Small Cap Stocks
Coming to Life
Small Cap Stocks
Coming to Life
by Alexander Paris
The Alexander Paris Report
While
the DJIA, S&P 500 and Nasdaq all appeared to mystically rise to successive
new highs in the face of the global economic news throughout the last couple
of years, the problems did leave an unmistakable mark on the structure
of the market. As should be widely known by now, those averages were
led by an extremely narrow list of very large stocks, while the majority
of stocks have been languishing. In fact, the performance gap between the
narrow list and the rest of the market, is the biggest and most sustained
in history. The gap between growth and cyclical stocks has also been extremely
broad.
Since
late March, however, these persistent trends appear to be reversing. The
former leaders, large technology, consumer nondurable and Internet stocks,
have come under some pressure. The money leaving them, moreover, has been
going into smaller stocks, as well as into economically sensitive industrial
issues. This trend is still in progress at this writing. The question is
whether it will be sustained.
Before
the recent surge, the stock market had been so badly mistreating industrial
stocks of all sizes over the past year or so, that one would have surmised
that either the economy was on the brink of collapse or that U.S. manufacturing
companies had suddenly lost all their competitiveness in the world marketplace
because of overseas devaluations and rising global competition. Neither
is true. Nevertheless, the valuations being placed on industrial companies,
even those that have had a strong track record and primarily a domestic
orientation, are lower than when magazine covers over a decade ago were
regularly depicting lead stories on U.S. manufacturing, like The Great
Rust Bowl, Is Manufacturing Dead? The U.S. industrial sector, as we've
discussed frequently, has been taking the major brunt of the negative impact
of the overseas crises and global deflation in commodity prices. But the
negative impact is by no means universal.
Clearly,
U.S. companies producing basic commodities have indeed been hurt. The metal
stocks is only one example of many similarly performing industries. But
they have been rallying lately, probably discounting a bottoming in commodity
prices, as the world crisis fades. The move in these stocks may have been
a little too strong, given what we believe will be a fairly slow upturn
in material prices when they occur.
But
the manufacturers who use the industrial commodities in their production
process have been blessed with lower material costs that have helped to
offset any rising wage costs. To be sure, most of them have suffered from
lower exports to depressed world economies, which has offset some of the
material cost advantage. But what about the manufacturers who are more domestic
oriented? It has been a pure plus for them, but for the most part, the market
has also ignored them. The diversified manufacturing company index has done
better, but still rose only 4.76% over the past year. Many such companies
have continued to show fairly strong and consistent earnings growth over
the past few years, with their only significant problem being their P/E's.
A few that come to mind from our list are Regal-Beloit, Milacron and
Kaydon.
Lean and Mean U.S. Manufacturers
The
most important factor that is being ignored, particularly among discrete
manufacturers, is the outstanding success of what we've referred to in the
past as The New Industrial Revolution. Perhaps investors earlier
this year were focusing on the big layoffs announced by many manufacturers
and the steady decline of manufacturing jobs over the past year. While some
of this is due to the pressures of weak overseas economies, it is essentially
what the entire revolution has been all about, the substitution of technology
and new efficient manufacturing philosophies for labor. Of course, investors
don't pay the same attention to the many jobs being created at smaller technology
firms that are supplying the new manufacturing software, automation equipment,
machine vision inspection systems and related equipment that manufacturers
are buying to become more efficient producers. A recent issue of Investors
Business Daily had some very interesting data in this respect. Actually,
manufacturing employment levels have been about flat during the entire decade
of the 1990's. The 18.7 million factory jobs in 1998 were not very different
from the 19 million in 1990, reducing its share of the American workforce
from 17.1% to 15.1%. But manufacturing in the 1990's still represented the
same 20% of the GDP that it did back in 1998.
The
difference, of course, is higher productivity. While the manufacturing sector
may be the same proportionate size, it is far leaner today. Productivity
in the manufacturing sector has grown at a 3.7% annual rate since 1998 and
at a 4.4% rate for the past three years, according to the National Association
of Manufacturers. While the market doesn't seem to care, this means that
manufacturers in the U.S. are becoming more profitable and efficient. The
announcements of layoffs and restructuring does not mean that the manufacturing
sector is going downhill, only that it is taking still another step toward
increased efficiency.
Despite
the weak overseas economies, along with the more aggressive competition
from lower priced imports, manufacturing production has continued to grow
at close to a 2.5% annual rate. Except for the directly impacted commodity
companies, profits and margins of manufacturers have generally continued
to increase. This demonstrates the enhanced ability of U.S. manufacturers
to survive and prosper under very difficult conditions. With a modest recovery
underway in Asia, relatively controlled economic downturns in Latin America
and Europe and easier monetary policy around the world, pressures on the
U.S. manufacturing sector should gradually improve.
Small-Cap Stocks Coming to Life
The
other major new trend in place since late March has been renewed investor
interest in small capitalization stocks. We believe the new trends, like
the increasing attention toward industrial stocks generally, is also related
to an overall change in sentiment among investors, not just regarding which
sector they will invest in, but an overall change toward the economy. As
such, it is likely to be more long lasting than simply a short-term sector
switch. The relative values have favored them for a long time, but it required
more investor confidence to trigger the change. We hesitated to term the
trend as a swing to small-cap stocks, because that may conjure up an image
of tiny companies. Instead, the performance disparity had been between a
short list of super-large companies and the rest of the universe. The small-cap
sector has generally been described as those stocks with market capitalization
under $1 billion and they represent 85% of all publicly traded
stocks. That is a very large proportion of the market that has not been
performing and a huge field of opportunity.
Record Underperformance by Small Caps
Small
caps have also not performed well on a relative basis since 1993, and with
a very sharp acceleration in the performance gap against large-cap stocks,
it has reached record proportions. Salomon Smith Barney estimates that small
company stocks trailed big company stocks over the last five years by the
greatest margin than at any time since 1969-1973. In 1998, stocks with market
caps greater than $20 billion were up 26%, while stocks with market caps
below $250 million declined 24%. Similarly, DLJ tells us that since its
peak performance in 1994, versus the S&P 500, the Russell 2000 has lagged
the S&P 500 by nearly 50%. Demonstrating the extreme narrowness of the
market after the last five years, the total value of the Russell 2000 in
late March 1999 was around $1 trillion, while the top three stocks in the
S&P 500, Microsoft, GE and Wal-Mart, have about equal value.
The
small-cap underperformance and extreme narrow breadth in the market was
especially pronounced and painful in 1998 and in the first quarter of 1999.
Led by very large-cap technology stocks, the Nasdaq index rose around 270%
during the previous six years, compared to only a 77% gain for the Russell
2000, and was up 12.3% in the first quarter of 1999. But, according to The
Wall Street Journal, two-thirds of the Nasdaq stocks declined in the
first quarter and 40% declined in 1998.
All a Matter of Size
We
see the laments of small-cap managers of growth funds, as well as those
of value funds, as if each were bearing the full brunt of the adverse market
structure. The truth is that the investment style doesn't make much difference.
The market structure of the past year or so was primarily one of size, large-cap
favored over small cap. Take the Russell 2000, or probably any other market
average, break the list into deciles and rank them on size, and the smaller
the average size of each decile, the worse will have been its performance.
The favored large-stock list, in turn, was comprised of either those stable-earnings
consumer staple stocks that afforded protection against the concerns of
the world economy, or those, primarily technology, that promised strong
momentum. There was very little interest in anything in between.
Value Funds
Value
fund managers generally want to purchase beat-down stocks that are selling
below their intrinsic value and have compiled very good long-term records
doing just that. But investors have had no interest in such funds for a
long time, whether they invested large or small value stocks. They wanted
stocks that were big in size and momentum. According to the Investors
Business Daily, the Oakmark fund, a formerly top-performing value fund,
saw its assets fall from $9 billion to $6 billion. The story has been the
same for most other value funds, primarily because the stocks they generally
invested in were generally either declining or languishing in spite of their
earnings performance.
According
to Morningstar, for the 12 months ending March 1999, large-cap growth
funds were up 28%, large-cap value funds were up only 3%, and small-cap
value funds fell 24%. As investors withheld or withdrew their money from
value funds, they helped make their expectations self-fulfilling by reducing
buying demand from the value mutual funds for those kinds of stocks. Looking
at the purchases of large-cap mutual funds in the 12 months ending December
1998, for example, growth funds got 59% of the money, compared to 23% in
1997, while value funds got 41%, compared to 77%.
As
with small-cap stocks, we are also seeing an increasing number of lead articles
asking the question, Is Value Dead? Value managers correctly, though
desolately, respond that prices and value always come together at some point.
They also point out that this year's investment concept of buying overvalued
stocks in the hope that they will get more overvalued, especially in the
Internet and technology area, simply cannot work over the long-term. In
other past periods, the concept was termed the greater fool theory, referring
to the notion that there would always be another greater fool to take the
stock off your hands at a higher price. Once the fascination with the "Nifty
20" or "30" fades, they again correctly surmise, the money
will pour back into value, whether they are in large or small stocks.
Small-Cap Emerging Growth
As
Salomon Smith Barney pointed out in a report in March 1999, small-cap stocks
have been in one of the longest losing streaks on record. We suspect that
most people presume that it has been the dull value-type stocks that have
been the sole victims of the extreme lack of breadth in the market. But,
as Salomon pointed out, smaller emerging growth stocks have also severely
underperformed the S&P 500 and DJIA as well. By mid-March of this year,
the emerging growth stocks had underperformed the S&P 500 at one point
for 8 consecutive weeks. They only did that on three other occasions in
the last twenty years. Once was in late 1996 and a second time in early
1997, both within the current extended period of underperformance that has
been in progress for over three years. It has carried the relative valuations
of emerging growth stocks to a 40-year low. It only stops there because
records have only been kept since 1960. The record may very well extend
back even more years.
Salomon
also cited the T. Rowe Price New Horizons fund, which has been used as a
proxy for emerging growth by many strategists for years. Its relative valuation
against the S&P 500 hit a record low 0.79 in March. That ratio has only
been below 1.00 on two previous occasions. The first time was in the first
quarter of 1977 (0.94), which was followed by a six-year period during which
it outperformed the S&P 500. The second time was in the fall of 1990,
when it hit 0.96. From that low, it had a 197% return over the next six
years, compared to 87% for the S&P 500.
Outlook for a Continued Broadening Market
The
improved performance in cyclicals and small stocks has been quite obvious
over the past month, but the debate is whether it will be sustained. Although
some of the reasons for the improvement in both cyclicals and small-cap
stocks are similar, the answers as to their future performance are different.
Cyclical Stocks
The
move in cyclicals actually started primarily among the commodity companies,
such as Alcoa, and other very large industrial companies. It also appears
to us that the recent move represents more of a bet on future economic growth
and a switching of funds from cooling previous large-cap market leaders,
rather than a sudden realization of relative values. It is still too early
to document a good recovery in Japan and some analysts believe growth can
remain negative. Japan still has a lot of restructuring to do, and, despite
a capacity utilization of only around 68%, capital spending is still substantially
higher than that in the U.S., for example. If the country does all the right
things in terms of biting the bullet and building for a stronger economy
ahead, the near-term effects of the policies will be negative.
So
the outlook for the industrial economies, and very large cyclical companies
in general, that require strong economy growth to thrive, is probably not
as bright as the market is currently painting it. World economic growth
will be better in 2000, but not that great. The positive impact of the recent
stronger performance cyclicals, in our opinion, is that it focused investor
attention on the fact that there is investment life outside the narrow list
of stocks that has been dominating the market.
The
best values in the cyclical sector have been in the small and mid-cap stocks.
As mentioned, most have much less international exposure; they are small
and flexible enough that they can show good profits even with modest economic
growth. At this point, we see the U.S. economy only slowing down to a more
sustainable rate, and given recovery in many overseas economies, modestly
better worldwide growth in 2000 compared to 1999. The low valuations on
small and mid-cap manufacturing companies are discounting something worse
than that. Consequently, a move in direction of more normal valuations in
itself can render some very good relative performance over the next year
or so in the general manufacturing sector. Most of the manufacturing companies
we cover have already been seeing improving orders and backlogs toward the
end of the first quarter and into the second.
Small-Cap Stocks
As
far as a sustained period of improved relative performance for smaller stocks
in general, we believe that the time has finally come. Some analysts have
written that there are some permanent structural changes that will bar small-cap
stocks from rebounding, but we doubt it. Wall Street lore is replete with
widespread vocal comments that things are different this time, in
defense of their beliefs that one trend or another would presumably continue
forever no matter how extended they might have become. Invariably, they
were quickly disappointed as the markets moved to correct the excesses.
We believe that markets eventually recognize values and those are among
secondary stocks today. Again, it's not just a question of large versus
small companies. As we've written a number of times in recent months, the
bull market simply cannot continue without broadening. That is what it has
started to do and it is a major positive. The value in the secondary stocks
has been there for some time, but it is the dissipation of many of the investor
fears of global problems that has helped to finally trigger the change.
Less concern about liquidity and a lengthening of the investment horizon
are positive factors behind the broadening, but it also didn't hurt to see
a few cracks among the former leaders like Coca Cola, Gillette and some
of the Internet stocks.
As
to how long the new trend can last, Salomon Smith Barney recently reminded
us that in the five years following each of their worst performing periods
on record, small-cap stocks beat large-cap stocks by no less than 25 percentage
points per year. We don't know if we'll see that kind of performance but,
as discussed earlier, this has been clearly the worst ever period of relative
performance for small-cap stocks over the past few years.
Editor's Note: With over three decades of experience, Alexander Paris
is one of the best known and well respected economists and investment strategists
in the business. Throughout his career, he has expounded the virtues of
his unique free-market credit-cycle approach to economic analysis which
has enabled him to predict all of the major turns in the economy over the
past few decades. Mr. Paris has authored The Coming Credit Collapse,
which accurately forecast the past credit problems in the banking, consumer
and corporate sectors, and A Complete Guide to Trading Profits, which
explains technical analysis in the stock market.
With his economic philosophy as
a centerpiece, Mr. Paris founded Barrington Research Associates, a brokerage
firm which provides economic and investment research to institutional investors,
including most of the leading mutual funds, banks, pension funds, insurance
companies and other professional investors.
The Alexander Paris Report
is the only way for individual investors
to gain access to the insights and recommendations that institutional investors
have relied upon for years. Every month, The Alexander Paris Report provides
a no nonsense analysis of economic and political events and trends and their
implications on domestic and world economies. In addition, Mr. Paris spotlights
several stocks which he expects to outperform the market. The Alexander
Paris Report is published monthly, 1 year, $195, by HMR Publishing Co.,
161 North Clark St., Ste. 2950, Chicago, IL 60601, (312) 634-6370, Fax (312)
634-6350, toll free 1-800-416-7479.
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