Sunday, November 22, 2015

Selecting by Market Cap Can be a Trap


Selection and diversification policies should be based on meaningful investment filters. To win and maintain accounts most institutional investors need to surmount brief discussions with consultants, “gatekeepers,” investment committees and similar part-time investors.  To make those that hold the keys to the managers’ revenues satisfied and retained, is to make comparisons easily understood. Only a weak client relationship will focus primarily on performance. This way of thinking was driven home to me last week.

Market Capitalization Traps

During the week I met with two investment committees, entrepreneurs and their advisers, and two publicly traded fund management companies in New Jersey, Monaco, and Toronto. In each case present and future investment performance was at the heart of the discussion. The comparisons used most often pivoted around easily definable groups, such as market capitalization. For instance Small Caps, S&P500 (which is essentially Large Caps,) or MSCI World Ex-US (again Large Caps).

Questions from the Audience

In Monaco I was asked how much should a portfolio hold in Small Caps. At that very moment my dilemma became clear. In the audience there were CEOs and their advisors/investment bankers from about twenty hopeful companies. Clearly it would have been foolish to perpetuate the dream that all similar market cap stocks or funds  could become holdings in a prudent portfolio. In answer to a question I did suggest for that particular audience that in my construction of the Endowment Portfolio within the TIMESPAN L PORTFOLIOS® depending on other factors a reasonable range for Small Caps could be between 15% and 40%.  Depending on facts and circumstances, a different range of small-cap investing could be considered.

Good and Bad Small Cap Stocks

One of the advantages of the give and take of question sessions is it makes you search for a quick suitable answer. Hopefully in my case it leads to a more thoughtful review of the topic. After much thinking and considering marketing factors, I know what I should have said. Small Caps are not a separate and distinct asset class. There are good Small Cap stocks and bad ones, and buying a stock just because it is a Small Cap is unlikely to give an investor a competitive investment.

Investor Selection Screens

More meaningful selection screens should be a function of the present and future enterprise risk and reward. The results should then be married to a separate analysis of the stock. To me the single most important risk element is that of the co-venturers, those presently and likely to be in the stock. What is the risk of one or more other sizable co-venturers moving in advance?

Another element would be the present price discount as to the future. There are countless other filters including some proprietary measures that can be used as screens. What I look for regardless of size are companies that are in businesses that I have some competence in; e.g., money managers vs. biotech where I believe that my view of the future is not already in the price.

Research Cuts at Major Banks

Having indicating my preferred way of analyzing securities, I believe that we may be entering an era when there will be bigger discovery value in Small Caps than what we have seen in the last decade. This week The Financial Times had an article reporting that research staffs at major banks have shrunk perceptively. This was not due to a view of the declining value of the research effort, but rather a reaction on the need to pay for increased compliance costs combined with restrictions lowering profitability on the use of the mandated regulatory capital. The cutback in the banks’ analytical forces will probably result in less analytical work to add new names at the edges of their portfolios, however the cut-back may also create opportunistic buying occasions.

Most banks need to have as good analytical coverage as possible on their clients’ holdings. As mutual funds are completely discretionary they can more easily add new names with appropriate research coverage.

Travel Cuts Too

Within 24 hours I flew in the business class section on an 80 minute flight going back and forth from Munich to Nice. On each flight there were people dressed in investment clothing of bankers and family office types carrying financial publications on the way to and from Monaco. In each case the business class section was less than half full. This may be normal German tight expense control particularly on such a short flight, but I had the impression that this was something of a new experience for them.

 Investor Opportunities

In Monaco I was the keynoter for an investment conference where there was only one representative of a major bank. The decline of major bank research and conference/sales participation may be an opportunity.   I think small cap buyers will have fewer competitors in finding good investments as these companies are the major contributors to domestic job growth.

This Week’s Concerns

There are a number of topics that I will be working on during the shortened Thanksgiving Week, as follows:

1. Trying to understand the dichotomy between favorable indicators for the stock market and cautionary signs for the bond market; e.g., a sharply falling Barron’s Confidence Index (an inverse indicator for the stock market) VS.  best quality bond yields dropping 14 basis points. This compares to only a 5 bps decline for intermediate credits, a widening of High yield spreads, a dearth of ratings upgrades and low reported core revenue growth.

2. In a reaction to some negative to flat performance results around the world, except in Japan, many marketing driven managers are becoming advocates of alternative investing. While there are a few quite successful practitioners, most are not producing significantly positive results and those that are garnering returns are doing so below the funding needs of their fiduciary accounts.

Disaggregating the performance of these groups may be a useful exercise. In the week ending Thursday the average US Diversified Equity Fund gained 1.32% with none of the alternative fund averages doing as well. This may be explained either by their total expense ratios being higher than the average funds or the fact that some of their extreme tactics are not working; e.g., 161 Dedicated Short Biased funds fell -3.22%. Some alternative funds may use leverage to magnify their results, 194 Equity Leveraged Funds gained 3.52%. For the year to date the short funds declined -7.47% and the leveraged funds dropped -6.75% as compared with a minuscule loss of -0.12% for the US Diversified  group and most alternative funds producing less than plus or minus 1%.

Question of the Week: What are your thoughts on the two topics above?

Thankful Harvests

As we move into the traditional harvest season, Ruth and I celebrate our blessings with family and friends on our Thanksgiving. This year we will be particularly aware of those less fortunate and particularly those who have lost dear ones through the violence of the last week.

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A. Michael Lipper, C.F.A.,
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