One of our major themes in our forecast for the coming year was stocks should perform well. Stocks in the small cap sector should perform especially well, we think they will substantially outperform the major market indexes.
Factors that should contribute to this outperformance include (1) an accommodative monetary and fiscal policy, (2) investors returning to the equity market (see note below on the ‘torrent’ of funds returning to the equities market), (3) reasonable valuations of stocks in the sector, (4) a positive and improving business outlook, (5) price momentum/persistence/relative strength in the equity markets, and (6) merger, acquisition and deal making activity.
Merger & Acquisition Activity
With regard to merger and acquisition activity the latest Forbes Magazine (Feb. 28, 2011) published an interesting article that noted the ‘tsunami’ of buyouts we will see over the next several years:
Investors have spent the past two years trying to preserve capital. Russell Glass says now is the time to start thinking like a buyout baron… Buyout-focused private equity funds have $450 billion in "dry powder," meaning capital that's been committed but remains unspent, according to Prequin, a London private equity research firm. Corporations are sitting on another $800 billion in cash.
Much of it will end up flowing into deals that are based on Glass' type of modeling. "You're going to see a tsunami of buyouts in the next 12 to 36 months," he says…
One of the firms the article mentions as an attractive acquisition candidate is natural gas producer Chesapeake Energy. “It has spent more than $2 billion on natural-gas-producing shale properties. Investors have cooled to gas stocks as rising supplies have driven prices down, but Glass takes the long view. So does his former boss. Last year Icahn doubled his Chesapeake stake to 5%.”
"Here's a company that has spent billions of dollars to acquire undeveloped acreage that is only now starting to produce cash flow," says Glass, who assembled his own position at $20 a share before Chesapeake's recent surge to $30. "Where we like to invest is generally the 6-, 12-, 18-month period before the new plant opens or the well begins to produce."
Chesapeake is too large for the LSGI portfolio so we do not follow the company, but we agree with the thesis of the article that merger and acquisition activity – especially in the natural resource sector – will continue forward at a frenzied pace. Or as Forbes notes, we expect to see “a tsunami of buyouts’. All of which should support higher stock prices – and smaller company stocks should see the most benefit.
Small Company Stocks Should Continue To Significantly Outperform
Small companies have performed very well over the last 12 months. Historical market data indicates that small company stocks substantially outperform when monetary and fiscal policies are accommodative.
During periods of expansive monetary policies small cap stocks generated much higher returns than normal according to a study of market data from 1960 and 1998 by Gerald Jensen, Robert Johnson, and Jeffrey Mercer, authors of “The Role of Monetary Policy in Investment Management”. The study results were statistically significant.
During expansive periods of monetary policy the study found that micro-cap stocks on average returned 31.3% annually. Larger firms during expansive periods returned 19.0% annually on average, 12.3% per year less than small company stocks.
Confirming the trends in their study of historical data, during the expansive monetary period over the last 12 months the S&P 500 index of larger companies returned 22.2%, 9.3% less than the small company stocks measured by the Russell 2000 index.
Don Hays of Hays Analytics has also examined the impact of monetary policy on returns. Hays included a chart by Robert Johnson of the CFA Institute in his commentary that set out performance comparisons over a sixty-three year period (1937 to 2000). The findings were very similar to the study mentioned above – small firms substantially outperform larger ones in periods of expansive monetary policy.
Note that most of the excess returns attributable to smaller stocks occur during expansive periods like we are now experiencing in the economy – during restrictive periods the stocks of small andlarger companies tend to generate similar returns.
Investment Thesis
We think the conditions that have historically been present when small firms outperform – expansive monetary and fiscal policies – will be in place for quite some time. As such, 2011 should be a very good year for small company stocks. We base our opinion on the following:
1. Unemployment remains elevated
With the current unemployment rate at 9.0%, and the broader “U6” measure of unemployment is roughly twice that level, it is unlikely that the Federal Reserve will tighten monetary policy any time soon. The Wall Street Journal noted in commentary last month:
“For all the Fed has done, it hasn't managed to spur job creation. U.S. output may be returning to prerecession levels, but the total number of nonfarm workers still is more than seven million shy of its December 2007 peak, and in fact is back at 1999 levels.
…Some say the Fed ought to double down, that policy makers actually have been too gun-shy. Yet the limits of monetary policy are becoming clearer. History suggests any further easing probably would do too much for the stock market and asset prices, and too little for jobs.”
The chart at right illustrates how far jobs have fallen below economic growth (courtesy Wall Street Journal). Historically the correlation between the two have been much closer.
2. Job gains have been limited to low-paying sectors
While employment gains have been disappointing, those jobs that have been created are the most part in lower-paying sectors – jobs unlikely to fuel a robust expansion. The Globe & Mail described the situation well in an article last month:
Not only has the U.S. economy failed to churn out new jobs, those jobs that have been created since the recession's end have come largely in lower-paying areas. Over the past year, a new report by Capital Economics found, employment in the United States has climbed by just 1.1 million positions, meaning America has regained only a small percentage of the more than 8 million jobs lost in the slump.
What makes the labor market recovery even more disappointing, however, is that those limited job gains have been disproportionally concentrated in relatively low-paying sectors and occupations, chief U.S. economist Paul Ashworth said in the report. The problem is not just the quantity of new jobs being created, but the quality of those jobs as well.’ …More than 14 million people who want to work can't, and just this week the Federal Reserve reiterated its concern over the elevated jobless level.
3. Dependence on temporary jobs increases
The Wall Street Journal noted last month that not only are the job gains limited to lower paying sectors, many are temporary positions:
U.S. companies have commitment issues. Since the labor market hit bottom in December 2009, 27% of the 1.1 million jobs added have been temporary ones—triple the ratio of temps hired after the last recession ended in 2001.
The Financial Times also discussed this trend last month and goes further, claiming that up to one-half of the U.S. jobs created since the economic downturn would be classified as temporary positions.
The Financial Times concludes that the increased reliance on contract, temporary and freelance workers is a reflection of economic and regulatory uncertainties. Temporary workers provide companies with greater staffing flexibility. Unfortunately temporary workers will face more difficulties financing large purchases (like housing) and will most likely be more restrained with regard to spending, which will restrain economic growth.
4. Real estate prices remain depressed
Real estate remains the main source of wealth for the average U.S. household. While residential real estate prices have leveled off, they are still 30% below the peak levels seen in 2006. For those who bought near peak valuations the loss will be substantial (see real estate price chart, courtesy Scott Grannis).
Add to the weak pricing mix the fact that (1) millions of housing units are in default or foreclosure, (2) the sales rate for new and existing housing units is relatively meager, (3) individuals have difficulty financing real estate transactions compared to activity seen during the mid-2000’s, and (4) those with negative equity in their housing will have difficulties re-locating to find a new job. The conclusion an analyst would draw from these facts is that real estate values on the balance sheet of the average U.S. household will remain severely impaired for some time. Until real estate begins to recover, and with it the average household balance sheet, the U.S. economy will exhibit relatively modest levels of growth.
Several additional factors also support our thesis that smaller firms will continue to outperform larger company stocks:
5. Merger, acquisition, and deal making activity is increasing
Numerous large deals were announced in the first month of the year in the oil, natural gas, tar sands, coal, iron ore, and related commodity sectors.
Higher global demand for energy and basic materials, and the upward trend in prices, drove many of these deals. With rising demand additional capital will have to be allocated to the sector in increase supply.
The Globe & Mail published an article last month discussing this activity, and why mergers and deal-making are increasing:
…the global recovery is boosting demand for resources, driving up both commodities prices and production. At the same time, stock markets are surging and shareholders are finally confident enough to look for growth rather than simply protecting valuations, which was a key focus during the financial crisis. That means deal-making is on the rise in many sectors, and for mining companies in particular, combining with other companies may be a faster and more cost-effective way of achieving growth.
The very nature of mining [and energy exploration] means companies can’t suddenly boast higher reserves or pump out more minerals… That puts miners on the prowl for new projects, which in turn bumps up exploration and development costs. There are only so many skilled engineers, service companies and mine mangers. Plus, mining is energy intensive and energy costs are creeping higher by the day…
Because the valuation gap is so appealing, companies… feel the need to act now rather than risk losing out to a rival large-cap miner, or waiting until the smaller firm discovers more minerals and its valuation pops… It is this sense of urgency that creates a sense of panic, convincing chief executive officers to bid aggressively for other firms
Merger and acquisition activity, deal-making, joint ventures, and the bullish outlook for commodity prices will establish a very positive environment for the stock market. Smaller to mid-sized firms will be very attractive to larger firms looking to quickly grow their asset base or revenues.
6. Small stocks exhibit ‘price momentum’
Return persistence or ‘price momentum’ – the tendency for stocks to trend in the same direction – has been the focus of numerous academic studies. The studies show that, on average, shares that have performed well in the recent past continue to do so.
Longer-term studies have confirmed that this “momentum” effect exists across long periods of time and even across asset classes (prices of commodities like crude oil or grains tend to exhibit the price momentum characteristic also).
An article in the Economist discussed the most recent academic study (see chart). If European investors in 2010 purchased the best-performing stocks of the previous year (2009), regardless of the valuation or fundamental outlook for these companies, their returns were more than 12 percentage points higher in 2010 than someone who bought 2009’s worst performers.
Over the last 12 months small stocks as measured by the Russell 2000 small cap index have returned 31.4%. Larger stocks as measured by the S&P 500 index have returned 22.2%. Smaller companies have in general outperformed, so we would expect them to continue to outperform under the ‘price momentum’ theory. Numerous academic studies indicate that excess returns attributable to price momentum is significantly larger for smaller company stocks.
Strategic implications
The historical outperformance of smaller company stocks during periods of monetary and fiscal stimulus has been significant – in fact, the outperformance has been what we would call ‘extreme’. We think history is repeating, and will continue to repeat for the remainder of 2011. Economic conditions are such that we see little change in monetary or fiscal policy. In our opinion, this bodes very well for small company stocks.
