Specialization is for Insects

The Great Debate…Boric versus Denning…small caps investing versus macro investing. Someone touched a nerve; here’s the reaction…

“Sure small-caps have been rallying. But so have just about everything else – large caps, emerging market stocks, real estate, gold, oil…everything. As I see it, small-caps are just one of the many beneficiaries of a U.S.-centric asset inflation. Assets in the States have been inflating for so long that there’s little value left in any of them.”

That’s what my friend and esteemed colleague Dan Denning said to the Orlando crowd at the World Money Show last week.

You see, several of your DR cast members, including myself, were in Florida on Wednesday and Thursday to participate in a debate about what the best investment opportunities for 2005 would be.

On the one hand was Mr. Macro himself, Dan Denning. He argued that you can’t be good at JUST one thing in this market and expect to make money.

Globalization has made it a lot harder for individual investors to find bargains in the U.S. markets, Denning argued. In other words, the big money isn’t just flowing into the U.S. anymore. Countries like India, China, Brazil and many others are competing for the greenbacks as well. As a result it’s hard to find much (if any) value in the U.S. – especially in the small-cap market.

In fact, Dan went on to say…

It is myopic to focus on smalls at the exclusion of all macroeconomic influences. Your narrow focus on small-caps, James, reminds me of a quote from Robert Heinlein: ‘Specialization is for insects.”

Small-Caps: Call Me an Insect

Call me an insect then. But your small-cap editor wonders…

Would I be an ant…a bumblebee…a spider…or maybe a cockroach?

Who knows? My buddy Dan thinks I’d be a bumblebee that only looks for nectar in one kind of flower. Fair enough. But I assure you, I would not be a fly. I’d much rather hunt other bugs or even plants than fly around all day looking for piles of manure.

While I don’t deny I could look a bit like a bug, I disagree with the notion that you can’t make money by being good at just one thing.

Specializing in JUST the small-cap market, as I do, is hardly limiting myself to one or two investment opportunities.

Right now two-thirds of the market is made up of small-cap companies with a market capitalization of $1 billion or less. That means as small-cap investors we have about 4,000 investment opportunities to choose from. Furthermore…

– 53% of the true growth companies on the market (those that are growing sales and net income by 10% and 25% Q over Q and Y over Y) are in the small-cap universe.

– 26% of the real value companies (those that are trading at or below historic norms in terms of price-to-earnings, price-to-sales and price-to-book value are small-cap companies.

– 73.3% of all the companies on the U.S. market that have more free cash flow than total debt are small-cappers.

– 60% of all the companies that have doubled their earnings (or more) in the last year are in the small-cap universe.

As I told the audience in Orlando…

These are telling numbers. And specializing in the small-cap market is hardly like being a magician with ONE trick – or an insect with only one job to perform. There are literally thousands of opportunities to make money in the small-cap market – always have and always will. Problem is…

Smaller companies don’t have the analyst or media coverage that the IBMs, GEs and Intel’s of the world get. So you don’t hear about most of these stocks when they are cheap. At least that’s what I thought.

Small-Caps: Still Value Left

After I made my passionate speech to the Orlando crowd, I asked them…

How many of you think that small-cap stocks are legitimate investment opportunities right now in this market?

I expected a handful of people to raise their hands. After all, I speak all the time – all over the world. And I’ve NEVER seen a case where more than a third of the people believe in small-cap stocks the way I do. But the answer I received in Orlando was unbelievable.

Every single person in the audience raised their hand. Some even raised two hands. I was shocked. Meanwhile, Dan was smiling from ear to ear. It seemed the audience proved his point. There must not be any value left in the small-cap market if everyone loves them at the same time. Game over, right?

As a contrarian, when the crowd all thinks the same way, you want to do the opposite. And I agree…

Now is NOT the time to chase small-cap companies with little in the way of earnings and sales. Those companies WILL fall. And despite my love for the small-cap market, I would not go out any buy calls on the Russell 2000 index. The average small-cap stock trades for 20 times earnings and 2.32 times book value. They are hardly a bargain compared to their larger peers.

But…

It would be absolutely foolish to think there is NO value left in the small-cap market. There is. It just takes time and a little due diligence to find the real bargains. And that happens to be what I do for a living. So here’s my advice for all you small-cap investors out there.

Now is the time to stick to your guns. Invest in the smaller companies that are growing, trading for a value and have lots of cash. They will be the companies that not only survive this year or next…but into the next decade and beyond. In fact, I am so sure of it, I made the audience a promise…

In 10 years from now, I’ll come back to Orlando. And I’ll show you how many small-cap companies from 2005 are mid-cap and even blue-chip stocks today.

It would be a shame to miss out on those opportunities.

Over the last 75 years, through bull and bear markets alike, small-cap stocks have proven to be the best investments over substantial holding periods. On average they outperform their large-cap peers 56% of the time in any given year. And the longer you are willing to hold, the better chance you have of winning.

If you hold a basket of small-cap stocks for 10 years, they will beat large-caps 66% of the time. Hold for 20 years and you’ll win 94% of the time. And hold for 30 years or long and you are guaranteed to come out a head.

Hmmm…

Maybe Dan was absolutely right. Small-cap stocks are like insects. They focus on one job at a time. Either they do the job well…or they die off. And over the long haul, insects have survived floods, fires, famines, droughts and every other disaster known to man.

There’s something appealing about an investment that does the same.

Best regards,

James Boric
for The Daily Reckoning

February 10, 2005 — London, England

P.S. Dan Denning was the guy who hired me into this business. I owe him everything. And in all honestly, he’s the smartest guy I know. But from time to time it’s nice to go head-to-head with him. I hope we debate again.

Editor’s Note: James Boric is the publisher of Penny Stock Fortunes and Penny Sleuth – two of the premier small-cap advisories in the country. Boric contends that the true value stocks always have and always will reside in the small-cap universe. Those who are willing to look can find great riches. That’s exactly how Templeton, Buffett and T. Rowe Price all made their first fortunes. And you can too.

James Boric has been working day and night on a new project…and it’s finally ready. This is ground breaking small-cap research. James calls it the ‘stock string’ effect. Look out for his research note, out tomorrow…

Yesterday’s news included an interesting little item: In the month of January, insiders practically stopped buying altogether. The total of insider purchases was only $34.1 million – the lowest number in 12 years.

There are two ways to try to make the world better, dear reader. And two ways to invest. But only one of them really works.

You can read the papers, watch the news, look at the whole public spectacle and try to form an opinion about what is going on. If you are a world improver, you might come to the conclusion that outsourcing needs to be stopped, or that China needs to revalue its yuan, or Pakistan needs regime change. If you are an investor, you might think China stocks will be a big success in the years ahead, or that Bush is bringing down the deficit, or that 2005 will be a good year for stocks.

But if you put down the papers and turn off the TV, you could study the things closer to you. If you wanted to make the world a better place you could plant flowers in your front yard, or flirt with the fat girl down the street. As an investor, you could study the company you work for…or visit one that is looking for investors.

A corporate insider has a huge advantage. Like Warren Buffett, he invests in public markets, but with the close, detailed information of someone running a private business. He doesn’t get his information from the newspaper – but from his own eyes and ears…and his own balance sheets and inventory reports…and his own sales numbers. He is someone who really knows something. He is not out to improve THE world. He is only interested in improving his own world. He is sometimes right and sometimes wrong, but at least he acts on the basis of real information rather than public babble.

Insiders have been wary of the stock market for several years. The last report showed stock market advisors – people whose views matter to the public market, but not necessarily to the private insiders – are bullish by a 2 to 1 margin. This continues the longest period of uninterrupted bullishness in history. The public is bullish too, along with economists. And so are the “strategists” at Wall Street firms. About the only people who are not bullish is the team here at The Daily Reckoning…and the insiders.

During the month of January, not only did the insiders buy little of their gown stock, they sold a lot of it – $1.9 billion worth. For every share the bought, in other words, they sold 55. We don’t know if that is a record, but it must be close to one.

If you want to make money, invest like an insider, on the basis of private information and direct, personal experience (though not necessarily your own). Merely putting your money at play with the rest of the lumpeninvestoriat, on the other hand, will give you no greater gains than anyone else. In bull markets, your stocks will go up. In bear markets, they will go down. Every transaction will be clipped by brokers and intermediaries. If you put your money in a mutual fund, you will pay an additional fee. And if you make any money – even if they are little more than increases at the rate of consumer price inflation – you will pay part of them to the government.

There are two ways to invest…but one of them makes you poorer.

More news, from our team at The Rude Awakening:

————–

Tom Dyson, reporting from Baltimore…

“…Of course, we’d never actually ‘go long’ of bonds. When you buy bonds, you lend money to the U.S. government. If you bought them today, you’d effectively receive 4.37% interest per annum, fixed for the next 30 years…”

————–

Bill Bonner, back in London:

*** Yesterday, we reported on Michael O’Higgins’ “Dogs of the Dow,” approach to investing. Buy the cheapest firms, he says.

Today, the TIMES tells of a similar approach, developed by economists at the London Business School.

Simply rank the 100 biggest stocks on the exchange by dividend yield. Then, buy equal amounts of the top 50. (In effect, you are buying the cheapest stocks – not too different from O’Higgins’ “dogs.”) You repeat this process each year.

If you had done this for the last 105 years, the TIMES reports, a sum of 100 pounds sterling would have grown to 6.9 million pounds this year. If, on the other hand, you had bought high-growth, low-yield stocks, you would only have 296,000 pounds. [Editor’s Note: If you’d invested $5,000 in each one of Steve Sarnoff‘s option recommendations since he took over the service from his father, Paul Sarnoff, you’d now have over $1 million.

*** Long bonds are still going up…with yield on 10-year Treasuries falling below 4%. Nor does gold show any sign of an inflationary boom. Both seem to be signaling that the insiders are right: harder times are coming. (We realize we said that last year too – but we didn’t say when!)

*** Last night, we went to see a play in the West End. “The Longest Journey,” takes place in the trenches of WWI. It is a longish play, a bit too slow for our tastes. We were nearly two hours into it before anyone got killed.

What was fascinating was the parallel with Hitler’s last days in “The Fall.” Here, too, the leader was going off his head. And here, too, the whole cast seem doomed…but no one was able to do anything about it. Instead, every man did his duty. A few delusional characters imagined that they were doing it for some Great Cause. Those who had their wits about them just did what was asked of them.

Many decades later, there are monuments to the winners…those who did their duty. But there are no monuments to those who refused. ‘Tis a pity; they are the ones most deserving of honor.

Imagine what a better world it would have been if both sides had simply laid down their weapons and said: “This is absurd…we don’t even know what we’re fighting for.” It almost happened, by the way. The Germans, the French, and British soldiers took matters into their own hands. They were all so fed up with the war they agreed upon an informal truce. They stopped shooting at each other. They even visited each other’s trenches and traded tobacco and alcohol. The situation threatened to get out of hand…exploding into some kind of peace…until senior officers cracked down and insisted that the men get back in order and start killing each other.

There are no monuments to the peacemakers, nor to the malingerers…nor to deserters. Instead, the granite is chiseled on behalf of the world improvers…and those who go along with them. Again, it is a pity; because it is rare that they deserve it.

In WWI, for example, Woodrow Wilson took center position on the world stage in 1916. He had a big idea that would turn the war into a Great Cause. It is a fight “to make the world safe for democracy,” he said.

The Europeans laughed. Until that moment, they had no idea that the war had anything to do with democracy. But the French and English needed American money…and American blood. Yes, of course, they agreed. It’s a fight for democracy! Thus, did they flatter Wilson’s vanity and flog the troops forward for another two years. Yes, the world would definitely be a better place, they continued…almost biting off their own tongues… if we were all more like you Americans, or at least if we were more like Mr. Wilson would like us to be. And so, the killing went on.

“From now on,” said Woody Allen’s loony activist in “Bananas,” “all citizens will change their underwear six times a day…and wear it on the outside, so we can tell.”

Well, say the apologists, “you can’t make an omelet without breaking some eggs.” Of course, mistakes will be made. Besides, as the Bolsheviks added, we can’t allow petty bourgeois sentiments to interfere with our mission. Build the gulags and concentration camps…raise taxes…starve the peasants! Surely, a better world is worth a little larceny and homicide!

The other way to a better world is much more modest. It recognizes that the petty bourgeois sentiments – honesty, fair play, dignity, manners, charity, and compassion – are not something to be sloughed off in order to build a better society. Instead, they are ends in themselves…they are the substance of a better world, not an impediment to it. This private approach is not grandiose. But, like a private approach to investing, at least it works.