Follow-ups and New Thoughts:
Bill Hinch is a 35-year investment veteran who now runs the First Eagle Small Cap Opportunity Fund after a long, successful stint at Royce Funds. I took the following notes from his presentation last Tuesday night:
- Inflation tends to favor smaller companies
- Small and mid-size banks can often times be more accurately characterized as real estate companies
- To win in small caps you need to have nerve, because the best returns occurs as you come out of the worst environments. You not only have to resist the urge to sell during price declines, but you have to have the guts to buy them. Very few people do. Therefore …
- … Good small cap managers will underperform in down markets, because they will be the only ones disciplined enough to buy weakness.
- Small cap investors need to get paid a premium for illiquidity and lack of management depth.
- Concentration doesn’t work in small caps. You can get out of a mistake in a large cap with a modest penalty, but having a large position in a small, illiquid stock that blows up will kill you.
- Some of the best opportunities come from investing in companies that are temporarily losing money
- That said, avoid investing in companies that have never earned money.
- Value managers almost never get to invest in a great company with great management; that’s why most managers don’t like that sector.
- In a tough small cap market, there will be no bids. You have to buy companies as if you are never going to sell them, because occasionally you can’t.
As I thought about this afterward, I recalled my education in the securities business back in the 1980s. Studies had just come out that showed that small stocks outperformed large stocks by several percentage points per year over time. These studies also showed that buying stocks with low price-to-book-value ratios was the best way to outperform the market. In the late 1980s and early 1990s, almost everyone invested this way.
As we now know, this was a sure recipe for under-performance. Why? Because those academic studies contained biases the authors didn’t allow for. The so-called small cap effect didn’t take into consideration survivorship bias. In other words, the data collected did not include the many small companies that went out of business in the 1930s and to a lesser extent the 1970s. By only counting the returns of the survivors, they overstated the returns anybody investing at the time would have received because they couldn’t have known which businesses would fail. The value bias stemmed from the fact that detailed investment recordkeeping really didn’t begin until about 1927. Interest rates were quite low then, around 2%. Studies done in the mid-1980s (made possible by big advances in computing power), with inflation around 9% after having risen to more than 14%, favored asset heavy companies because the value of their raw materials, equipment, and property had inflated at very high rates. Growth companies did not do nearly as well because with a double-digit cost of funds, they couldn’t fund losses anywhere near as long as companies can today.
The point of this is that we can’t know what the future will bring, or which of the assumptions that we all have with regard to the markets will prove to be dead wrong in hindsight. That said, investing in areas that have been thirty-year winners – like large cap growth (and U.S. stocks in general) – is more dangerous because it is easy to make the assumption these areas will continue have systematic advantages that the future is sure to reward. I have seen consumer staples and pharmaceuticals command premium multiples in the late 1980s and early 1990s, technology in the mid-to-late 1990s, financial services and real estate in the early 2000s, and energy in 2007 and 2008. Every one of these sectors gave up their premiums when costs, competition, regulation, and/or commodity prices changed the game.
So far, a good year for diversification. The U.S. stock market under-performed Europe, Japan, Asia-ex-Japan, Frontier Markets, and especially Latin America in January. Let’s see if that continues. Commodities were the strongest sector, though gold did not participate in the commodity rally. A lot of things are touted as inflation hedges (even bitcoin lately) that are actually fairly miserable in this regard over short and intermediate time periods.
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