Preparing for a Recovery

James Boric argues that once the bottom is in, you’ll find no better place for your money than in small caps stocks.

In 1939, at the ripe old age of 27, John Templeton, who would become the world’s most successful fund manager, asked his boss to loan him $10,000. John didn’t need the money to pay his rent. Rather, he wanted it to invest in the stock market.

I can only imagine how that conversation must have gone. At the time, the Dow was down over 64% from its high in 1929. And Templeton wanted to borrow $10,000 to invest. Was he nuts?

Templeton’s boss didn’t think so. He gave it to him. All ten grand – the equivalent of $126,500 today. Templeton took the money and bought 100 shares of every stock (on the major exchanges) selling for under $1. Four years later, in 1943, the market began to recover. That’s when Templeton cashed out…and quadrupled his money.

Did he just get lucky? Not at all.

Templeton knew something most investors didn’t know then and most don’t know now. Following every bear market in the last 77 years, the quickest stocks to recover have been – without exception – small cap stocks.

In fact, with or without market tumult, the best stocks to own for any extended period of time are those trading for pennies on the dollar. And there’s no better time to buy small cap stocks that just before a market recovery.

From 1926 to 1996 small cap stocks outperformed all other stocks – even the stalwart blue chip stocks – 56% of the time. The average return in any given year was about 14% for small cap stocks. It was just 9% for large caps. And the longer you held your small cap stocks, the better off you were.

Over any five-year period from 1926 to 1996, small cap stocks outperformed large cap stocks 58% of the time. And investors made almost 18% more than their large cap friends. One dollar turned into an average of $7.48 in five years for small cap investors – just $6.34 for large cap investors.

If you held a basket of small cap stocks for 15 years you beat out your large cap-investing counterparts 70% of the time. And if you held for longer than 25 years, you won 100% of the time.

That’s right. Since 1926, there has NEVER been a period of 25 years or more where investing in large cap stocks has proven more lucrative than investing in small cap stocks.

That’s a fact. So why don’t more people invest in small cap stocks? The answer is simple. They are intimidated. And small caps can be risky. People are scared of things they don’t know or understand. And the popular media rarely ever mentions investing in anything other than Fortune 500 companies.

If there was ever a time to get over that fear, that time is now – before the market begins to recover. Since January 2000, the Dow is down 31%. Only twice has there been a bigger drop. Once in 1929 and once in 1973-4. And in the years following both those crashes, small cap stocks were the quickest stocks to recover.

I’ve already shown you how Templeton quadrupled his money during the recovery period following the crash of 1929. You could have done it again following the crash of 1973-4.

From 1973-4 the Dow fell 44% from 1,051 to 587. And in the recovery years of 1975-1980, small-cap stocks took off. They grew 349%. Meanwhile, blue chip stocks went up a meager 58.5%. The surest and quickest way to multiply your money is to invest in the cheapest stocks with the best valuations. It was true in 1939. It was true in 1975. And it’s still true today.

As of right now there are 6,500 companies listed on the major stock exchanges. Of those, 5,402 have market caps of 1.5 billion or less. Those are your small cap stocks. That leaves only 1,098 large cap stocks.

A quick study reveals some interesting facts: 1,289 small-cap stocks have a P/E ratio of 15 (about the historical average) or less. Only 245 large cap stocks can say the same. Digging even deeper I found that 657 small cap stocks had a P/E of 15 or less AND a price-to- sales ratio under 1. Only 114 large cap stocks made the cut.

Now for the clincher. An anemic 26 large companies have a P/E under 15, a price-to-sales ratio under 1 AND a price-to-book ratio under 1. On the other hand, you can choose from over 299 small-cap companies that meet all three criteria.

As we begin to recover from this current bear market you will have about ten times as many opportunities to grow your money in small cap stocks compared to blue chips.

So as you prepare for the future think about John Templeton and how he quadrupled his money in 1943. He didn’t wait around for anyone to confirm his thoughts about a recovery. He went ahead and invested in the cheapest stocks when no one else was investing. Then when the recovery finally did hit, he cashed out for four times his original investment.

It’s impossible to know when the recovery will start…or if it has already begun. But one thing is for sure: When the recovery does set in, the brave investors who put their money in small cap stocks will walk away a lot richer than those that don’t.

So when will the recovery begin? I don’t know for sure. No one does. But the good news is it doesn’t matter. In 1939, Templeton didn’t know when the market would recover. He just knew that eventually it would, and the best stocks to own when it did would be small caps. As it turned out, the Dow actually fell another 40% from 1939 to 1942.

But in 1943 the recovery hit. And he quadrupled his money. If I could predict when this current bear market would turn around, I would tell you. But I don’t know. The only thing I do know is that if you buy small cap stocks now – and can stomach some short-term volatility – you will be in position A when the recovery does hit – maybe even in position to quadruple your money.

For now you should look for small cap stocks trading for bargain prices. That means looking for companies selling for under $10 a share with a P/E under 15, a price-to- sales under 1 and a price-to-book under 1. Two other things to look for are double-digit revenue growth and a rising net income.

Find these gems now and you’ll be rewarded later.

James Boric,
for The Daily Reckoning
September 24, 2002

Editor’s note : James Boric is editor of the small cap advisory letter Penny Stock Fortunes, where he looks for great companies at penny stock prices. James also writes a weekly e-mail called the CXS Alert. For more advice on how to profit from small cap stocks, see:

Penny Stock Fortunes

"As is often the case, politics won over principle," says Joseph Stiglitz, explaining away his involvement in the largest financial bubble in the history of mankind.

It’s amazing what comes to light when the shinola begins to hit the fan, isn’t it? In the October issue of The Atlantic Monthly, Stiglitz, former head honcho at the World Bank, Nobel Laureate in Economics and chairman of President Clinton’s Council of Economic advisors, chimes in on a theme that regular readers of The Daily Reckoning will recognize: employee option compensation schemes.

As early as May 2000, Bill Bonner suggested, "capitalists are once again being exploited by the workers. Management is free to re-price its options to retain and reward valuable employees. If you are an investor, however, you should not expect to have your shares repriced – except by the market itself…and lower."

In July of this year, Porter Stansberry suggested in a DR guest essay that "options schemes" had gotten so out of hand at Maxim Integrated Systems that the sole purpose of the company’s management had shifted from building competitive products to using complicated accounting procedures to hide how much shareholder money they were giving away in compensation. That stock, by the way, has been repriced 41% lower by the market in the weeks since Porter’s report.

Now Stiglitz offers an embarrassing admission…despite all their eleventh hour posturing and countless threats to put all the "bad CEOs" in jail this past summer, NOT requiring companies to account for their "options schemes" was an idea pushed through by the government! "The Treasury and Commerce Departments sent a letter to the Financial Accounting Standards Board (FASB)," writes Stiglitz, "arguing against accounting for options. Other pressures were brought to bear, and the FASB finally gave in. As the events of the last few months illustrate, this was a mistake."

"Stock options and other badly designed compensations proved as problematic in the financial sector as elsewhere," writes Stiglitz, "with even more serious consequence." Prediction: as the bubble continues to unravel we’ll see ever more of these ‘serious consequences’ …not the least of which we have evidence of in Eric’s report below.

Eric?

————–

Eric Fry from the city of New York…

– The cacophonous rattle of sabers in Baghdad and Washington seemed to rattle investors’ nerves yesterday. Over the weekend, Iraq vowed to reject any new UN resolutions on weapons inspections, prompting President Bush to step up his PR campaign against Iraq. The renewed prospects of an imminent American assault on the Middle Eastern nation sliced 114 points off the Dow to 7,872, while the Nasdaq tumbled 3% to 1,185…And that, my friends, is a brand new six-year low for the Nasdaq Composite!

– But the Nasdaq was not alone in setting new multi-year extremes yesterday. Over in the bond market, the 10-year Treasury note yield dipped to a fresh four-decade low of 3.69%, down from 3.77% on Friday. The price of crude oil, meanwhile, jumped 87 cents a barrel to a new 19- month high of $30.71.

– Of all the bubbles that folks talk about these days, almost no one mentions the possibility of a Treasury- bond bubble. But the Treasury market certainly possesses some bubble-like qualities – the first being that "price is no object." Investors are throwing money at the bond market because it is "safe." And in one sense, that’s certainly true. A bond buyer paying $1,000 for one Treasury note today will almost certainly receive $1,000 upon expiration. But that doesn’t mean that $1,000 in 2012 will buy as many Starbucks cappuccinos as it does today.

– It’s just possible that dollar will buy far fewer goods and services 10 years from now than it does now. Furthermore, a 3.69% annual return is pretty meager compensation for loaning money for ten years to the world’s largest debtor nation – a nation which also happens to be running the world’s largest current account deficit.

– "On the sentiment side, bonds appear to be setting up nicely for a major top," Kevin Duffy, a professional investor told me yesterday. He says that bullish sentiment in the bond market is hitting extreme levels. From a contrarian standpoint, such extreme bullish sentiment readings often indicate a near-term top. Duffy wonders: "Is fixed income peaking globally, ushering in a new era of inflation (the bad kind), increasingly worthless paper, and rising gold prices?" We bears wonder and wait.

– On the home front, the latest economic news from the Conference Board did not give investors any warm and fuzzy feelings, either. The index of leading indicators (LEI) fell for the third consecutive month in August. The LEI slipped 0.2% last month, following a 0.1% decline in July and a 0.2% drop in June.

– What’s more, seven of the 10 indicators in the leading index decreased in August, indicating that the slowdown is spreading… and it’s spreading all the way to Wall Street.

– In fact, the slowdown is erasing jobs on Wall Street like a high tide erases sand castles. A friend of mine who recently lost his job in the financial services industry told me yesterday, "The jobs just aren’t there." Worse, some of the jobs that are still there today won’t be there next month. "The dream of retiring young faded last week for many financiers," writes the Financial Times, "after several investment banks inflicted yet another round of job cuts on their demoralized employees." Goldman Sachs Group, in particular, is preparing to hand out a fresh slew of pink slips over the next few weeks.

– "The senior management of Goldman’s investment banking group has told department heads to start assembling lists of candidates to be laid off," the NY Post reports.

– Goldman’s job cuts are but the latest in a series of similar cuts elsewhere on Wall Street. Morgan Stanley fired about 200 staffers in its investment banking unit a few weeks ago and Dresdner Kleinwort Wasserstein cut about 500 banking jobs last week. The obvious problem is that the business simply isn’t there. Global mergers and acquisitions volume has dropped about 30% since last year.

– Goldman’s job cuts, according to the Post, "will be focused heavily on the firm’s senior-level bankers, who can’t produce enough revenues in the current market environment to justify their eye-popping pay packages. In good years, managing directors, the highest-ranking bankers behind senior management, typically earn at least $1 million in total pay. Some command pay packages of $5 million to $10 million or more."

– It’s debatable, of course, whether these bankers were ever worth the lush compensation packages they received. But that’s water under the bridge. What happens now? What does a jobless investment banker do during a bear market? Does he work in the men’s department at Barneys? Does he mow lawns in the neighborhood? It’s tough to say what career path logically proceeds from a resume that reads: "Proven talent for secretly offering ‘buy’ recommendations and other semi-illicit perks in exchange for investment banking business."

————–

Back in Paris…

*** You have to hand it to Joseph Stiglitz. Despite all that has come to pass, he’s sticking to the story line he helped craft last century: "…the fundamentals of the U.S. economy are strong and they were strengthened during the 1990s. The New Economy is real, even if its significance has been exaggerated."

"The fact that the New Economy is real, however, doesn’t mean that we’ve understood it," Stiglitz says… and then goes on to prove it.

He admits early in his piece that the fact that prosperity reigned while he and his cohorts were having coffee together at the president’s behest was dumb luck. But "in explaining our success in the nineties to ourselves" … is apparently where the errors crept in. "We have largely drawn on a set of myths that desperately need debunking: that deficit reduction by itself led to the economic recovery of the 1990s; that the brilliance of our economic leaders created our newfound prosperity; that deregulation and self- regulated markets are the key to sustaining that prosperity, and should thus be exported to the rest of the world…

"These myths arguably served a purpose. But no matter how useful they were in the short term, ultimately they are harmful. The deficit-reduction myth suggests that if, say, Argentina or Japan is in a recession and has large deficits, cutting those deficits will bring back prosperity. But almost all economists recommend instead an expansionary fiscal policy, fueled if necessary by larger deficits." [Are these the same brilliant economic readers he’s referring to in the preceding paragraph?]

"The myth that prosperity was the work of our economic heroes [whoops… I spoke to soon]…shifts attention away from where it should be – on policies. [Ah, yes… the ‘policies’] Economic vicissitudes inevitably cast doubt on our heroes’ ability to perform miracles, and a loss of confidence in these heroes will bring a corresponding loss of confidence in the economy." [Gee… you think?!??]

"Economies are like large ships: they cannot be turned around quickly." No doubt, running high deficits… focusing on ‘policies’… increasing regulation… encouraging consumer profligacy… and glorifying our ‘economic heroes’ is the way to get this one started in the right direction.

Following Stiglitz’ line of thinking, you get the feeling we really will need a miracle to restore confidence in the economy, eh?

*** Speaking of economic heroes… how about this preposterous idea: What if Greenspan, the former Randian acolyte, did it all on purpose?

A DR reader passes on this article from World Net Daily: "…there can be little doubt that the implosion of the equity markets will soon be followed by the pricking of the credit and real estate bubbles. As great financial houses such as Citigroup and JP Morgan Chase teeter on the edge of bankruptcy, it is well within the realm of possibility that the triple whammy of the equity, credit and real estate implosions will lead to the collapse of the entire global financial system.

"And all thanks to The Genius That is Greenspan (TGTG). My hero.

"You see, I reject the notion that TGTG is incompetent, cowardly or vain. I contend that he is a superhero, an agent undercover, a mild-mannered chairman of the Federal Reserve Board by day and a freedom-fighting Randian titan by night. Consider the following quotes:

"’In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value… The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves. This is the shabby secret of the welfare statists’ tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth.’"

– Alan Greenspan, "Gold and Economic Freedom," 1967

"’The substantive financial powers of the world were in the hands of these investment bankers (also called ‘international’ or ‘merchant’ bankers) who remained largely behind the scenes in their own unincorporated private banks. These formed a system of international cooperation and national dominance which was more private, more powerful and more secret than that of their agents in the central banks…They could dominate governments by their control over current government loans and the play of the international exchanges.’"

– Carroll Quigley, "Tragedy and Hope," 1966

"It is clear that TGTG, from his humble beginnings as an acolyte of Ayn Rand, has been secretly determined to shoulder the weight of the financial world on his shoulders, then, like Samson in the temple of Dagon, bring it down upon himself and his fellow Masters of the Universe who are holding us captive in endless financial serfdom. Hard days may lie ahead, but soon the day will come when there will be no more Federal Reserve, no more confiscation through inflation, no more federal debt, and no more unconstitutional income tax. America will be free again, all thanks to my hero, the genius that is Alan Greenspan…"

Addison Wiggin,
The Daily Reckoning