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 January 2012 Lessons from Portfolio 2 Small Caps Outperform, but Not Why You Think
While such rags-to-riches stories make a good, well, story, few will ever experience it. Few stocks shoot through the ranks from small unknowns to super mega-caps. The handful that does may take years to do so. Most importantly, small cap success typically doesn't come from shares rapidly rising through capitalizations to arrive at the top of the heap. To be sure, money -- and a lot of it -- can be made trading small cap stocks, not this way.
Our small cap model, Portfolio 2, is a good example. As you'll notice from its historical return graph, P2 has cumulatively returned over 50% more than its benchmark, the Russell 2000. The way it's done this along with several of the lessons learned in the process tell a lot about small cap investing.
Results First As you can see from the performance chart, P2 didn't get off to a momentous start. As a small cap value portfolio, the late 1990s weren't the best environment. Large cap Techs and Financials led the way, and growth stocks dominated value. Although P2 was a value model, it wasn't uncommon to see turnover above 100% in the first 5-6 years. Which brings up the first source of return for long-term small cap investors:
Returns are Inversely Proportional to Turnover Unfortunately, that was precisely the problem with P2 in the early years of its existence. Seeing other stocks (mostly growth) zooming up, we were tempted to only give our small cap value picks 9-12 months before looking elsewhere. Many of the shares that were dumped early in the process went on to become mid caps and eventually a few even moved on to become large caps (e.g. Expeditors International). When the rest of the market was jumping virtually everyday, it was hard to be patient even with a portfolio of quality value stocks. To be fair, many short-term traders made a lot of money trading in and out of small cap "headline" stocks. Those tended to be the ones that made a big splash when they first went public and had a new product or strategy. Many proved to be just as fleeting as their publicity but traders who were savvy enough to buy at the start of the run-up made out quite well by selling at or at least near the top. Unfortunately that's not the way P2 is supposed to work. Instead, P2 seeks long-term performance through a portfolio of small cap value stocks. The goal was to buy them when they were down (or as discussed above, "mispriced" by the market). They would then be held for gain when the rest of the market came to the same conclusion. Unfortunately, in the late 1990s, 9-12 months seemed like a "long term" commitment, one that just couldn't be a lucrative as a short term trading strategy. Contrary to popular belief, P2's performance picked up significantly when we went from actively trading the portfolio to what amounts to a modified buy-and-hold approach. Rather than seeking under-priced stocks we took to be ready to "pop", we instead focused on under-priced stocks with a good market position, strong fundamentals, and competent management. (These qualities ended up being more important that we initially realized as we'll shortly see.) Stocks like this -- underpriced without an immediate catalyst for growth -- could stay that way a long time before finally moving back towards fair value, but at least they wouldn't whipsaw the portfolio in the volatile market. There were several surprises to this strategy. Although it looks quite conservative, it actually yielded better results than active trading. It seems the old brokerage saw is true, "A portfolio is like a bar of soap. The more you handle it, the smaller it gets." Notice in Chart 1 how turnover spiked during the market downturn a the beginning of the last decade. It started to decline in 2004 and rapidly declined. Although it jumped back up in 2007, there was actually a non-trading reason for that as you'll see in a moment. The important thing to note is as soon as the turnover declined, performance (as illustrated on the cumulative return chart) went up. So much for the need for rapid-fire trading, even with a small cap portfolio.
Big Isn't the Goal You see, by the time they proved the value of their products, markets, and management, they were already on the radar for acquisition by larger companies. That's precisely what happened in 2007 when four of P2s ten holdings were either taken private or acquired. Other trimming was needed that year as remaining shares pushed above the upper limit of small capitalization.
As you're probably well aware, it's not uncommon for acquisition targets to jump double digits in just one day when the transaction is announced. That's a lot faster than waiting for the stock to move through the various capitalizations. It certainly helped P2's returns as well. So the secret for the small cap investor really isn't to seek little stocks that can grow big, but rather those that have an appeal to larger acquirers. Which brings up the next lesson from P2:
Uniqueness is Not the Ticket Microsoft was in the right place at the right time, but opportunities like that are few and far between. The fact that a company develops a unique process or even a better one is no guarantee of success. Apple fans have always contended its operating systems were far superior to windows Windows, yet the installed base is, and will always remain, less than Microsoft's. A unique process itself isn't sufficient to assure small companies and their stocks will grow. Interestingly enough, what we found with small cap Portfolio 2 is competence is often more likely to be rewarded than superiority. Once you realize the majority of the portfolio's gains will come through acquisition, you need to focus on what companies seek to acquire. While a new technology might seem like a great thing to pursue, it's also generally unproven and, as Apple arguably illustrates, superiority is no guarantee of success. On the other hand, small companies providing complementary services can be a good addition to acquirers with limited outlets for internal growth. The better run, the better the target regardless of how mundane the overall business. Consider Chart 2 which lists the stocks that have in one way or another been acquired from P2. Each of these transactions was profitable to the portfolio, yet none of the acquisitions were particularly sexy businesses. Competence was rewarded, nothing more. Did you expect to find that with small caps? We didn't initially, but once we caught on, you can see what happened to performance.
High Numbers Hurt
According to Modern Portfolio Theory, stocks have two primary sources of risk: Market risk and diversifiable risk. Market risk can be thought of as coming with the territory. The stock market is inherently risky and that's why investors are rewarded with higher (at least long term) returns than those garnered from less volatile "safer" investments like bonds, money markets, and CDs. Just by owning stocks you're subject to Market risk; it's something you simply can't escape if you're an equity investor. On the other hand, diversifiable risk can be reduced by, as it's name implies, diversification. Think of it this way, if you own only stock of one company, you're subject to a lot more risk than that of the market. The value of your shares will be dependent upon the fortune of the company's industry, its management and any number of things that are unique to that company. If you combine that holding with shares of companies in other industries, with different products and services, and (hopefully) skilled management, you can "diversify away" a lot of that risk of just one stock in one company. You can, in essence reduce risk by building a portfolio of risky assets. That's the benefit of diversification. This, of course, brings up the question, "How much diversification is enough?" Obviously if you owned shares in all the listed companies in the U.S., your risk would only be that of the market. At some point, however, well before reaching that number, enough shares in enough different industries and companies should deliver roughly the same benefit. The question is, at what number does that occur? Some contend its as many as 35 - 40 stocks, others say as little as 10 - 15. All else being equal, one might think a small cap portfolio might require a larger number of stocks to diversify away the greater volatility of each individual holding. But like just about everything else in investing, there are some trade-offs involved. In this case, the source of return is a critical factor. Since we're apparently seeking to hold well-managed and equally well-positioned companies in hopes of an acquisition, fewer is better. It's not hard to see why. Consider two portfolios, one 100% invested in a stock that soars with an acquisition offer and the other with that stock, but nine others as well. In the first, 100% of the initial investment will be rewarded while only 10% is rewarded in the other. In that case, the nine additional stocks may supply additional diversification, but they weigh on return as well.
From inception, P2 has always held ten stocks. No more, no less, just ten. Clearly, that hasn't hurt performance and in fact, may have helped particularly in those years with multiple acquisitions. What about risk? Do ten stocks supply enough diversification? Well consider the fact that P2's beta, a measure of portfolio risk, has always been about 0.90 when measured against the S&P 500's 1.00. That's pretty amazing when you realize the 500 is a large cap index with 500 stocks. When compared against the Russell 2000, P2 has a beta of 0.75, so no, the restriction to ten stocks doesn't seem to have left it with too much diversifiable risk. One other thing to consider, those ten stocks were always chosen for their appreciation potential, not for their diversification potential. So although the next Microsoft will probably to prove elusive, it's still possible to enjoy some market-topping results without risking the farm or day trading. If P2 is any indication, small cap investing may have gotten a bad rap simply because smaller individual stocks tend to be riskier than their larger counterparts. If you put some thought into building the portfolio and avoid over-concentration in any given sector or industry, and you're patient -- make that very patient -- it's possible to attain excellent risk-adjusted returns. This has to be true or else we were either lucky or quite astute in the management of P2. We've never been accused of being either. Search this site! Just enter you key word or words: Get current quotes or follow your own custom portfolio,
courtesy of E-Line Financials:
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