Wednesday, 10 January 2018

In The Middle Of The Cap

Time for my first blog of 2018 and this time it is about mid cap-enterprises, which have entered the spotlight in the past few years especially in Finland. Mid cap enterprises are considered as interesting among investors and economics, since investors see lucrative valuation and potential profits, economists see great potential for the economy.

Finnish company Inderes performs analysis to Finnish stocks and they are among the very few who produce information and analysis considering the Finnish mid cap firms. This partly has probably raised the interest towards these firms even further.

Usually mid cap-firms, as you might expect, fall into between of small-cap and large-cap firms in terms of market capitalization. Unlike small cap firms, mid cap firms have proved the that their business works in general and they have passed the most rapid phase of expansion. However, mid cap firms haven't entered yet the maturity stage and that's why offer good potential in revenue growth. This especially is the major cash flow driver that the investors are interested in.

So if you are considering investing in mid cap firms, what can they offer? First of all, the mid cap firms, especially the ones that aren't valuated or followed by analysts, can be undervalued. A mid cap firm in the shadows can offer hiding potential before it enters the spotlight of analysts and investors who then start to control more the quote of the stock. This combined to the rapid revenue growth could make a mid cap firm a good choice for your investment.

But I don't think that Finnish mid cap enterprises are the winning horse.

I've examined some Finnish mid cap enterprises, both listed and unlisted and I've faced some risks and specialties that we must think about. If the firm is listed and is analyzed by only one party (Inderes, for instance), whatever this party says about the stock can have a major impact on the quote. For example, if a party like Inderes decides to drop a stock from its TOP-3 list even if the stock is still performing well and the fundamentals don't change, investors might still drop the stock as well from their portfolio, causing the stock to crash several percentages without any fundamental reason. I'd like to call this the "Inderes-risk". This is because there exist no other information or quantitative analysis from the stock that the investors could chew on.

Another major risk is the business environment. In Finland, where the markets are relatively small, mid cap firms can be dependent on one large customer. The customer might have bargaining power for the firm and the gross margins can vary considerably, thus affecting the cash-flow of the firm. Also if the markets are small, how big is the potential for rapid revenue growth?

Another major concern that comes from possessing one large institutional customers is the cash squeeze caused by accounts receivables turnover and accounts payable turnover. A friend of mine who has been working with Finnish midcap enterprises, described that usually large institutional customers can negotiate long terms of payment for their bills. The mid cap-firm however commonly possess a relatively short terms of payment for its payables. If costs are paid fast and no cash is coming from the customers in the same pace, the firm might face some troubles.

Midcap-enterprises can also possess more private debt than large cap enterprises, for instance. This will cause their credit rating to suffer, which then again makes them pay higher interest to the borrowers. This increases the firms operation costs.

But the biggest problem in my opinion is the general business environment in Finland itself. In the start of the 21st Century, Nokia and the technology sector become the most important businesses in Finland. This created a need for new products, product development, product deisgn, product this and product that. This boom in Finland created an increasing demand for product oriented engineers to drive more innovations to Finland. These same engineers are now also very commonly in charge of the corporate governance of the (surprisingly, technology oriented) mid cap firms in Finland. The directors are very product oriented and might in worst cases possess no real experience in management or financials of a business. This makes also the marketing communication of these firms very product oriented and generally just bad.

So here we are. Even though Finnish mid cap enterprises are blazed all over the financial media, I don't think that they have just yet the best to offer. The corporate governance, the cash flow drivers and the potential of these firms in the domestic markets have to be evaluated in more specific to get me excited.

Sincerely, an investor of European and American large cap enterprises and value stocks.

Text: SW
Pictures don't belong to me

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