Why Does Hillary Hate Small Caps?

By WallStreetDaily.com

It really is all about competition. It’s survival of the fittest, and the “village” couldn’t care less about you. That’s why most investors shun what’s often considered a “Wild West”-type market outpost.

She’s a $225,000-per-hour creature of Wall Street. And we know Wall Street has no time for small caps.

It’s all part of our new, “improved” bubble-wrap society, where helicopter parents (and helicopter money) insulate children (and investors) against any discomfort, edification be damned. There can be no risk.

And so there can be no real reward, of the “success is peace of mind which is a direct result of self-satisfaction in knowing you did your best to become the best you are capable of becoming” type.

Well, at Wall Street Daily, we’re taking an old-school approach, inspired by folks like John Wooden, to investing in new-school innovation, in the manner of Sir John Templeton.

Sir John was a big advocate of open-mindedness, of seeking new paths as the means to market-beating returns.

The whole point of the 1939 exercise where he borrowed $10,400 to buy 104 stocks trading below $1 was about picking nations, industries, and companies hitting rock-bottom. It’s what he called “points of maximum pessimism” – to dare where others will not.

“Success is peace of mind which is a direct result of self-satisfaction in knowing you did your best to become the best you are capable of becoming.”
–Coach John Wooden

It’s a pretty profound illustration of Sir John’s unfailing optimism and his belief in progress. At the same time, there was no clearer proof that he was also a relentless questioner and contrarian.

This type of approach to investing – to life – demands a lot of those who choose it. As Sir John said, “I want people to realize that you shouldn’t think you know it all.”

We sure heard plenty from the know-it-all set last week.

But let’s get to a very basic threshold question: What are we talking about when we talk about small-cap stocks?

Let’s start with a breakdown of the Russell 2000, the leading small-cap benchmark. And we’ll compare it to the S&P 500, the main gauge of large-cap U.S. equities.

As of June 30, 2016, the top five sectors in the Russell 2000, by market capitalization, were Financial Services, Consumer Discretionary, Technology, Healthcare, and Producer Durables.

The S&P 500 was most heavily weighted to Information Technology, Financials, Healthcare, Consumer Discretionary, and Consumer Staples.

The Russell 2000 has posed three-, five-, and 10-year average returns of 7.1%, 8.4%, and 6.2%, respectively. The S&P 500’s marks are 11.7%, 12.1%, and 7.4%.

The average market cap for the Russell 2000 as of June 30 was $1.722 billion, the median market cap was $679 million, and the largest stock’s market capitalization was $4.245 billion.

Meanwhile, a company has to have a $5.3 billion market cap just to be eligible for the S&P 500, which captures about 80% of available market capitalization. The average market cap for the S&P 500 was $37.794 billion, the median was $18.126 billion, and the largest stock was $523.641 billion.

“I want people to realize that you shouldn’t think you know it all.”
–Sir John Templeton

From a fundamentals perspective, the Russell 2000 is cheaper on a price-to-book basis at 1.95 versus the S&P 500’s 2.77.

The Russell 2000 reports price-to-earnings excluding negative earnings; the reported P/E ratio is 23.64. The S&P 500 as of June 30 was priced at 23.83 times trailing 12-month earnings.

The Russell 2000 includes recognizable names such as Abercrombie & Fitch Co. (ANF), Advanced Micro Devices Inc. (AMD), Angie’s List Inc. (ANGI), Men’s Wearhouse Inc. (MW), and Noodles & Co. (NDLS).

Those are all names with solid businesses that may one day accomplish what Church & Dwight Co. Inc. (CHD), the home of Arm & Hammer baking soda, did: Grow out of the small-cap designation.

Over time, stock prices follow earnings. That’s what happened with Church & Dwight.

One way to limit the risk of investing in small caps is to focus on companies that have cash on their balance sheets and can, therefore, self-fund their growth. Volatility is limited because they don’t need access to capital markets during crises.

So we do like free cash flow and strong balance sheets.

But we also look for something about the business that’s unique… innovative.

Emergent BioSolutions Inc. (EBS), for example, combines positive cash flow generation, a solid balance sheet, and a first-mover role in the increasingly critical biodefense subsector.

The company’s largest product, BioThrax, is the only FDA-licensed vaccine for the prevention of anthrax.

And subscribers to VentureCap Strategist have enjoyed a 158% gain on USA Technologies Inc. (USAT).

USA Tech is still enjoying “sweet spot” status amid the long-term trend toward cashless, electronic payments at a host of self-service or small-ticket “unattended retail” locations, such as vending machines, laundry facilities, car washes, and parking garages.

Upticks, Downticks

The Russell 2000 added 7 points, or 0.5%, last week to finish at 1219.94, 6.2% below its all-time high.

According to the Bureau of Labor Statistics, 12.3 million Americans had payroll jobs in manufacturing in June. That’s down about 30,000 from June 2015, off nearly 1.9 million from June 2006, and down 4.9 million from 1996. In the past 20 years America has shed 28% of its manufacturing jobs.

Over the past 100 years, the Industrial Production Index, prepared by the Federal Reserve Bank of St. Louis to measure the value of the output of the manufacturing, mining, and utilities industries, has risen steadily, even over the last several decades. That’s because manufacturing in the U.S. become a disproportionately high-end activity, concentrated in heavy machinery, tools, and cars.

The Bank of Japan “disappointed” observers by not announcing a “helicopter money” flight plan. But extraordinarily easy monetary policy got even more extraordinarily easy, as the BoJ did increase the size of its ETF purchases and expand the scope of its dollar-lending facility. Wall Street’s dope fiends wanted more, though.

After 18 months in negative territory the Citigroup Economic Surprise Index breached zero on July 8. Economic growth hasn’t accelerated, but the data have been better than expected. And “upside surprise” is good for stocks. The June ISM PMI came in at 53.2 versus a consensus expectation of 51.4, and the June Employment Situation report showed 287,000 net new jobs versus a forecast of 175,000.

MAD magazine cartoonist Jack Davis, who drew many portraits of Alfred E. Neuman, died at 91. (Full disclosure: One of my best friends from law school nicknamed me “A.E.” during our time together at Villanova, for reasons that become obvious if you look at my picture, above.)

Smart Investing,

David Dittman
Editorial Director, Wall Street Daily

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