The Advant "Hedge" Of Small Caps?

By: ContraryInvestor | Sat, Apr 1, 2006
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The Advant "Hedge" Of Small Caps?...As you know, moving into the new year there were a lot of folks suggesting that large cap stocks would finally overtake their smaller cap brethren in 2006. Even we suggested that a larger cap defensive stance might be appropriate in the new year. In part, the defensive end of the deal (telecom and health care) has been Okay so far, but the suggestion of looking to the large caps as a class has not yet been the proper market cap stance. Although moving back toward large cap exposure may indeed still be quite appropriate posturing for "tomorrow" for all we know, it so far hasn't been the case in 2006. Year to date, investment performance for the headline equity indices is as follows:

Index YTD Price Performance Through March
Dow 3.7%
S&P 3.7
Russell 2000 13.7
S&P MidCap 400 Index 7.3

As you know, across market history, large cap equity performance relative to small and mid-cap price strength has ebbed and flowed over meaningful periods of time. Half decade stretches of large caps dominating small caps, and vice versa, is far from uncommon. In fact, it's much more the rule than not. You can see this very clearly in the chart below. At least at the moment, we rest at a multi-decade high in terms of Russell 2000 (small cap) price performance relative to the S&P. And although we see a bit of a near term divergence in terms of the monthly RSI configuration being flat against the upward direction of the relative price trend itself between these two indices, both real price action in the market and longer term price trend in the chart below are not suggesting that change in the outperformance of small and mid caps relative to the larger capitalization issues is ready to reverse immediately. Very quickly, we think the 24 month EMA and RSI indicators will help keep us on the right side of the very big relative moves here, but in no way will they get us in or out at exact tops and bottoms.

Moreover, as you'll again see below when looking at the S&P on an equal weighted basis, as opposed to its conventionally cap weighted computation; the index does indeed sit at a new all time high. Again, this is clear testimony to the direction and strength of smaller capitalization equity tiers for now.

As we mentioned in a discussion we did late last year focusing on the operational cash flow numbers of many a large cap company, valuations for the bulk of these large cap big boys has contracted quite significantly since the time of the Dow, S&P and NASDAQ equity index peaks in early 2000. And rightfully so given their extended valuations at that time. But in like manner, macro valuations in the small and mid cap space have increased quite significantly over the last half decade-plus. We currently see multiples of EBITDA (earnings before interest, taxes, depreciation and amortization) in small and mid caps pushing top end historical numbers as of late. The bottom line is that any type of valuation chasm between small and large cap issues that may have existed six years ago near the major market equity index peaks has in very good part been erased. Just have a look below. (Please note we are using trailing twelve months earnings in these calculations. Secondly, we're excluding negative earnings from the Russell numbers. If we had not, the P/E multiples would be much higher.)

Year End TTM P/E Multiples
Year End S&P 500 Russell 2000
2000 27.4x's 15.9x's
2001 46.5 18.3
2002 31.9 16.9
2003 22.8 20.4
2004 20.7 21.8
2005 17.5 21.0

Moreover, at least historically, small caps have not been a great sector to own when the general level of domestic interest rates is rising and when corporate profits peak on a rate of change basis, as we believe is now in the process of occurring. So why the continued out performance of small caps so far in 2006 if a few macro negatives for the group seems firmly in place? And what can we look for in terms of new ways to watch for potential change, since many of the historical tried and true indicators have not yet kicked in, so to speak?

We think there's another very meaningful factor of the moment that may indeed be extending the current small cap cycle, or at least keeping the large caps from acting a bit better, despite many of these companies really being global mutual funds in single stock sheep's clothing, so to speak. And this meaningful factor may be the recent interplay between large institutional money and the hedge fund community. Here's what we're thinking. As you'll remember, whenever we're analyzing the dynamics of sector weighting change in the S&P 500, we're always pretty darn skeptical of the major sector weights of the moment in that excessive sector weightings directly show us what has already been bought by the bulk of the investment community. It's one of the main reasons we have stayed away from the financials over the last few years. Point blank, they are already very widely owned. Well, if one looks across the broad investment landscape both domestically and internationally, it's really the large institutions that can move the markets meaningfully over longer periods of time. As these institutions (state and local pension, private corporate pension, foundation, etc.) allocate capital into and out of various asset classes, they leave a very wide financial wake in their path. And into this wake are pulled many trend traders, momentum types, proprietary trading desks and lesser (than institutional) girth investors, as well as mom and pop America.

As we headed into the latter part of the 1990's, we believe it's very more than fair to say that the very large institutional investors both domestically, and really globally, were more than loaded up with large cap domestic US growth stocks. Why? Because these were the very stocks that had just led a two-decade equity bull market. And, as per the laws of human nature, as a bull market in any asset class reaches its conclusion, the asset class leader is necessarily owned by "everyone". It has to be. Otherwise, of course, it would not have been the bull market leader in the first place. So, as we look back, the large cap US growth stocks were very heavily weighted in large institutional investment portfolios come early 2000. It's no wonder the small and mid-cap issues were able to sprint ahead of the large load the big institutions were carrying in large cap stocks six short years ago. But there's more to the story.

We also know that as the equity markets peaked and institutional pension funds began to fully realize their large cap dominated portfolios were pulling them ever nearer to under funded status by the day as the early 2000's equity bear market began to unfold, they began to scramble in relative earnest for investment return in absolute terms. And because the large institutions by their very nature are "the crowd", and tend to act in herds over longer periods of time, they one by one began allocating increasingly important amounts of their investment dollars to "alternatives". As we all know by now, one of the most popular alternatives over the last half-decade has been the hedge fund product. So here we have large institutions fully loaded with large cap US growth stocks then beginning to increase their funding of alternative/hedge investments. And just where was the money going to come from to fund those alternatives such as the hedge fund complex? You guessed it, from existing large cap investments. Let's face it, where else?

And if we follow this train of logic a bit, once this money for alternative investing got in the hands of your friendly neighborhood hedge fund, where did it then go? Into Coca-Cola? How about GE? Maybe Microsoft? Not on your life. The hedge money went into high beta vehicles. Emerging market, small cap, mid-cap, emerging market debt, etc. It went directly into the financial asset classes that have led the macro charge so far this decade. The bottom line is that by default, movement of large institutional assets over the last half decade has created the perfect environment for higher risk assets to outperform and for the large cap US stocks to at best lay dead. We need to realize that during the current cycle, relative small versus large cap investment performance has as much to do with the changing structure of institutional portfolios as it does with the fundamental merits of large and small company stocks. When we recently looked at 2006 US equity mutual fund inflow characteristics in one of our subscriber discussions, we mentioned that for the first time in memory, large equity index fund inflows have been negative YTD in 2006 while flows to aggressive funds are up strongly and flows into small cap funds remains solidly positive. Remember, the large institutions leave a huge asset performance wake into which the public is ultimately drawn. We're watching this very thing occur right now. The public is selling their large cap index oriented mutual funds so far this year. Remember, at least historically, these folks are always wrong at important market inflection points. So as we move ahead, we need to think about how much small cap strength and large cap weakness is actually reflective of company specific business fundamentals, valuations, etc., and how much is attributable to the ongoing continuation of large institutional portfolio rebalancing. In other words, are individual company small cap investment opportunities leading money to the sector, or is the reallocation of institutional investment money simply "creating" small cap out performance while in extended transition? In our minds, the correct answer to that question will have a large bearing on how we allocate our own investment dollars ahead.

As you've probably anticipated by now, it's time to look at some numbers and relationships. First, we believe there is an observable pattern between the growth in hedge assets under management over time and the relative performance relationship between large and small cap equity sectors. Below is a combo chart showing the growth in hedge industry assets since 1990. Below in the top portion of the chart is the same Russell 2000 and S&P relative performance chart we showed above.

What we notice is that between 1993 and 1995, money being allocated to the hedge complex grew very slowly. In fact nominal dollar growth over these few years was smaller than some monthly growth in hedge assets we've experienced from time to time over the last few years. And although there was decent hedge investment asset growth during 1996 and 1997, additional money being allocated into hedge vehicles in 1998 literally dried up. As is coincidentally true in the bottom portion of the chart, between year-end 1993 and 1998, Russell 2000 investment performance plummeted relative to the S&P. You remember the old saying which is not to be forgotten - follow the money. When the hedge industry was not receiving meaningful additional funding, so too neither were small cap issues outperforming their large cap amigos.

But we think taking this one step further makes the analysis much more meaningful and gives us something to watch and monitor directly. Below is a chart of hedge assets as a percentage of the total capitalization of US equities. The hedge data is the same used to construct the chart above. The equity market capitalization numbers come directly from the Fed Flow of Funds report. In other words, we have not had the ability to manipulate the form of the graph in any manner. Our whole thesis of the importance of the rate of hedge funding and institutional portfolio allocation comes clear below. You can see that although hedge assets were growing in nominal dollars from 1993-2000 in the chart above, the graph below tells us that hedge assets as a percentage of total equity market capitalization was flat over this same period. We believe this is very important in that perhaps the correct question in trying to get a sense for large versus small cap relative performance near term becomes, is the hedge complex becoming a larger part of an expanding equity market, a smaller part, or simply remaining flat? Quite simply, are hedge assets growing at the margin relative to the total equity market or not?

It is absolutely clear over the entire fifteen-year period in the chart above that when hedge assets were growing faster than total equity market capitalization, small caps were outperforming their large cap brothers in arms. But when that was not the case, the large caps took control of the relative performance game. Although our little implicit suggestion of watching the asset base in the hedge complex and monitoring the dynamics of its growth rate relative to the total equity market is not the sole and singular rationale for large versus small cap relative performance dynamics, we believe it is a very important part of the overall financial market capital flow puzzle. And a piece of the puzzle to which we believe the Street has not given much attention. Again, you can count on us monitoring these dynamics over time, as well as keeping an eye on the character or relative index price chart work.

One last comment for perspective. 2005 estimated investment flows into the hedge sector were below 2003 and 2004 experience. We're already seeing a rate of change decline. Although we are in no way making a case for the death of the hedge fund industry, so to speak, have a look at the following table of performance numbers brought to us by the wonderful folks at Greenwich-Van Hedge (GV). We have to believe at this point in the game, more than a few plan sponsors are "asking questions" about the performance advantage of alternative investments. Interesting, no? Does money continue to gush into the hedge community with aggregate numbers like this? Or perhaps the more correct question is, do plan sponsors as fiduciaries continue to believe paying 2% (of asset value) and 20% (of annual profits) is a good thing in terms of gaining increasing exposure to alternative investments?

Index 2005 3 Year Annualized
GV investable 5.0% 10.7%
Long/Short 6.1 16.2
Market Neutral 5.0 6.4
Directional Trading 1.6 (1.7)
Specialty Strategy 7.6 13.3
S&P 500 4.9% 14.4%

As we have suggested many a time over the recent past, we are absolutely convinced that in the current investment environment getting equity sector allocation correct has been and will continue to be a critical part of the ongoing battle. In conjunction with that, equity capitalization and style (growth versus value, etc.) choices are just as important. It's part of our job to provide bigger picture perspective within the context of the ongoing guarantee of the financial markets that is change.




Author: ContraryInvestor

Market Observations

Contrary Investor is written, edited and published by a very small group of "real world" institutional buy-side portfolio managers and analysts with, at minimum, 20 years of individual Street experience. Our credentials include CFA, CPA and CFP, as well as the obligatory MBAs in Finance. We are all either partners or employees of institutions with at least $1 billion under management.

Contrary Investor is our vehicle for providing what we believe is institutional quality financial market research, analysis and commentary that is characterized by honesty, integrity and credibility. We live the business and hope to bring what we learn from our daily experiences to our work at Contrary Investor. Having checked our egos at the door many moons ago, we hope to allow our work to stand on its own and speak for itself, without the personal promotion of any one individual getting in the way. No investment guru's here. Just lifelong students of and participants in an ever-changing financial marketplace.

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