History shows, and investment strategists tout, that small cap stocks are the best performing asset class. While small caps outperformed the runner-up, large cap stocks, over the last nearly 100 years, research has shown that the outperformance hasn’t persisted over all multi-year time periods and that the outperformance is concentrated in microcap stocks.
We have always been go-anywhere, all-cap, investors. In the early 2000s, when we were finding little value in large caps and a plethora of value in small caps, we became concentrated in that area. And while our declared preference is to be all-cap investors, availing ourselves of a greater opportunity set—knowing that smaller companies can get absurdly undervalued which rarely occurs with larger companies—our preference is to emphasize large caps. Because we do believe potential returns from large caps can match that of small caps. Larger, more well-known companies trade more efficiently; and therefore, tend to revert more quickly to fair value. Also, in order to use our macro overlays—which are designed to alert us to a recession or bear market—we wish to have the opportunity to exit positions, rather than being liquidity constrained (as one might be in small caps), in order to limit the impact of market drawdowns.
Value vs. Undervalued
We don't buy value stocks per se. We buy undervalued stocks. There’s a difference. Value stocks are generally understood to be those that trade at low multiples of earnings or book value. And many investors practice their trade by purchasing what they believe to be cheap stocks by finding those that are trading at relatively lower multiples than the market or industry peers. We prefer a stricter approach, analyzing companies and arriving at appraisals of fair value such that we have an absolute (as opposed to relative) view of the company’s price with respect to our fair value estimate. We believe this approach offers a better margin of safety and provides us with the ability to have appropriate targets—fair market values (FMVs) where we look to exit positions. Most stocks trade between undervaluation and fair value. Once fair value is achieved, the best one can hope for is to track a company’s growth rate but the stock becomes more susceptible to a downturn from any overall change in the expected growth rate or other factors impacting its value.
Growth vs. Value
Observers also like to distinguish between growth and value stocks. Generally, growth stocks are those that trade at high multiples and whose earnings are expected to grow at a fast clip, whereas the opposite view is held for value stocks. Again, here, we have a different opinion. Most of the time, a company must be growing, and at a decent pace, to justify it being good value—though a company can have flat or declining earnings and still be undervalued, if its price is too far below the expected future free cash flows of the business. However, normally it’s a value trap—a company that appears undervalued but whose fundamentals are deteriorating, in turn eroding fair market value along with its share price. We seek to own companies whose FMVs are growing up and to the right—companies whose earnings are ever-advancing but for various reasons, usually a recent setback, the share price has declined or remained flat while our view of underlying FMV remains higher.
While this may sound academic (i.e., too technical), it’s an important distinction. It has led us to focus on the type of securities we prefer to own. Research over many years has shown that owning value stocks over growth stocks leads to market-beating results. We have always embraced that research. However, we try to focus on companies that aren’t just undervalued but also have steady earnings growth rates, generally higher quality businesses that are strong operationally and financially, in an effort to also mitigate losses.
Fully Invested vs. Hedge?
It’s generally believed that one should be fully invested at all times. The reasoning is simple. If stocks are the highest returning asset class and if market downturns are difficult to predict— there’s always some prognosticator calling for doom and gloom—then one should ignore the noise and remain “in it to win it.” Here too we differ. In spirit we agree—one should be fully invested most of the time—because over two-thirds of the time we are in a bull market. If, on the other hand, one could forecast the timing of the other third—the bear market—one could avoid the drawdowns. Something business schools teach can’t be done—to have our cake and eat it too.
We don’t like drawdowns and our clients detest them. And, simply put, when FMVs are falling, so are share prices. When are most company values declining? In a recession. So we developed an Economic Composite (TEC™) to alert us to recessions both in the U.S. and abroad. Similarly, we developed a market momentum indicator (TRIM™) to alert us to bear markets—those that decline by more than 20%. And, in periods when our alerts aren’t triggering, like today, we should have even more confidence to be fully invested. Though, one key caveat now, we still need to be able to find enough investment opportunities that meet our criteria—currently not an easy task. In our large cap only portfolios we have held an outsized cash position which has restrained our returns. Not because we have been bearish, but for lack of our ability to find enough attractive opportunities, not for lack of looking.