More and more investors leave small stocks out in the cold

The growing importance of passive index funds, which shadow the price of a stock basket, is rewriting the rules of the game in the stock market. Smaller stocks in particular have to fight harder and harder for the attention of retail and institutional investors. Will there still be a turning point?

What on earth am I doing wrong? That question asked infamous fund manager David Einhorn increasingly in recent years as he determined that his leveraged fund, Greenlight Capital, was failing to deliver the same, high returns as before.

During the financial crisis, Einhorn garnered fame with his "short" on the U.S. major bank Lehman Brothers. In the summer of 2007, he was one of the first to realize that Lehman was running immense risks with its exposure to the overvalued real estate market in the US. By betting on a fall in the Lehman Brothers stock price, Einhorn made millions of dollars. In 2008, the bank went bankrupt.

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

Until he understood why the mayonnaise didn't pick up. Einhorn noted that expensive stocks often remained expensive because they were blindly bought by passive index funds. Those trackers or ETFs buy a basket of stocks from a particular index - say, the S&P500 or the Nasdaq100 - and otherwise make no judgment about a stock's fair value. Conversely, cheap stocks remained cheap because they were outside an index basket and almost nowhere on the radar.

Megatrend

While that conclusion by Einhorn deserves some nuance, it reflects a structural megatrend in financial markets: active fund managers are increasingly clearing the way for passive index funds. A new milestone was reached in that regard earlier this year. According to specialized market researcher Morningstar, passive funds overtook active index funds as the most popular investment product for the first time. In the U.S. today, ETFs represent 50.02 percent of invested capital, while actively managed funds remain at 49.98 percent.

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

In Europe, that transition has been somewhat slower, but with a 27 percent market share, the importance of passive funds has more than doubled in a decade on the old continent as well. 'We sometimes call it the Taylor Swiftification of equity markets,' says Wouter Verlinden, fund manager at Belgian fund boutique Value Square. He manages a fund specializing in European small caps, publicly traded companies with smaller market capitalizations.

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

Worrying dive

That shift to passive funds has important implications. 'The flight to ETFs works to the disadvantage of small- and mid-cap companies, because they are much less likely to be bought up by passive index trackers,' says Guy Sips, an analyst at the brokerage house KBC Securities. He specializes in small- and medium-sized Belgian stocks. 'Moreover, mainly private investors invest their pennies in passive funds, while precisely those amateur investors are so crucial for trading the smaller companies. Especially for a relatively small stock market like the Belgian one, private investors are an important lifeline.'

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

A dip into trading volumes on Euronext Brussels reveals a worrying picture(see table). For many small and medium-sized shares, the number of transactions has been decimated in recent years. Certainly over the past three to four years we have experienced this drying up of liquidity," says Verlinden. 'Why exactly, I don't know, but the growing popularity of index trackers certainly has something to do with it.'

'As a result, the smaller stocks risk ending up in a vicious circle,' adds Degroof Petercam analyst Kris Kippers. 'Illiquid shares arouse less interest among investors, causing the price to lag. You then often see the company or major shareholder start buying up the shares themselves, but this reduces the number of freely tradable shares even more. The end game is then a buyout offer to take the company off the stock market. This is how great companies like Resilux, Sioen and Duvel Moortgat have disappeared from the Belgian stock market in recent years.'

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 interest of our client,' says Rik Dhoest, who manages the bank Nagelmackers' European small-cap fund.

'With some small companies, the market has dried up to the point where we cannot trade without completely disrupting price discovery. We have decided to avoid companies with a market capitalization below 500 million euros. Initially that threshold was set at 100 million euros, but that is no longer workable for us,' Dhoest says. 'We still had holdings in Belgian companies like Jensen, but that is no longer an issue. I think small investors can still take advantage of it.'

In this way, market players 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 - good for a market value of over 400 million euros - achieved a daily turnover of about 160,000 euros last week, in what was still a fairly busy trading week following the annual figures. The food producer What's Cooking, formerly Ter Beke, barely touched 15,000 euros in daily sales. Far too little, therefore, to be somewhat investable for larger investors.

Index records

The success of ETFs has its reasons, of course: the costs are much lower than for actively managed funds, and often the returns are even higher. Of funds actively managed in Europe over the past 10 years, only 17 percent could achieve a higher return than a comparable passive fund or ETF, Morningstar figures show.

In the US, indices such as the S&P500 and the Nasdaq are smoothly setting one record after another, led by tech giants surfing on the AI enthusiasm. European barometers, to the delight of index followers, are also at record levels. At the same time, a lot of stock pickers are left with seemingly eternally undervalued "gems" on the Brussels stock exchange or elsewhere. In historical perspective, European smallcaps have rarely been so cheap (see graph).

'A bargain that remains a bargain is no bargain,' Kris Kippers recalls an old stock market wisdom. 'Yet I wonder if we are not quietly approaching a turning point. The rise of ETFs in the past decade was accompanied by an exceptionally good era in the financial markets. Other than the corona dip, passive investors have hardly experienced any financial storms. I think active management will still prove its worth in the event of a real shock in the financial markets.

I suppose even passive investors are starting to quietly question the sharply higher valuations of tech giants in the U.S.
- Rik Dhoest (Fund Manager at Nagelmackers)

Dhoest joins him: 'I assume that even passive investors are gradually beginning to question the sharply rising valuations of the tech giants in the U.S., whose enormous stock market value guides the performance of U.S. and global index funds.' He is convinced that sooner or later the cycle will turn in favor of small- and mid-caps.

That said, the situation in a lot of small stocks is acute, given the languishing liquidity. 'If that continues, even more companies will leave the stock market,' fears Guy Sips. 'Though I'm the last one to encourage that, as an advocate of a broad palette of fine companies in the stock market.' He has some suggestions for resuscitating trading in the lower echelons of the stock market.

'It starts, of course, with good results. But the smaller players must also dare to sell themselves,' says Sips. 'Take a nice company like Van de Velde. It may not always be fun to go on the air with investors and keep repeating that they sell bras, but it is necessary. It keeps you on the radar of stock exchange houses and investors. In the long run, it pays off.

The image technology group EVS is a good example in this regard, the analyst believes. 'Two or three years ago, that was still a typical, small company that had difficulty attracting investors. But the management has brought a transparent and consistent growth story and is gradually being rewarded for it.' On the stock market, EVS is now chafing 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 threatens to "break the markets," because "the algorithmic and machine money" from those funds does 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 price formation on 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 need not despair either: one day the neglected stock market gems will be rediscovered anyway. 'Over the past year and a half, the climate for small caps has been very bleak,' says Yves Vaneerdewegh, the top executive of Leuven investment company Quest for Growth. 'But I see that as an opportunity rather than a structural danger. When sentiment turns, things can sometimes go fast. Small investors can also benefit from that.'

Value Square's Verlinden agrees: "If no one else comes to the market, there is business to be done. As value investors, we are convinced of that. I note that takeover or buyout offers regularly come in on companies in our portfolio. That usually yields a nice return, although you might wonder if that won't eventually lead to a darkening of the stock market landscape.'

Kippers: "In the 1980s, Belgian shares were promoted to the general public via the Cooreman-De Clercq law, which provided for a favorable tax regime for Belgian shares. That law was a success: a lot of savings found their way to the stock market and thus to the real economy. Perhaps it is time to repeat something like that?

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References

• Source: The Time
• 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