Small companies can often trade on low multiples and at large discounts to fair value for long periods of time. This is due to market illiquidity and the inherently higher risk compared with larger more established companies. Those with a form of competitive advantage, either tangible (such as an advanced factory), or intangible (such as brand or technology) can be good investment candidates. These companies can see very strong share price performance as earnings improve, or through a takeover offer. On the other hand, those small companies without a compelling advantage or valuable assets can see their share prices languish for long periods of time despite a seemingly attractive valuation.
In 2018 there were a few examples of corporate action realising value in underperforming small companies. One example is SLI Systems. While a poor performer since IPO, SLI Systems returned 225% during 2018 after a takeover at 65c.
Prior to the offer SLI had a market value of $19m with $9m cash valuing the business at less than 3 times 2018 cash earnings. While a very low multiple, an investment case would have required confidence in the value of their technology.
SLI systems provides search tools for online stores. A basic tool is easy to build, while the competitive advantage is in understanding what a customer wants and suggesting additional potential products they might buy. With the aim of increasing the proportion of website visitors that buy something and how much they spend.
When SLI systems listed at $1.50 in 2013 they were a first mover with low competition and had been growing annual recurring revenue at an average of 25%+ since 2008, with expectations that this would continue. After listing however, SLI continued to disappoint and the share price fell to a low of 18c.
There are many opinions on what went wrong, largely the market was flooded with competition and the market shifted to cheaper “plugin” solutions. Despite SLI arguably having better technology, it wasn’t price competitive. An employee review from Glassdoor sums this up well.
“A great software solution, probably the best in the industry, but they present it in the worst possible way. Clients have no idea why they should be paying 30% more.” [i]
In late 2017 SLI announced a restructure focused on cutting costs in the short term to preserve cash, while investing in a new “plugin” solution which would be significantly cheaper. If successful there likely would have been a meaningful improvement in earnings. Before this strategy could be realised however (at least in a public domain), SLI was acquired by ESW for 65c in October 2018.
ESW are a Texas based Private Equity Firm that buy software companies with the purpose of growing them for the long term. They are focused on companies with long tenured customers (a sign of competitive advantage, which for SLI was likely their technology) and are less concerned with growth / earnings history which can ultimately be fixed. Compared to a poor brand or outdated technology which is much harder to fix.
When looking at investments it’s important to go one step further than finding a company at an attractive valuation. You should identify whether there is a competitive advantage or catalyst which will result in change. This is especially important in smaller companies which can trade at low valuations and go underappreciated for long periods of time.