The Law of Accelerating Returns

Historically, small caps outperform larger companies…but it was not so during the bubble years. Jim Davidson argues small caps will make a resurgence once a major flaw in tracking of stock deliveries is rectified.

More than 20 years ago, in 1981 to be exact, a graduate student produced an important research paper comparing the returns on stock investment based on market size from 1926 through 1969. Much to everyone’s surprise, he proved that large-cap stocks – the ones that everyone knows about, such as IBM and GE – significantly underperformed smaller companies that most people have never heard of. He showed that small-cap stocks had risen at a compound rate of return of 12.1%, as compared to 9.8% for large- cap stocks.

The premium performance of small caps resulted in a huge difference in wealth accumulation in the long run. Portfolio theorists were fascinated by the findings and immediately began to seek explanations for the divergence in returns. A few simple explanations seemed to account for most of the difference.

The first explanation suggests that smaller companies can be more effective than larger ones in evading competition. Smaller companies can serve "niche" markets, where they may face less competition and consequently can charge higher prices. Higher prices then lead to higher earnings, and thus a higher stock price. For obvious reasons, large companies are seldom found engrossing niche markets, although Microsoft might have been an exception for a time. The idea was that the "niche" strategy provides a sustainable competitive advantage that could explain why some small-cap stocks have outperformed larger companies over time.

Of course, sometimes the "niche" market is also a new market, and among the factors forestalling competition is patent protection. Many fortunes have been made on investments in small-cap companies employing patent protection to develop niche markets.

The second reasonable explanation shows that smaller companies are often in emerging industries, and therefore have the possibility of generating huge earnings growth in the future. The greatest opportunities for wealth creation arise from buying the stock of a small-cap company that has the potential to grow into the next Microsoft or Intel.

For reasons of simple arithmetic, it is implausible that an investment in Microsoft or Intel today could compound as far as investments in companies like GeneMax, a company developing immunotherapy treatments, can if they attain their potential.

At $8 per share, GeneMax has a market cap of about $121 million. If its immunotherapy, which has effectively cured cancer in laboratory animals, works as well in people, it is easy to imagine that GeneMax could be worth $80 per share, or even $800 per share. I don’t know what a cure for cancer would be worth. But it could be worth a lot. GeneMax could grow a hundredfold in value. Or maybe a thousandfold. To attain a market cap equivalent to that of Microsoft, GeneMax would have to reach a share price of approximately $15,500 per share based on the current number of shares outstanding.

The Microsofts of the world cannot easily grow a hundredfold in value. At its recent price of $43.77 per share, Microsoft had a market cap of $234.76 billion. While it is unlikely that the GeneMax stock price could appreciate by almost 2,000-fold, it is impossible that such an appreciation could happen again to Microsoft. To be more precise, for Microsoft to compound by 1,960 times, equivalent to the growth that GeneMax would require to become the size of Microsoft now, Microsoft’s market cap would have to exceed the GDP of the United States by about 45 times over.

It does not take a divine genius to see that that is unlikely. Put simply, very-large-cap companies cannot grow much faster than the economy as a whole. They certainly cannot duplicate the growth rates that are possible for mini- and small-cap companies.

Given the strong track record of small-cap companies in the half century prior to 1981, it is hardly surprising that a number of new-money management firms were founded in the early ’80s with the express purpose of investing in small-cap stocks.

We know small-cap stocks dramatically outperformed large- cap stocks from 1926 to 1969, but over the last 15 years, from 1987 to 2002 – after the small-cap "anomaly" was discovered in 1981 – the returns have not met the expectations that the research supported. In fact, after the experience of the 1990s, most investors probably feel that large caps outperform small caps. Almost everyone has had a personal experience of a small-cap holding that seemed promising but ended up plunging in price.

From 1987 to 2002, the S&P 500 generated a compound annual rate of return of 12.1%, while the smallest capitalization stocks averaged only marginally better – 12.6%. The strong performance of the large-cap S&P relative to small-cap stocks is particularly noteworthy in that there are strong reasons to expect large-cap stocks to underperform ever more significantly.

For example, Ray Kurzweil, a computer scientist at MIT, has recently calculated that we will see a century of technological change in the next 25 years. Kurzweil believes that exponential growth of computational power – up by an astonishing 40 billion times in the past 40 years – has set the stage for ever-accelerating technological change. This exponential growth, which he calls "the law of accelerating returns," proved predictive of many of the technological advances at the end of the last century.

According to Kurzweil, "the rate of technological progress is speeding up, now doubling each decade." Kurzweil believes we will see 20,000 years of technological progress by the end of the 21st century. Rapid-fire technological change of the kind foreseen by Kurzweil turns the logic of 20th century investment strategy upside down. It makes investment in smaller companies with simpler business models, paradoxically more attractive than blue chips like Cisco Systems or conglomerates like Tyco or even General Electric.

No one has ever become wealthy buying shares in companies that were already successful. To make big money, you have to buy when companies look like dogs, and most people doubt that they will ever succeed. John Templeton based his fortune on buying shares of the hundred lowest-price companies he could find listed on stock markets before World War II. Even during the Great Depression, profitable stocks did not trade below earnings.

That said, it is important to understand why the over- performance of small-cap stocks has virtually vanished at a time when technological change should have given an added impetus to smaller companies.

This is a complicated issue. Part of the explanation for the greater performance of large-cap stocks is the buoyancy of the market itself during the decades of the 1980s and 1990s. During the 1980s, for example, stocks as a group returned 17.57%. During the 1990s, returns were even higher – 18.17%. Only during the 1950s did market returns exceed those in the last two decades of the 20th century.

Obviously, when markets are compounding at a high rate, small-cap companies soon become large-cap companies, and thus escape from the category. Microsoft was a small-cap company when it began trading on March 13, 1986. But after the rapid growth of its business and eight stock splits, it migrated into the "large-cap" category. So paradoxically, part of the reason that small-cap investment appeared to be less successful was precisely because it was so successful.

But there is also a darker subtext to the issue. It involves market manipulation made possible by well- meaning institutional responses to the staggering increase in trading volume on U.S. stock exchanges. Prior to 1829, total stock trading volume in America never reached even 50,000 shares a day. By 1886, daily volume first ballooned to more than one million shares.

Yet even in the heady days of the 1920s, stock ownership remained relatively narrowly based and volume relatively small. Indeed, the last time daily trading volume fell below 1 million shares was in the Eisenhower administration, on Oct. 10, 1953. By 1972, daily trading volume exceeded 15 million shares per day. By the end of last year, volume had exploded to more than 2.5 billion shares per day, more than a 10-fold increase from the early 1990s and thousands of times greater than in the early ’50s.

This stupendous explosion of trading volume created a logistical challenge of the first magnitude, namely how to transfer stock certificates to reflect the changes in ownership from sales and purchases by customers. In the infancy of stock trading, when volume was light, it was relatively simple to effect delivery of shares. Messengers scurried around and delivered paper certificates by hand from one investment bank to another. In 1924, the Stock Clearing Corporation was established to facilitate trading. But with trading volume escalating into the billions of shares daily, securities dealers and stock market officials sought a better way to clear their trades. The result was electronic clearing organized through the Depository Trust Company.

The Depository Trust Company is a trust company organized under the banking laws of New York State. It is owned by banks and broker-dealers. It is a custodian of securities that effects "book-entry delivery" in which "transfers of securities within the DTC system are processed by debits and credits to Participants’ accounts."

In reviewing a lot of material about the DTC, which I must say is obscure and boring in the extreme, I got the distinct impression that its organizers were more concerned with effecting payment for securities than with the niceties of securities delivery. The DTC says, "DTC does not itself guarantee any funds or securities transfers which its Participants are obligated to make." The DTC is organized on the assumption that broker- dealers, market-makers and clearing agents are all operating in goodwill and need looking at mainly to ascertain that their wire transfers in payment for securities don’t go astray.

Where this electronic settlement becomes an issue is when it comes to the shares of mini- and small-cap companies traded on the Pink Sheets, the OTC and the Nasdaq. The rules and conventions that have arisen around electronic settlement effectively permit unscrupulous operators among the many thousands of broker-dealers to counterfeit large quantities of stock, which they can sell for payment.

Given the magnitude of the logistics problem in clearing trades, it is understandable that this could happen. It is much easier to monitor the delivery of payment than it is to authenticate the delivery of shares, especially in an electronic clearing system where every broker-dealer has the de facto capability of counterfeiting securities by simply finding a buyer for them.

Say you want to buy a million shares each of GeneMax and another small cap company. Market maker Doaks has shares of neither. But, either on behalf of some client or on his own account, he sells them to you, crediting your broker’s account with 1 million shares of GeneMax and 1 million shares of the other. Your broker now has an electronic credit for those shares, against which he wires funds or nets funds against his credit at DTC to Doaks’ Participant account there. Thus are counterfeit shares created and put into circulation.

Doaks or his client has pocketed a lot of money for counterfeiting shares he did not have. And your broker has an electronic credit for those shares at DTC. When another of his clients dies, the executor of his estate orders the liquidation of his account, including 500,000 shares of GeneMax. The credit for those shares originally concocted by Doaks now transfers to the account or accounts of the participating broker-dealers whose clients bought the GeneMax shares from the estate. And so on.

Ostensibly, broker-dealers have the capacity to sell securities they don’t own and don’t have to borrow – as you would if you were selling short – to facilitate market-making. In theory, the broker-dealers can sell quantities of stock they don’t own in order to make an orderly market and prevent the price from spiking on big buy orders. In theory, abuses are limited by the requirement for the market-maker to post capital and limit "naked short sales" of any one issue to 10% of the capital account.

That is the theory. The reality is a bit more ugly. No one is really monitoring the aggregate impact of the counterfeit sales on any given issue. It is simple to confirm that payment has been rendered for a sale. When the cash credit is transferred between participants within DTC or the Fed wire hits, the issue is resolved. But in an electronic, book-entry deposit system, every credit for a share purchased is indistinguishable from an actual share issued by the company treasury, even if it was counterfeited. No one bothers to reconcile the share credits in the DTC system with the authorized, freely trading shares of the company.

Consequently, it is quite common for the effective float of small-cap companies to be inflated significantly by electronic counterfeiting. In some cases, the total effective float has been multiplied many times over.

Hence the sometimes weak performance of mini- and small- cap stocks. Their stock prices plunge because the supply of stock is artificially multiplied by naked short selling, better understood as electronic counterfeiting. Unscrupulous broker-dealers and market makers can effectively drive the prices of stocks into oblivion by selling vast quantities of stock not issued by the company.

Having come to understand this, I see an urgent need to curtail this electronic counterfeiting of the shares of small-cap companies. It not only fraudulently deprives investors in the affected companies of wealth but it is also destructive to the economy. And the news media seldom deign to report on it. Other than a few minor squibs on the news pages of The Wall Street Journal, there has been virtually no coverage of this issue.

Indeed, it is so obscure that you may not even know what I am talking about.

If so, that only underscores the need to shed more light on this predatory practice. I should also say that I am confident that this problem will be rectified. Maintenance of honest and orderly capital markets is tremendously important to the economy of the United States.


Jim Davidson,
for The Daily Reckoning
November 27, 2002

P.S. Having made the argument for small caps, and shed light on the potential for small cap manipulation…you should also know that small-cap stocks are more volatile and "riskier" than large-cap stocks. Small-cap companies generally are more heavily indebted relative to their income than their large-cap counterparts, meaning their earnings are more leveraged. Small-cap companies have fewer assets than large-cap companies. Small-cap companies are statistically more likely to go bankrupt than large-cap companies. So portfolio theorists calculate that the extra return you get over time is a result of investors being compensated for bearing more risks. Keep that in mind if one or more of your "high- upside" stocks bites the dust.

Editor’s note: James Davidson is a best-selling author and venture capitalist. His articles have appeared in The Wall Street Journal, Investor’s Business Daily, The Washington Post and USA Today. Mr. Davidson currently sits on the boards of over 20 small-cap companies, and has been invited to join Merrill Lynch’s technology advisory board. Davidson’s latest research and investment picks can be found in:

The Vantage Point Investment Advisory

After a great and glorious binge – in the late ’90s – of stock-buying and borrowing…lying and cheating…and living it up as though there would be no tomorrow, tomorrow came. The nation fell into a miserable slump, with crashing stocks, disappearing profits, recession…and titans of industry hauled off in hand cuffs.

Alan Greenspan’s Fed decided it was time to put the nation into a 12-step recovery program.

Month after month, he cut rates, until there was not much left to cut. Shortest term dollar deposits earn only 1.25% interest…while the inflation rate is around 3%. In effect, the central bank is already giving money away.

And yet, where’s the recovery? Corporate profits continued to fall in the last quarter, even faster than they did in the quarter preceding it. Bankruptcies, in the 3rd quarter, were rising at a double-digit rate. The holiday shopping season looks as though it might be grim. The number of homes in foreclosure is at a 30-year high. And revenue shortfalls among state governments are so bad that the governors called it the "worst budget crisis" since WWII.

"Lenders are flush," says a USA Today article. But it may be too late for the borrowers. The water is high and beginning to swirl. They "have so darned much debt that even at low rates it’s hard to pay," reports USAToday.

"Debt hounds those at the edge," says a Chicago Tribune headline. Freddie Mac, chartered to spread the joy of debt to the multitudes, decided to turn the hounds loose on those in the middle, too – raising its limit on mortgages from $300,700 to $322,700.

But now that Greenspan has completed his 12-step program…and real rates are well below zero, what next?

Ben Bernanke, one of the Federal Reserve’s seven governors, whom we quoted yesterday, followed up by saying "The U.S. government has a technology called a printing press – or, today, its electronic equivalent – that allows [the Federal Reserve System] to produce as many U.S. dollars as it wishes at essentially no cost."

"There is virtually no meaningful limit to what we could inject [from the money supply] into the system, were it necessary," added the chairman.

Technically correct, for the Fed could always charter a fleet of helicopters and drop $100 bills over lower Manhattan, but as a monetary policy, printing money is not without its drawbacks.

The essential requirement of money is that it be valuable, which requires that it be of limited supply. But that is also the essential problem with all managed currencies. Its managers may create more of it when it suits them, but never so much that the illusion of scarcity is destroyed.

The U.S. economy, we keep reminding ourselves, earns less than it spends. The difference is made up thanks to the kindness of strangers in foreign countries. If those foreigners ever begin to feel that the dollar is not what it is supposed to be, they will dump greenbacks in favor of other colors, say, the blue and pink of euro notes.

"What the U.S. owes to foreign countries it pays – at least in part," observed Charles de Gaulle in 1965, a full 37 years ahead of Greenspan and Bernanke, "with dollars it can simply issue if it wants to."

De Gaulle was first in line at the ‘gold window’ at the Fed, where he exchanged his dollars for gold and brought the world’s monetary system crashing down. Nixon slammed shut the gold window and the price of gold began to move upward. Over the 12 years leading to the peak in January 1980, gold gained 30% per year – exceeding the return on stocks in any 12-year period in history.

Gold bugs were so excited by this that they bought – even as gold reached $800…and regretted it for the next 22 years. Now, the price of gold moves up cautiously…the gold bugs have less money and more sense. Still, on the open market – if no longer at the gold window – the neo- de Gaulles of this world have a way to exchange their dollars for gold. Greenspan and Bernanke must be causing them to think about it.

Central bankers are as human as gold bugs; the thought must have occurred to them. If they can manage a currency, they can mismanage it too. More below…

Eric, give us the latest from the dream capital of the world…please.


Eric Fry in New York…

– On Monday, Baltimore’s celebrated mutual fund manager, Bill Miller, proclaimed that the bear market is over…finished…kaput. On Tuesday, the Dow skidded 173 points…Go figure. Miller’s "Legg Mason Value Trust Fund" has outperformed the S&P 500 for the past 11 years. So that makes him an expert, right? Well…yes and no.

– While Miller’s fund may have bested the S&P 500, it has still managed to fall more than 40% since March of 2000. Mr. Market doesn’t seem to like experts very much…As soon as somebody becomes one, Mr. Market is sure to make an idiot out of him.

– Miller is no idiot – not yet anyway – but he is prone to the sort of myopic optimism about financial markets that leads a man to pay very rich prices for stocks. And Miller has paid some very, very rich prices over the last few years for stocks like Amazon and Tyco, which is why his shareholders have lost so much money since March of 2000.

– If you had lost 40% of your money buying expensive stocks, wouldn’t you be proclaiming the end of the bear market, also? Among professional investors, the act of predicting what you hope for is called "talking your book." No doubt about it, that’s what Miller is doing. He’s predicting the end of the bear market because that’s what he HOPES will happen.

– Here at the Daily Reckoning, we have no "book." We simply call ’em as we see ’em. And what we see is an expensive market that should be falling rather than rising. Yesterday, it did what it was supposed to do. It fell. The Dow dropped nearly 2% to 8,676, while the Nasdaq fell 37 points to 1,444.

– Yesterday’s selloff was somewhat ironic, given the fact that so much good news crossed the newswires. First up, third-quarter GDP was upwardly revised to a 4% growth rate from the previously reported 3.1% rate. Next, consumer confidence jumped in November from 79.6 to 84.1 – breaking five straight months of declines. But these hopeful news items fell on deaf ears, as investors took a break from buying stocks to buy bonds.

– Despite yesterday’s gains, bond rallies have been few and far between these days. Several weeks ago in the Daily Reckoning, we raised the possibility of a "bond bubble." The fact that bond prices have been tumbling ever since has done nothing to undermine our theory. The prospect of a bond bubble is alive and well.

– One classic feature of any full-scale bubble is widespread ignorance about the asset class that the hoi polloi is so feverishly purchasing. (Remember when folks paid $71 for each share of on the day of its IPO in May of 1999? What were they thinking? Did the buyers have any inkling what sorts of miraculous feats the company would have had to accomplish in order to merit its fleeting $1.5 billion market cap?)

– On the mass-ignorance scale, the prospective bond bubble qualifies nicely. According to a recent poll by the Vanguard Group, very few bond fund buyers understand the connection between price and yield, or, for that matter, the connection between a rising yield and rising capital losses. According to Vanguard’s online "literacy test," 70% of respondents did not know that bond prices and interest rates move in opposite directions.

– Even so, a record $116 billion poured into bond funds during the first nine months of this year, according to the Investment Company Institute. The fact that a lot of "dumb money" is throwing billions of dollars worth of its dumb money at the bond market is not incontrovertible proof of a bond bubble, but neither is it a very encouraging sign…

– Not that anyone cares, but supplies of oil and heating oil are relatively lean at the moment. U.S. distillate inventories (that’s stuff like heating oil) fell for a third-straight week, and supplies now stand 11% below the year-ago level as the market heads into the winter demand season, according to the American Petroleum Institute.

– Petroleum supplies are in a "tenuous situation," one oil analyst told CBSMarketWatch – "in every major category, supplies are well below where they were a year ago. It can’t make you feel too warm and cozy as we head into winter season." I’m feeling chilly already.


Back in Paris…

*** The last shall be first. This from Evan Pickworth, our correspondent in South Africa:

"Data compiled by Dow Jones Newswires show that South Africa’s JSE Securities Exchange South Africa (JSE) is the best-performing equity market in the world in US dollar terms since the start of the year up until the close on November 22.

"Its gain over that period is 33.15%…almost double second-placed Thailand’s 17.84% gain and in sharp contrast to the world’s largest stock market, the US, which has slumped by 18.93% so far this year.

"The global index has declined by 16.37%. If the US is excluded from the global index, the performance is a decline of 13.46%.

"Most of the rest of the world has followed the US into negative territory. Of 34 major equity markets tracked by Dow Jones Newswires, only six (Austria, Indonesia, New Zealand, South Africa, South Korea, and Thailand) were in positive territory."

*** Abby Joseph Cohen is still bullish, which confirms our view that the market has further to fall. "Recent data points," says Goldman’s chief seer, "do not support ugly scenarios."

*** "Gold shares may offer light in the equity gloom," says a Reuters headline. Britain’s only gold fund, Merrill Lynch’s Gold and General, is up 53.9% in the first 10 months of 2002. Over the last 10 years it rose 400% – while the price of gold actually declined.

Gold shares "have a habit of doing well when other assets are doing badly," said Graham Birch, the fund’s manager.

*** James Grant of Grant’s Interest Rate Observer makes a recommendation: buy the new Newmont. The company is in the gold mining business. The new Newmont came about when the old Newmont merged with Franco-Nevada of Canada and Normandy of Australia; presumably, the people who run the business are better at mining than geography. Not that the company makes a lot of money. Au contraire, on a price-to-earnings basis, Newmont is expensive. But the company has a lot of gold – an estimated 97 million ounces of proven or probable reserves. When doubts arise about the real value of paper currencies, a lot of gold is a good thing to have.