do not form any opinion about the value of a stock. However, Belgian analysts and fund managers do not want to go that far. They point out that pricing in the financial markets is still ultimately done by active investors, averse to the influx of passively managed money.

And so the stock pickers among us don't have to despair either: one day, the neglected stock market pearls will be rediscovered. “In the past year and a half, the climate for small caps has been very harsh,” says Yves Vaneerdewegh, the CEO of Leuven investment company Quest for Growth. “But I see that as an opportunity rather than a structural threat. When the sentiment changes, things can sometimes go fast. Small investors can also benefit from this. '

Verlinden from Value Square agrees: “If no one else comes to the market, there are things to do. As value investors, we are convinced of that. I note that there are regular takeover or buy-out bids for companies that are in our portfolio. That usually provides a good return, although you may wonder whether this will not lead to a deterioration in the stock market landscape in the long run. '

Kippers: “In the 1980s, Belgian stocks were promoted to the general public through the Cooreman-De Clercq Act, which provided for a favourable tax regime for Belgian stocks. That law was a success: a lot of savings found their way into the stock market and thus also into the real economy. Maybe it's time to repeat something like that again? '

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References

• Source: De Tijd
• Link: https://www.tijd.be/markten-live/analyse/steeds-meer-beleggers-laten-kleine-aandelen-in-de-kou-staan/10531259‍
• Author: Evert Nerinckx
• Date: 08/03/2024
• Photo: Photo by Rosa Rafael on Unsplash