Interesting NYT piece on small-cap valuations. Would welcome comments.
A piece in today's New York Times argues that small cap valuations may stay down for some time. Since the link expires tonight, I'll quote relevant portions here:
What is keeping small stocks down? A series of factors, both large and small, obvious and obscure.
The biggest factor in small-stock underperformance is the dominance of institutional investors in today's markets. Direct stock ownership by individuals has fallen to about 47 percent of all U.S. equities last year from 91 percent in 1952. Individuals have handed over management of their portfolios to professionals who run mutual funds and pension funds.
Because many of these professionals have billions of dollars under management, they require easy entry and exit from the stocks they buy.
Being able to buy a $5 million position in a stock without pushing its price up is known as liquidity, and the demand for it among institutional investors has driven prices of the large-capitalization stocks in the Dow Jones industrial average and at the top of the S&P 500 to record valuations. Meanwhile, small stocks lag behind.
"The demand for liquidity has created a new class of stocks we call orphans," said J.D. Sullivan Jr., vice president of Carleton, McCreary, Holmes & Co., the Cleveland-based investment banking arm of Keycorp. "The people with all the money can't own them, so they have not enjoyed the same kind of value appreciation enjoyed by the market as a whole."
At the same time that the demand for deep liquidity in stocks has risen among institutional investors, liquidity among many small stocks is in decline, making them even less likely to be traded by professionals.
Perhaps the biggest contributor to illiquidity among small stocks is the change in Nasdaq market trading rules, which took effect last year. The new rules, mandated by the Securities and Exchange Commission, require that a Nasdaq market maker post an investor's price for a stock if it falls between the firm's bid and offer prices. ...
Result? Major brokerage firms like Merrill Lynch, Salomon Smith Barney and Bear, Stearns are cutting back on the number of Nasdaq or small-cap stocks they trade for their customers.
We are not talking about big, actively traded stocks like Cisco Systems, Oracle or 3Com Corp., which continue to have many firms trading their shares. But a more obscure stock that might once have had 10 market makers, could easily now be down to five. A result of fewer firms making markets in a stock is much less liquidity.
Small-stock investors face more problems than just a lack of liquidity. According to James Paulsen, chief investment officer of Norwest Investment Management in Minneapolis, small companies are likely to be hurt by declining inflation much more than big companies are.
Small companies, with their lower overhead and more nimble operations, have traditionally won customers by doing what their bigger competitors do more cheaply. But, Paulsen contends, declining inflation forces big companies to reduce their prices, stealing low-price thunder from small concerns.
In addition, small companies are less likely to have either the capital to invest in technology to lower their costs or the money to buy other companies to achieve economies of scale.
"In a disinflationary world, small companies can't compete as easily with big companies," Paulsen said.
As proof of his theory, Paulsen pointed to small-cap stock performance during other periods of low inflation or deflation going back to 1925. Small-cap stocks underperformed their larger colleagues throughout the 1920s and 1930s, when inflation was low or in negative territory.
Only when the Consumer Price Index surged in 1945, did small stocks start to recover. Then again, in 1975, when inflation started to pick up, so did small stocks.
'It's my belief that the small-stock outperformance over the last 70 years is a result of the fact that the period had more inflation than less," Paulsen said. "If low inflation continues, that could change the outlook for small stocks."
Disinflation could explain the intriguing deterioration in operating margins among small companies recently identified by Christine Callies, investment strategist at Credit Suisse First Boston in New York.
In the first quarter of this year, operating margins at companies whose market capitalizations were among the top one-fifth came in at an average 13.5 percent. Those in the second and third quintiles showed operating margins of around 11 percent.
But operating margins among the smallest companies -- those in the fourth and fifth quintiles in market cap -- averaged 9.3 percent and 5.4 percent, respectively.
Ms. Callies pointed out that the drag on small-company performance was not limited to the first quarter; margin deterioration among these concerns was a constant through the second half of 1997 as well.
She also noted two more reasons that small stocks are not likely to recover anytime soon.
First, a bull market in small caps has never materialized near the middle or end of an overall advance in stock prices like the one we are in. And second, recent data from the Federal Reserve Board shows a surge in foreign buying of American equities.
"Foreign investors prefer large-cap companies with global names," Ms. Callies said. This goes a long way toward explaining the recent outperformance of the S&P 500 and the Dow Jones industrials.
While many articles recently have examined small-cap market lagging, this piece introduces some arguments I hadn't seen elsewhere. I'm not persuaded by the liquidity point, since it cuts both ways (and helps many of the "little guys" like us), or the foreign buyer point, since this will be quite transitive (and eventually should put a drag on big-caps when a crisis arises or foreign economies recover.) But the deteriorating margin point is interesting, though disinflation seems to me to be an improbable cause.
In short, I'm still of the opinion that small and micro cap stocks are where the early 21st century's great equity buys will cluster, but this piece gave some interesting food for thought. There's a lot of expertise on this thread, and lots of us focus on the small caps. Thus I would enjoy hearing your thoughts on this.
Regards to all,
Dave |
