GuruFocus Premium Membership

Serving Intelligent Investors since 2004. Only 96 cents a day.

Free Trial

Free 7-day Trial
All Articles and Columns »

Chuck Royce's Markets in Perspective - The Gannon Report Another Look at Small-Cap Myths

January 04, 2013 | About:
Holly LaFon

Holly LaFon

255 followers
Principal and Portfolio Manager Francis Gannon provides thoughts regarding the economy, the markets, and small-cap investing. Francis, a former panelist on Louis Rukeyser's Wall Street, has 19 years of investment management experience and joined our team in 2006.A few years ago we wrote about several small-cap myths. As we begin the New Year, we thought it might be helpful to revisit some of the more prominent misconceptions about our chosen asset class and to examine how they have factored into recent performance.

First, many investors still believe that smaller companies are more fragile, especially from a balance sheet perspective, than their larger siblings. Yet in our 40-years of experience, we have never struggled to find conservatively capitalized small-cap businesses. This is important because quality companies with low leverage are likely to have an advantage as it relates to access to credit, especially in credit-starved periods. Financially strong companies are also better positioned to grow over the long term, as they are usually better equipped to navigate short-term squalls.

In our research, we prefer to measure leverage broadly by looking at the ratio of assets to stockholder equity. Using this method allows us to note changes in long- and short-term debt, as well as in accounts receivable. This type of examination paints what we believe to be a more complete picture of a company's financial wherewithal. Interestingly, as of 12/31/12 our research shows that 53% of the small-cap Russell 2000 Index (excluding financials) would pass our basic balance sheet test, while only 33% of the large-cap Russell 1000 Index (excluding financials) would pass.

Historically, prudently capitalized companies have been solid investments. Furey Research Partners conducted a recent study which showed that for the 10-year period ended September 30, 2012, the lowest leveraged companies in the Russell 2000 gained 49.8% while the highest leveraged companies gained only 1.3%. However, for most of the past year the market has been rewarding more highly leveraged businesses. These companies have been taking advantage of today's zero interest rate environment, benefiting from the ability to restructure their debt, lower funding costs, and extend maturities. In fact, our research shows that in the Russell 2000's most recent 43.8% rally from the low of October 3, 2011 to the high of September 14, 2012 real estate investment trusts and commercial banks, two highly levered industries, led the small-cap market.

In addition, near-zero-percent interest rates have given highly leveraged companies the luxury of time, which they normally would lack. This has presented challenges for active managers such as ourselves who prefer to focus on the operational leverage a business might possess. Furey Research Partners recently pointed out that for the 18-month period ended September 30, 2012, the lowest leveraged companies in the Russell 2000 declined 10.5% while the highest leveraged companies gained 0.2%. However, we think that the days of over-levered companies benefiting from record-low interest rates is behind us and that strong, low-debt balance sheets will once again be a positive stock-selection factor for investors.

Another persistent small-cap myth is that dividends are the sole province of larger-cap equities. Again, our experience shows that dividends and small-caps are a frequent match. We also believe that including dividend-paying smaller companies in an equity portfolio offers both a potentially effective cushion against volatility and a strong component of a total return, particularly during lower-return periods. According to our research, as of 12/31/12 approximately 1,193 of 4,105 small-cap companies (those with market caps up to $2.5 billion) pay a dividend; approximately 763 boast a dividend yield of 2% or greater.

We see dividends as a marker of quality that can help to mitigate risk. However, in today's interest rate environment we think that chasing yield—the equivalent of searching for risk-free returns—carries increased valuation risk. Being risk averse in today's market is not necessarily risk averse. Fear has driven a flight to supposedly risk-free "bond proxies" in the equity market, leaving behind inexpensive, quality businesses that generate free cash flow and pay consistent dividends. We continue to believe companies with these qualities can provide solid absolute and relative returns, which many investors seem to be missing in today's pursuit of short-term, seemingly risk-free results.

We see abundant company quality in the small company world in the form of strong balance sheets, dividends, high returns on invested capital, and the ability to generate free cash flow. Finding companies with these qualities is critical in our efforts to mitigate risk and achieve above average long-term returns. As long-term investors, we believe that companies with sound fundamentals should deliver superior returns over the long term, particularly when purchased at attractive prices.

For some time, we have also been suggesting that higher-quality companies, regardless of market cap, would lead in the market recovery, especially when the economy moves from recovery to expansion. Yet low-quality companies mostly outperformed in 2012, benefiting from the Fed's open-ended policies which are distorting asset prices and valuations. Furey Research Partners points out that "since the third quarter of 2011, the bottom quintile of the Russell 2000 ranked by return on invested capital (ROIC) [one of our core measures of business quality] has outperformed the top quintile by more than 10% through September 2012."

Not surprisingly, at the end of November 2012 the highest quality small-cap companies within the Russell 2000, as measured by ROIC, traded at a 15% discount to the highest quality large-cap companies, and the lowest ROIC stocks account for virtually all the small-cap premium relative to large-caps. This too has presented challenges for active managers like us who consistently focus on higher-quality companies trading at attractive valuations.

The small-cap asset class is often poorly understood. Our goal as active managers is to take advantage of these misconceptions and dislocations to uncover high quality smaller companies trading at significant discounts. It is a process we repeat every day.

Stay tuned…

FDG



Important Disclosure Information

Francis Gannon is a Portfolio Manager of Royce & Associates LLC. Mr. Gannon's thoughts in this essay concerning the stock market are solely his own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above, will continue in the future. The historical performance data and trends outlined are presented for illustrative purposes only and are not necessarily indicative of future market movements. Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group.The Russell 2000 is an index of domestic small-cap stocks that measures the performance of the 2,000 smallest publicly traded U.S. companies in the Russell 3000 Index.The Russell 1000 is an index of domestic large-cap stocks that measures the performance of the 1,000 largest publicly traded U.S. companies in the Russell 3000 Index.


Rating: 4.0/5 (3 votes)

Comments

Please leave your comment:


Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)
Free 7-day Trial
FEEDBACK