What drives significant value creation in a small cap company? In this video, Shaun Nicholson shares how companies focused on making improvements in ROIC that also have low embedded expectations can create value over time.
1. What inefficiency exists in the small cap space?
We believe the market equates value creation to such metrics as earnings growth, revenue growth, and large market opportunities. Our team views significant improvement in Return on Invested Capital (or ROIC) and its byproduct, free cash flow, as the ultimate driver of underlying equity value, not revenue or earnings.
We look for companies with management teams focused on driving improvements in ROIC that also have defendable competitive advantages and low embedded expectations. This combination leads us to companies capable of compounding value over time by generating strong free cash flow, reinvesting that cash at increasing rates of return, which results in increasing equity value.
In fact, small cap companies in the Russell 2000® Index that have generated the greatest improvements in ROIC have historically outperformed the Russell 2000 over the long-term and created significantly more value.
2. How does your investment approach capitalize on this inefficiency?
We use a disciplined ROIC research process, with the goal of being early in identifying companies we believe have the largest opportunity for significant improvement in ROIC that is not reflected in the current enterprise value of the company. We focus on identifying catalysts for change that can lead to these improvements, such as changes in company management and corporate culture and the implementation of operational excellence initiatives.
At the same time, we spend time evaluating management teams, looking for those that are strengthening their capital allocation discipline and aligning their incentives in order to drive improvements in ROIC.
We also key in on the competitive advantages of the businesses we are evaluating. Participating in a niche market and having a defendable competitive advantage help keep competition out of the market and are key to improving the ROIC level of a firm.
The opinions expressed in this video are solely the opinions of Segall Bryant & Hamill or an unaffiliated third party. You should not treat any opinion in this video as specific inducement to make a particular investment or follow a particular strategy, but only as an expression of opinions. The opinions expressed in this video are based upon information considered reliable, but completeness or accuracy is not warranted, and it should not be relied upon as such. Market conditions are subject to change at any time, and no forecast can be guaranteed. Any and all information perceived from this video does not constitute financial, legal, tax, or other professional advice and is not intended as a substitute for consultation with a qualified professional. The opinions and statements are subject to change without notice and Segall Bryant & Hamill is not obligated to update or correct any information in this video. For illustrative purposes only. Segall Bryant & Hamill does not provide accounting, legal or tax advice. This information has been prepared solely for informational purposes and is not intended to provide or should not be relied upon for accounting, legal, tax or investment advice.
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