“Nobody knows anything.”
It’s one of my favorite quotes, from famed screenwriter William Goldman. It’s also the title of season one, episode 11 of the seminal HBO series The Sopranos.
Well, we know something… at least just a little bit more than a couple of Wall Street group-thinkers, who took to CNBC in mid-February 2016 to basically proclaim “the death of small caps.”
From February 26, 2016 through July 26, 2016, the Russell 2000 was up 18%, while the S&P 500 was up 11%.
So, since the exaggerated rumors of its imminent demise, the small-cap benchmark index has outperformed the large-cap standard by 64%.
February 26 is important because it was the Friday before that we published a piece about how small-cap stocks were on the verge of a resurgence.
Click here to read the article and watch a video featuring Wall Street Daily’s Chief Investment Strategist, Louis Basenese.
Sure, small caps have enjoyed a strong rally over the past five months. But the Russell 2000 is – unlike the S&P 500 and the Dow Jones industrial average – still well below its all-time high.
Large- and mega-cap stocks have led this surge – floated by extraordinarily easy monetary policy or not – off the March 2009 Global Financial Crisis/Great Recession lows.
From June 2015, when the Russell 2000 pushed out to 1,284.66, until its recent February 2016 low, the Russell 2000 crashed by more than 25%.
According to the math, it means there’s still about 10% to go until small-cap investors are made whole again.
That doesn’t necessarily mean it’s going to happen, of course. But this is a shorter-term question.
Ours is a long-term case for small-cap stocks. And that case rests on three key pillars.
#1: Wall Street Isn’t Paying Attention
The simple fact is that most Wall Street research houses can’t afford the time or staff to cover small- and micro-cap stocks.
And most mutual funds are too large to comfortably trade in and out of them.
The bottom line is that small-cap stocks are often mispriced. We like to take advantage of it.
We focus on extraordinary value and extraordinary growth potential.
#2: They’re Gonna Zig, We’re Gonna Zag
As I noted yesterday, “Risk aversion is the name of the game. But we’re doing it on a strategic basis, where we can exploit information advantages.”
The Wall Street group-thinkers – one from Société Générale, the other from Oppenheimer Funds – talked up the S&P 500 at a time when that index was outperforming the Russell 2000 by more than 80%.
From January 1 through February 17, the S&P was down 6%, while the Russell 2000 was down 11%.
Curiously, though, those and other “smart money” types continue to chase companies with deteriorating fundamentals.
Price-to-sales ratios of big caps recently pierced 13-year highs versus small caps. And sales growth for seven of the 10 big-cap sectors, as defined by the S&P, has slowed.
There’s a split between companies whose sales are expanding and those that are seeing contraction.
Most investors seem to want the latter. We prefer the former.
And, excluding telecommunications, sales growth for small companies has outpaced large companies in every industry of the stock market.
Sales growth leads to earnings growth. And history proves that earnings growth is rewarded with higher share prices.
#3: We Have Vision
Yogi Berra famously said, “It’s tough to make predictions, especially about the future.”
What we do is evaluate small-cap companies’ data – sales, costs, profits, balance sheet items – and augment the picture with “primary due diligence.”
This means our analysts don’t just pore over material prepared by the companies we’re covering – although reading quarterly and annual reports, conference call transcripts, and investor presentations are a big part of what we do.
We take an extra step: We call clients of the companies we’re covering – the actual consumers of their products and services.
This helps us make general predictions that are better than those from Wall Street shops, which have neither the time nor the inclination to do such hardcore digging.
Good for us… and good for you.
It’s true that the official “fact sheet” for the Russell 2000 reports a price-to-earnings ratio “ex-negative earnings.” That means it doesn’t account for companies in the index that are losing money.
Yeah, this is a little dodgy. And it’s reason to be selective. But it’s not reason to shun all opportunities. Our calling card is informed risk.
Take Second Sight Medical Products Inc. (Nasdaq:EYES), for example, a favorite of our Chief Investment Strategist, Louis Basenese.
Second Sight is losing money, but management recently reported remarkable five-year data in its continuing study of patients using its Argus II Retinal Prosthesis System.
In plain English: This system will help blind people regain the ability to see.
Talk about a breakthrough.
Sir John Templeton is the godfather of small-cap investing.
In 1939, he invested $10,400 in equal amounts across 104 stocks that were trading below $1.
Thirty-four of the companies went bankrupt. So, yeah, there’s going to be a failure rate.
But the success rate was sufficient to turn that original $10,400 into more than $40,000 by 1943.
Here are a couple of quotes from Sir John – who famously relocated his research operation to the Bahamas because, as he said, “When you’re in Manhattan, it’s much more difficult to go opposite the crowd” – that inform our discussion today.
- “Everything is in a constant state of change, and the wise investor recognizes that success is a process of continually seeking answers to new questions.”
- “People are always asking me where the outlook is good, but that’s the wrong question. The right question is: Where is the outlook most miserable? The obvious application of this concept in practice is to avoid following the crowd.”
Editorial Director, Wall Street Daily