Time for the great American small-cap stock heist
I'll say it as plainly as I can. Buying a portfolio of small stocks
today, (middle to late September) would be like taking candy from a baby.
In fact, the analogy may be apt. The average age of the mutual fund portfolio manager
today in America is 28. This age implies three to six years of involvement in the stock
market. In most professional fields, an individual progresses from apprentice to
journeyman to master, each phase taking as much as five years. One would hardly
think that individuals with three to six years in a professional field are even journeymen.
Perhaps this is the best explanation for why the Russell 2000 is down 20 percent year to
date, while the S&P 500 is up 7 percent. It can't be the fundamentals, since the growth
rates, the P/Es and the financials of the small stocks as a group exceed the outlook for
large-cap stocks today. I can only imagine that companies selling at their cash value (cash
+ marketable securities, minus debt) are selling there because somebody doesn't know
what they are selling. (Has anyone noticed the dramatic increase in insider buying?)
Small capitalization stocks are now selling at one of their historic low valuations.
(See exhibit one.) As measured by the Russell 2000, the best index measure of
small-capitalization stocks, the average small stock declined 32 percent from the April
1998 high. The average S&P 500 stock, however, has declined only 19 percent from its
July high.
Small stocks are down 20 percent for the year, while the S&P 500 has recovered a bit
and is up 7 percent. This under-performance has occurred in spite of the fact that the
earnings outlook for small stocks in 1999 is better than the S&P 500. However, there are
many technical reasons for the debacle in small stocks. Let's list a few.
1) A record number of initial public offerings in the last two years
has put a strain on Wall Street's ability to cover all the new
companies.
2) The record number of new companies is also putting pressure on market makers who
are less familiar with the stocks they market.
3) The emergence of the SOES bandit, or the new Nasdaq market makers. With anyone
able to place an order to buy or sell on the Nasdaq (and have that order shown to the
public), market makers are operating only in those stocks they feel they have information
about. This leaves a lot of stocks subject to Internet rumor mills and chat/newsroom
opinion influence.
4) The Asian debacle has frightened a number of individual investors into cash.
5) Margin selling hits stocks with low prices more frequently and more harshly due to the
sliding margin requirements placed on low-priced stocks.
6) The normal providers of liquidity to the small-cap market (mutual funds with small cap
charters) are fleeing the area as their relative performance declines. Smith Barney
conducted a poll of mutual funds that historically have owned greater than 50 percent of
their fund in small stocks. Today, only 21 percent of those funds currently hold greater
than 50 percent of the fund in small stocks.
Our forecast
Small stocks and the Russell 2000 Index will outperform the S&P 500 from here on out,
until sometime in the year 2000. Bold statement? Not really. It is much easier for a stock
selling at $5/sh today, down from say $20 or $15 (not so atypical of many stocks I can
think of), to bounce back to $10-12/sh in the next year, than it is for General Electric's
stock to go from its current $78/sh to $156/sh in the same time frame.
All it will take is some psychological relief from Asia. As I write
this, Japan's opposition party announced a successful negotiation with the ruling Liberal
Democratic Party to create an independent committee to oversee banking reform and
restructuring, only to see the agreement overturned two days later.
The important part of this agreement would be to take the banking reform process out of
the Ministry of Finance, where the crusty, incumbent, "old boy" network continues to
procrastinate. If such an agreement is reached in the next few weeks, this will be
perceived as a good thing for Japan and a positive first step. I'm reminded of Pogo's
famous admission: "I have met the enemy. It is us."
Peter Lynch, the famous former portfolio manager of the Fidelity Magellan Fund gave
two pieces of advice recently: "The world will sort itself out" and "Buy a portfolio of
small stocks, they are the cheapest today." We, too, think that buying small stocks
today is a no-brainer. Current prices are: "ludicrous," "suicidal," "idiotic," and "frightening."
Don't follow the crowd. Get to know one of the "ugly ducklings" and ask it to dance. You
won't have to wait long for it to turn into a beautiful swan.
Christopher R. Helton appears as the Strategist at Stocksite. Christopher
<crhelton@go2net.com> appreciates receiving email from both early adopters and
laggards alike.
Source: stocksite.com |
