Big Things, Small Packages.

November 30, 2015

America prides itself on going big. Big country. Cars. Buildings. Homes. Toys. Egos.
Yet, when it comes to investing, our size fixation hinders more than it helps.
The last five years have seen the large cap S&P 500 return 17.6 percent annually. Recently, however, the index has trended sideways. Going nowhere for much of the last year. In other words, large cap stocks look tired. As they should be. For five years they have carried the load.
As of November, large companies have outperformed their smaller counterparts for seven years. Whereas, heading into the '08 crisis, small cap stocks had outperformed for much of the previous century.
Leadership among the various asset classes differs during individual market cycles. Small caps. Mid caps. Large caps. Mega caps. Each will lead or lag, at various times. But, those asset classes accompanied by more risk will, over longer periods, result in better returns.
Still, a four to six year cycle may see small companies outperform, after which the market leadership rotates to large companies for a few years. Point is, the rotation remains a permanent fixture. The market leadership passes from leader to laggard. And so on. In perpetuity.
At some point, sooner than later, we believe that rotational shift will occur again.
Year to date, small cap stocks have underperformed large caps by roughly two percent. And that spread has recently narrowed.
Traditionally, small cap stocks -- represented by the Russell 2000 index -- have handily outperformed large caps. Accordingly, as in all market-based issues, there will eventually be a mean reversion. Whereupon a rotation into small caps will occur. Followed by several years of small-cap outperformance.
Large caps, having led the pack for seven-years, are due for a pause. While small caps, which have traditionally posted better returns for those comfortable with a bit more volatility, have lagged large caps for years. Thus, small cap stocks should offer greater opportunity. Even as large caps pause, trade sideways and recharge.
Unfortunately, most investors will be left out.
The average investor's focus on large cap stocks says more about Wall Street than it does about themselves.
Wall Street's sell-side research departments spend most of their time, energy and resources producing massive amounts of research on the nation's largest public companies. After which they opine on those same companies to CNBC, Fortune, Bloomberg TV, Forbes and other financial outlets. An exercise referred to as "talking your book" in Wall Street parlance.
Why the focus on large companies?
It is simply easier to analyze, dissect and discuss the nation's largest companies, about which the most information is readily available. And from which the most investment banking and M&A fees can be derived. So, that is where Wall Street spends its time.
Accordingly, investors find it easier to invest in well-known, blue-chip, mega-cap companies that comprise the Dow Jones Industrial Average and the S&P 500 indices. Investors are comfortable with the large, familiar names that inhabit their consumer habits. And about which they can find copious amounts of erudite research. So fulfilling the intellectual need to "affirm one's gut feelings." Referred to in psychological circles as confirmation bias.
So, the virtuous cycle is complete. Wall Street can more easily manufacture reports about, speak highly of, and glean banking and consulting fees from the nation's largest companies. Enabling Main Street to comfortably invest in that which is most familiar. In so doing, Wall Street stays rich. Main Street's fortunes ebb and flow with the index tides. And nobody need learn any new dance moves.
Yet, as Frost poetically penned, it is often better to take the road less traveled.
Ibbotson Associates reports that small caps, companies with a market capitalization between $300 million and $2 billion, have returned 12.1 percent annually since 1925. Simultaneously, large caps have delivered 9.9 percent. Compounded annually, that 2.2 percent disparity becomes a fortune.
That performance disparity is no coincidence. Small stocks have a number of inherent advantages over the big ones.
First, small caps provide that rare opportunity for investors to stake out raw land. Mutual fund managers and other institutional investors are often prohibited from buying public shares trading for less than five dollars. Sometimes they're prohibited from buying companies valued at less than $1 billion in market capitalization. This enables discerning investors to arrive before the herd. Stake their turf, and wait for the public to notice.
Further, due to the lack of visibility, research and investor awareness, discerning investors can find discrepancies between small-cap fundamentals and their stock prices. Smaller company stocks are more likely to be mispriced than their large-cap peers. Such mispricing does not exist among the likes of IBM, P&G or Goldman Sachs. Because all of the information is already available. And everyone already owns them.
What's more, small caps tend to be thinly traded. You simply don't have the same volume of trading activity associated with larger companies. Thus, investors can purchase promising small cap companies and benefit immensely as the public increasingly becomes aware of the stock's existence and future prospects.
But Main Street isn't the only herd that is slow to discover the watering hole.
Consider the example of Small Packages Inc. (SMAL), a promising small cap company that you discovered, researched, and invested in.
Some months after you invested, SMAL garners increasing attention from traders and investor circles. Soon, SMAL is discovered by hedge funds, which do their own due diligence and begin to accumulate shares. Of course, the hedge fund guys love talking their book. Love touting their ideas. As they do, Wall Street takes notice. Leading to
increasing amounts of analyst coverage. Which enhances the attention paid to the formerly unheard of stock.
Soon, analysts are assigning "Buy" ratings to SMAL. Which greatly increases institutional investor awareness. As SMAL grows in share price and cap size, mutual funds and pension plans can eventually buy the shares. So increasing SMAL's exposure and price.
Before long, that little-heard-of stock is gaining mention in Fortune, CNBC and Forbes. Suddenly, yesterday's Cinderella is on everyone's watch list. By the time the public even hears of SMAL, the stock has risen 237 percent. Only then do you hear it described as being "fairly valued." Yet, SMAL mania pushes shares up another 35 percent.
Leading Wall Street's sales force, brokers from Merrill, UBS, Morgan Stanley and Wells Fargo, to begin sharing the "idea" with clients. Transferring the contagion from Wall Street to Main Street.
All of which culminates with your neighbor, Biff McGillicutty, and his braggadocios claims of investment eminence for having recently purchased SMAL. Precisely three years and 328 percent after you did the same.
You see, Wall Street is no less comprised of herd animals than is Main Street. Only, because Wall Street inhabits higher ground with a better vantage point, it is usually able to get the jump on the less-informed members of the species.
Yet, in addition to the opportunity to invest in tomorrow's darlings, there is also value within the flexibility and nimble operations of smaller companies.
Larger concerns must run everything up a huge bureaucratic tree. Only to eventually have a decision struck down by a board of directors who meet once per quarter. Smaller companies benefit by faster, more agile decision making. Smaller organizations involve less politics. Fewer opportunities for infighting.
Another opportunity for small cap investors is the M&A activity that drives shares higher.
While larger companies can merge with and acquire each other, it does not happen often. Yet, small companies are constantly viewed as takeover targets. It's much easier to buy a small public company with its existing operational wherewithal than it is to start a business from scratch. When these acquisitions transpire, shares jettison higher. But, even the ongoing rumors of such activity can serve as perpetual catalysts for a stock.
Of course, small cap stocks tend to be more volatile than large caps. But, not always. In 2008, the Vanguard Small Cap Index outperformed the S&P 500.
We tend to see large cap stocks in the same light as Manhattan Real Estate. Everybody wants it. So it's rarely a buyer's market. And you tend to overpay.
Small caps, however, are more akin to the raw, untouched land just beyond the city limits. Arrive early, wait patiently and you may be handsomely rewarded.
Still, some will argue. This is America! Bigger is better!
Occasionally, ship size matters. More often, however, bet on the motion of the ocean.

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