I just read an article about small stocks and how historically, they have done pretty well. The author of the article believes that small stocks have seen their day and will begin to fall. He cites the average P/E ratio as a cause of this slide. He seems a bit pessimistic, but with the recent predictions of increased inflation and the problem with global liquidity, he might have a point.
The article is posted as the first comment in this thread. It comes from The Daily Reckoning.
1 comment:
The Daily Reckoning PRESENTS: Everybody loves small stocks. Investors feel that's where the money is - and that you can't lose with small stocks... which is exactly why the timing is perfect to bet against them. Steve Sjuggerud explores...
SMALL STOCKS, BIG TROUBLE
by Steve Sjuggerud
You can make an enormous amount of money in small stocks. Gerry Tsai can tell you...
You may not know his name. But nvestors in Gerry's fund made an absolutely ridiculous amount of money in small
stocks - so much that people were actually willing to pay up to half of their first year's investment, just to get a piece of Gerry's fund.
What was Gerry doing with people's money to make it multiply so quickly?
Gerry was known as a "gun-slinger." He was the poster-child of an era of gun-slinging portfolio managers - managers who favored new issues, small fast-growing stocks, and "concept" stocks. Some of his big-name gun-slinging contemporaries performed even better... Fred Carr's Enterprise Fund rose 118% in one year as he jockeyed in and out of various stocks. And Fred Mates' fund was up 158% a
year later.
These maverick young guns all did one thing... they avoided the big old blue chips... or the old "buggywhip companies," as they joked. They wanted smaller, newer,higher-risk stocks. Why? Because they were convinced that:
Small companies always beat the old companies.
Gerry was the king of the 1960s. "Gerry Tsai is buying it!" That's all it took. Whatever Gerry did, the rest of the
crowd wanted to do. For example, when Gerry Tsai bought 120,000 shares of National Student Marketing (NSMC) for
five million dollars, he put the company on the investment map. And NSMC wasn't the only stock. It happened over and over again.
At the end of 1965, after making 50% for his investors that year in the Fidelity fund he ran, Gerry Tsai left Fidelity to start his own fund... the Manhattan Fund. Investors clamored to get in - he raised a quarter of a billion dollars from investors... an astonishing amount back then.
In 1967, the Cult of Tsai and the other "go-go" managers rolled on... he earned investors a return of 40% that year.
Everyone knew it. Small stocks simply had more upside potential than the big old dogs. Always have, always will.
(Or will they?) "We are at least in a different - if not a new - era of
traditional thinking, the standard approach to the market is no longer in sync with the real world... we have never really been here before, and therefore cannot be certain of what happens next."
- Forbes Magazine, October 15, 1968
With the benefit of hindsight, we know what happened next... there was no new era. And small stocks got obliterated.
Shares of National Student Marketing are a perfect example. With Gerry Tsai's stamp of approval, National Student Marketing had become THE stock to own. The stock had soared to $120 in February 1970. An international conference of institutional investors was held at the Hilton in New York in February of that year. The two thousand delegates were polled, and their favorite stock was National Student
Marketing.
Then the bottom fell out. From a price of $120 a share, NSMC dropped 95% by July that year - in just five months!
The game was over. Investors who bought Tsai's Manhattan Fund on its opening in 1966 lost over half their money by
February 1973, not counting dividends, according to Time magazine (February 12, 1973). And then the terrible bear
market came...
Losses in small stocks piled up. Small stocks lost 35% of their value in 1973. And then again, in 1974, they lost
over 25% of their value once again.
The great bull market in stocks peaked in 1968. Yet the real obliteration came five years later... Stocks in general lost half of their value between 1973 and 1974, and small stocks took it on the head even worse.
Fast forward to today. The great bull market in stocks peaked in 2000. Is the real obliteration going to begin today - five years later?
It sure looks like it.
While the NASDAQ has taken it on the chin since 2000, small stocks have hung in there remarkably well.
The time has come for small stocks to pay the piper. Why do I think this?
It all comes down to my three criteria... to enter into a new investment; ideally, I'd like to see all three of these things: Extraordinary value, an opportunity that is hated, and the clear beginning of an uptrend.
In the case of small stocks, we have exactly the opposite of all of these. Really, the timing is perfect. It's time to bet against small stocks. Let's take a look:
First of all, small stocks are expensive.
One simple measure of a stock's value is its price in relation to the company's sales. And by this simple
measure, small stocks (as measured by the Russell 2000 Index) are as expensive today as they were at the peak of the stock market bubble in 2000! With the exception of a
brief moment in the late 1990s, small stocks are as expensive as they've ever been, going back to the start date of the Russell index back in the 1970s.
Looking at other measures of value, like P/E ratios, small stocks are also expensive. The P/E ratio of the Russell
2000 Index of small stocks is currently over 20 - high by any standard (except tech stocks during the Bubble of
2000). For reference, the P/E of the Russell 2000 Index of small stocks back in 1982, at the beginning of the great
bull market in stocks, was 8. Based on current valuations, a fall of 25% to 50% is not hard to imagine.
Second, small stocks are loved. It's easy to see why...
Investors always love to buy what has already done well. I don't get it. But it's what people do. "How's the five-year performance?" investors ask. And the five-year performance of small-cap "value" stocks has been just great.
So now, after five years of stunning out performance, it's Gerry Tsai time, all over again.
Everyone is saying, "Small stocks are where the money is... you just can't go wrong in small stocks." Uh-oh. Here comes trouble...
Small stocks are like real estate on my island here in Florida, where everyone's saying "You just can't go wrong in real estate on this island." I'm closing on the sale of a house today here. The trend is still up in home prices locally, so I may be getting out early on that property.
Now the home we live in is all the Florida real estate we've got, and I'm fine with that.
While the trend is still up on Florida coastal real estate, it is now down when it comes to small stocks... which is part three of our three criteria...
The trend is just now breaking down... this week, the Russell 2000 Index closed at its lowest level in 2005. I'd
have to call that a downtrend... and it's just getting underway.
So we've got everything we're looking for in a sell... small stocks as a group are overpriced, they're too loved
(everyone thinks they're where the real profits are), and the trend has now turned down. Perfect! To sell...
Regards,
Steve Sjuggerud
for The Daily Reckoning
Editor's note: Dr. Steve Sjuggerud has worked in the
investment world as a stockbroker, the vice president of a
$50 million global mutual fund, an international hedge fund
manager, and the director of several research departments.
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