In somewhat of an anomaly in a year full of many anomalies, smaller stocks actually managed to beat larger ones last year. While traditionally, small stocks have fared very poorly in deteriorating economic environments or weak stock markets, they actually outperformed in the last bear market as well. As you can see in the chart below (click to enlarge), which shows the S&P 600 Small-Cap Index since its debut, and contrasts its performance in the bottom panel with its sister index of the S&P 500, the overall relationship has been pretty flat the past few years:
In the late 90s, valuations rose dramatically on the largest stocks, setting the stage for smaller stocks to do better as the large-cap PEs corrected. More recently, the relative performance has been consistent (a function, I believe, of the battering the dollar took that aided export-sensitive large companies), but the relationship was very volatlile last year. In the summer, due primarily to massive short-covering of a large macro trade, the smaller stocks spiked to an all-time relative high before getting crushed in the first part of Q4. In December, small-cap bounced back strongly, but it is behind thus far in 2009.
While the Russell 2000 may be a more popular benchmark, I am going to focus on the S&P 600. For those not inimately familiar with the differences and similarities between Russell and Standard & Poor's indices, here are a few things to consider:
- Russell rebalances annually by strict rules, while S&P has a committee that continually adjusts its indices for "representativeness"
- Russell cuts the top 3000 stocks into the R1000 and the R2000, the latter of which is "small-cap".
- S&P partitions the top 1500 by the top 500 (large-cap), the next 400 (mid-cap) and the final 600 (small-cap).
- The market cap of the R2000 is higher than that of the S&P 600 in aggregate, but there is significant overlap
While I remain very bearish and am sticking to the forecast I recently shared regarding the bear market continuing this year, I do believe that smaller stocks in general will outperform larger ones. Most importantly, I believe that there will be many small stocks that have a reasonable chance of actually preserving most of, if not all their value this year.
Before supporting my less pessimistic outlook on smaller stocks, I would like to put the universe into perspective. If all 600 members of this index were a company, they would be the 2nd largest in the S&P 500:
When one looks at it this way, one realizes that the whole small-cap market is rather trivial compared to the overall market. When comparing its composition at a top-level to that of the S&P 500, several differences stand out:
I highlighted the most significant deviations, most of which bother me at the first glance. I actually prefer Energy to Industrials, so this disturbs me a bit. It also seems a bit unfair to have to compete with extra Financials vs traditional bear-market stalwart Consumer Staples.
I have written in detail in the past, though, that small-cap Financials are a very different entity than the large-cap ones. With that said, I am not particularly excited about a lot of exposure to regional banks. Staples, though, are overvalued in many cases.
As I will describe later, I believe that my biases about sectors may be more relevant to larger companies than to smaller ones. One major risk-factor that I should mention is that the decline in retail investor participation and the decimation of the hedge fund community, which is typically net-long small stocks, will serve as headwinds this year.
So, why do I think the Small-Cap sector could offer better relative performance in a weak market?
- Better balance sheets
- More nimble
- M&A potential
If I had to pick a single factor that will drive stock prices this year, it is the level of indebtedness. While I believe that the market is well aware of leverage in Financials, it is transitioning still to the idea that deleveraging in other sectors could have significant implications on borrowing costs and, in some cases, control of the company.
I have looked at a number of different measures of leverage and find rather dramatic differences no matter how I look at it. On a net debt to capital basis, the S&P 600 has an overall advantage relative to the S&P 500, but it really shows up at the median: 19% vs 28%. Given that the composition is quite different (especially with the big weighting of Financials in the S&P 500), I looked at the sector level and found almost universally better comparisons, with significantly less net debt to cap in Industrials, Consumer Discretionary, Staples, and Health (actually net cash).
On other measures that go beyond just "debt" and focus on liabilities relative to EBITDA or current assets, the smaller companies dominate in every sector. So, in a year where having a better balance sheet could be the difference between insolvency or higher borrowing costs or not, the edge goes to smaller companies.
My next point is perhaps a bit touchy-feely, but I have long maintained that in a maturing or slowing economy especially, it is easier for small companies to adapt to change. Larger companies are now jettisoning huge chunks of their employee base to cut costs, as this is about all they can do.
Small companies, in my opinion, are able to actually make business process changes more quickly and react to changing circumstances. I do understand that many of the smaller companies are often relegated to being the tail that the big dog wags, but there are truly some niche companies out there that can preserve pricing power and even volumes due to their unique nature.
On valuation, smaller companies are more expensive on some measures, but cheaper on others. On PE, either trailing or forward looking, the large companies are certainly cheaper on a market-cap weighted basis. This is not the case when looking at the median, where smaller companies command just a fraction of a premium. On a trailing basis, the median of the S&P 600 is 10.9X compared to 10.4X for the S&P 500. Looking at EV/EBITDA, which adjusts for the higher net debt burden to some degree, the market-weighted average is 8X for both, though the median valuation is 6.3X for the smaller companies and 6.6X for the larger ones.
So far, I would have to say valuation isn't really an issue, but my new favorite metric for bear markets especially of price to tangible book paints an entirely different picture. One has to be careful here, though, as the presence of so many negative ratios in the S&P 500 distorts the overall averages. The bottom line is that 58% of the S&P 600 trades between 0 and 3X tangible book value, while only 38% of the S&P 500 does. This is important potential downside protection.
My final argument too is hard to support beyond anecdotal evidence and logic, but it is clear that mergers of size are much tougher than they have been in quite some time (the big Pfizer (PFE)/Wyeth (WYE) deal today notwithstanding!). If I am correct that the present conditions of a weak economy and fragile banking system will remain in place for quite some time, things like share repurchases and accretive M&A won't be coming back for quite some time. In the interim, though, it seems feasible that larger companies could do smaller deals, whether with private companies or with publicly traded ones. With the whole pot of money for LBOs and deal-related financing a shadow of its former self, it would seem that only smaller companies have much of a chance of accessing what is available. Again, this phenomenon could offer modest support in a challenging environment.
So, clearly I don't expect great things from stocks whether large or small, but I do believe that smaller companies have a better risk/reward profile here than larger ones. In a year in which I expect balance sheet pressures and extreme pressure on sales, margins and thus profits, I think it makes sense to find companies with strong balance sheets and low valuations relative to their assets. It appears that we are much more likely to find those attributes within the small-cap universe than among larger companies. Thus, I believe that a higher allocation in general or a greater focus on individual small-cap names makes a lot of sense in 2009.
Disclosure: No position in any stock mentioned.