Good Things in Small Packages. Investment Perspectives, Part III

October 29, 2013

In The Road Ahead, Investment Perspectives Parts I and II, we explained how the United States, as well as much of the developed world, will contend with far-reaching systemic issues in the years ahead.
Economic and financial headwinds in the form of demographic trends and unsustainable policies will force a reckoning throughout the global economic system.
There are, however, areas within the global market place that will provide dynamic opportunities for intelligent, forward-looking investors.
Last week we focused on the massive opportunities within the liquid natural gas and shale revolution. This week we focus on another opportunity.
This is the third installment in a five part series.
. . .
As a nation, we pride ourselves on going big. Big country. Cars. Buildings. Homes. Toys. Egos.
Yet, when it comes to investing, our size fixation hinders as much as it helps.
The last five years have seen the large cap S&P 500 return 17.5 percent. Recently, however, the index has begun to exhibit a topping pattern. In other words, large cap stocks look tired. As they should be. For five years they have carried the load.
Heading into this year, large companies had outperformed their smaller counterparts for much of the recovery. Whereas, heading into the '08 crisis, small cap stocks had outperformed for much of the decade.
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.
A four to six year cycle may see small companies outperform, after which the market leadership rotates back to large companies. Point is, a rotation always occurs. The market leadership passes from the former leader to the former laggard. And so on.
We believe that rotational shift occurred earlier this year.
Year to date, small cap stocks have outperformed large caps by roughly seven percent. We believe the rotation has been established, and small cap outperformance will likely continue for the next few years.
If you read Investment Perspective Part I two weeks ago, you will recall our thesis that large caps are due for a pause. Yet, we feel that small cap stocks will continue to offer opportunities. Even as large caps begin to pause, trade sideways and recharge.
Savvy investors will be the beneficiaries of this performance realignment. 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 investors.
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. Following, they spend their days opining on those large cap companies on CNBC, Bloomberg TV, and other financial news outlets.
It is simply easier to analyze, dissect and discuss the nation's largest companies, about which the most information is readily available. So, that is where Wall Street spends its time.
Accordingly, investors find it easier to invest in those 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 lives and consumer habits.
Yet, as Frost poetically stated, it is often better to take the road less travelled.
Ibbotson Associates reports that small caps, companies with market caps between $300 million and $2 billion, have returned 12.1 percent annually since 1925. Simultaneously, large caps have delivered 9.9 percent per year. Compounded annually, that 2.2 percent disparity is a fortune.
That performance disparity is no coincidence. Small cap stocks have a number of inherent advantages that large caps cannot duplicate.
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 take notice.
Further, due to their relative lack of visibility, research and investor awareness, discerning investors can find discrepancies between small-cap fundamentals and stock prices. Smaller cap 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.
What's more, small caps tend to be thinly traded. You simply don't have the same volume of trading activity associated with the small cap names. Thus, investors can purchase promising small cap companies and benefit immensely as the public increasingly becomes aware of the stock's existence and prospects for growth.
As promising small companies garner increasing attention, analyst coverage begins to increase. This enhances the attention paid to the formerly unheard of firm. Soon, analysts are assigning "Buy" ratings to the stock. This can greatly increase the institutional awareness. And word eventually emanates from Wall Street to Main Street.
Before long, our little-heard-of stock is gaining mention in Fortune and Forbes. Suddenly, yesterday's Cinderella is on everyone's watch list. By the time you hear of it, the stock has risen 237 percent. Only then, do you start to hear it described in terms of being "fairly valued." Yet, continuing mania pushes shares up another 35 percent.
Beyond the opportunity to invest early in these lesser known stars of tomorrow, 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 entail 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 other large companies, it does not happen often. Yet, small companies are constantly rumored to be takeover targets. It's much easier to buy a small company with its existing operational wherewithal than it is to start a new business from scratch. When these acquisitions transpire, shares jettison higher. But, even the ongoing possibility 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. It's rarely a buyer's market. So you tend to overpay.
Small caps, however, are more akin to that 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 always better!
Occasionally, ship size matters. More often than not, however, bet on the motion of the ocean.

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