(Some) Small Caps Are Still Cheap

We can expect that the crowd will probably be wrong. Or as Fred C. Kelly put it more emphatically: “The crowd always loses because the crowd is always wrong. It is wrong because it behaves normally.” Kelly wrote this in a little 1930 book titled Why You Win or Lose: the Psychology of Speculation. We’ll see what Kelly meant below.

We don’t know all that much about Kelly. We know he was a writer, traveler and breeder of dogs. He also played the stock market. “For several years now,” he tells us in his book, “including much of 1929, I have had the astounding experience of being in the stock market most of the time without losing anything. It would have been a wonderful adventure even if I had lost, for I had opportunity to learn of quirks and foibles of human nature in the greatest human laboratory on earth. It was like going to college, tuition free, with an occasional bonus for encouragement.”

We should all be so enthusiastic in our pursuits. Kelly’s main interest was in what goes on between the ears. As the subtitle of his book suggests, he was interested in the mental aspects of speculating in markets. Kelly’s key to success, in his estimation, largely turned on his ability to not do what everyone else was doing. In other words, he didn’t follow the crowd.

This is what he meant by the crowd behaving normally. Normally, people tend to do what other people say they should do. Normally, people like to look for a consensus of expert opinion and then back that consensus.

In most things in life, that works much of the time. If ten home inspectors tell you that your house needs a new roof, you can safely conclude that it does. If eight out of ten auto mechanics tell you need to replace your timing belt, you probably should. But trusting in the consensus opinion tends to work poorly in financial markets. If 10 out of 10 experts say you should buy tech stocks, you probably shouldn’t. And if eight out of 10 say you should avoid utilities, then you should probably take a look at buying them.

That’s why a recent poll by Barron’s makes me a little nervous about 2010. Barron’s asked 12 experts – all strategists from blue-blood firms like Goldman Sachs and JP Morgan – what they like and don’t like for the next twelve months. There were lots of mixed opinions, but every single one of the experts predicted the stock market would advance in 2010.

The consensus was almost as universally bullish in the late 1990s, just as an epic bear market was about to begin. During the late 1990s, stocks were as popular as they were expensive. In 1999, the S&P 500 traded for 44 times earnings – an all-time high. During the ensuing ten years, the S&P 500 delivered a total return of approximately zero!

As we head into 2010, the stock market trades for about 20 times earnings. That’s not cheap. But it’s also not horribly expensive, either, especially if you consider that we are in a recession and profits may well improve big-time over the next few years. Either way, I do not make investment decisions based on the valuation of the overall stock market. I look at individual stocks. There is nearly always something worthwhile to buy in any market. Sometimes good ideas are more plentiful and sometimes they are more scarce, but I let my bottoms-up rooting around tell me what’s what.

At the moment, my research is turning up more bargains in the smaller-cap stocks than the big stocks. In my investment letter, Mayer’s Special Situations, I focus on small and underfollowed stocks. During 2009 only one of the stocks I recommended to my subscribers had a market cap greater than $1 billion. We picked up a debt-free emerging iron ore producer, now up 119%. We also grabbed a debt-free nat gas producer with lots of shale gas, now up 120%. We’re up 91% on a small Brazilian gold miner. We closed out a double on a Mexican silver miner earlier in the year.

Those were some of the best picks, but we had many other solid market beaters with great upside remaining. I look forward to finding more such small-cap goodies in 2010.

Regards,

Chris Mayer,
for The Daily Reckoning