3 key things an analyst looks at when researching a small company

There is a reason ‘small cap’ specialists are engaged to invest in small cap stocks - there are some key areas of focus for small stock investing that are often taken for granted in large cap investing.

IR Department senior consultant John Burgess has almost 20 years’ experience as an analyst across a range of sectors and companies. John explores three key focus areas of analysis that differ between small and large cap stocks. If you're a small company, it pays to bear these in mind when undertaking investor relations. 

Photo by Mari Helin-Tuominen on Unsplash

There is a reason ‘small cap’ specialists are engaged to invest in small cap stocks - there are some key areas of focus for small stock investing that are often taken for granted in large cap investing.

IR Department senior consultant John Burgess has almost 20 years’ experience as an analyst across a range of sectors and companies. John explores three key focus areas of analysis that differ between small and large cap stocks. If you're a small company, it pays to bear these in mind when undertaking investor relations. 

Management

Management is a far greater area of focus for analysts when assessing small companies due to resourcing, the phase of a company’s development and resulting ‘key man risk’.

Larger companies tend to have great breadth and depth of management, a dedicated HR department, the financial resources to recruit key people and clear succession planning. Management in larger companies often have the luxury of powerful market shares, an established brand name & customer base and the financial resources to execute their strategies. 

In smaller companies, by comparison, management could comprise just one or two people. So, exactly who those people are and what they bring to the table becomes of great importance to the company’s outlook.

Analysts will look at the reputation, skill set and experience of management in small companies, along with the support available to them. Analysts are looking to ensure management have the skills and experience appropriate not only to their role, but the company’s phase of development. 

The stage of a company’s development is particularly important to consider because business models are ever evolving as a company grows, as competitor responses change and products evolve. Different stages of a company’s evolution can require vastly different skills. Using a mining company as an example, the skill sets required for exploration differs markedly from the financing & construction phase, which differs markedly from the production phase. Very few individuals will have skill sets that cover all stages of evolution.

Smaller companies tend to have more entrepreneurial management, and with less management breadth and depth, they are much more reliant on their Board for guidance. So analysts also place greater weight on the skill set and experience of a small company’s Board than they would of a larger company. 

The skill sets required to manage small and large companies are often vastly different. Despite this, there is a clear preference in Australia to appoint people with ‘large company’ backgrounds into small companies, and this should be a key consideration for ‘cultural fit’ within an organisation (albeit hard to measure).  

The transition and involvement of ‘founders’ is often a key consideration for small companies, particularly if the founder/CEO moves to the Chairman position, which is always a contentious situation for analysts and investors. This is because it is very rare that a founder can completely step away from the business and not interfere while new management put their ‘stamp’ on the company. Large companies tend not to have such dominant individual shareholders and therefore influence.  

While you’re unlikely to see an analyst make any of this thinking open and public, it is likely to emerge in some way, shape or form in their judgements. 

Bear in mind also that an analyst has only limited exposure and interaction with a company’s management, so making a judgement is challenging and ultimately comes down to comparing words against results.

Key questions an analyst will ask when looking at a small company’s management include:
•    What is the breadth and depth of management?
•    What is the skill set and experience of management, and is it appropriate for the company’s stage of growth?
•    What support is available to management? E.g. is the Board an appropriate source of support?
•    Do words match actions and outcomes?
•    Is management running the company for all shareholders?

Capital intensity

Smaller companies tend to be growth-oriented but capital-constrained, and as a result they’re forever balancing their growth ambitions with their capital requirements.

In this light it is very important to understand the capital requirements of a business model, and in particular the working capital and capital expenditure requirements to achieve future revenue ambitions.

This is even more important when a company is in the early stages of commercialisation and therefore likely to be loss-making at the profit and loss line, as well as cash flow negative, which is rarely the case with a larger company.

Furthermore, debt funding is typically not an option for small companies at the early stages of their growth cycle, which limits both funding options (to mainly equity) and timeframes to achieve funding.

From a working capital perspective, days receivables relative to days payables is a key focus, as small companies tend to be dealing with larger companies, and are therefore at the mercy of large company payment terms. It will be very rare that a small company has receivable terms superior to their payment terms, and this mismatch typically requires the small company to fund this gap as revenue grows.

For companies selling goods, the inventory requirements are also a major consideration, as is stock turn and the gross margin of the product being sold.  The lower the stock turn and lower the gross margin, the higher the inventory requirements will be.

Analysts will also look to ‘normalise’ these key metrics in their forward estimates longer-term as "year-end" balance sheet positions can often be misleading, given they are only a “snapshot in time”.

Key questions an analyst will ask when looking at a small company’s capital requirements will include:
•    What is the difference between payables & receivables?
•    What is the relationship between inventories and sales?
•    How are these metrics likely to vary over time?   
•    How will the company fund growth ambitions with the above in mind?

The assumptions in forward earnings estimates
Analysts and investors alike value a company on future earnings and cash flows. The past may provide some help in determining cycles and trends but all valuation tools are forward looking.

It is therefore important to understand what key assumptions make up future earnings estimates, and how such changes could impact earnings and valuation.

For larger companies, this is relatively easy to determine as there is usually a well- established operating history, some guidance from the companies on key variables and a number of analysts following the stock closely, providing a solid "consensus" estimate from which to understand forward earnings assumptions.

Independent analysts and their broking firms can make a living providing independent analysis on larger companies, and as a result research tends to be well articulated, up to date and independent. 

For small companies, the operating history is often less established and as a result, it is much more difficult for management to provide guidance on key earnings variables. Regarding stock coverage, there will typically be less than three analysts following the stock. Many of these will only follow the stock to ‘round out coverage’ of the sector, because achieving a return from brokerage is almost impossible with today’s brokerage rates.

There is also the issue of a ‘sponsoring broker’, with these brokers providing good company knowledge but typically ‘optimistic’ forward estimates. All these factors make assessing the future earnings estimates of small companies problematic.

Key questions an analyst will ask when looking at small company earnings estimates include:
•    What is the relationship between the writing analysts and the company?
•    What are the key assumptions that drive forward earnings and the resulting valuation?
•    Do I believe these assumptions and if not how would my assumptions change the numbers & valuation?