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Summary

  • Small-caps and mid-caps often offer above average earnings growth.
  • Under-covered stocks often provide outsized returns over the long term.
  • The Russell 2000 is leaving the level at which it bottomed twice in 2014.

Everything-Else Caps

I had been writing mostly about large-cap stocks up until a few weeks ago, so the goal of this article is to explain why I recently shifted my focus back to small-caps and mid-caps. Certain parts of my investment theses are common to all of the small- and mid-caps I cover, but detailing those aspects of my theses in the articles about each company would make those articles even longer and harder to follow. So, this article explains the common threads that apply to all small-caps and mid-caps I've written about lately, as well as others that I may write about soon. First, I should explain the article title.

The first part of the title, "everything-else caps," is from my late-July market outlook article 2014 Mid-Year Call Performance And Updates, and refers to the fact that very many investors lump together all small-caps and mid-caps. I believe that is important because it means when there is opportunity in the small-cap group, there is often opportunity in some mid-caps too:

"Even prior to the Fed kick, I planned to shift my focus back to small- and mid-cap stocks after my next article, but I now plan to hasten that pivot. I included mid-caps because a large portion of investors makes no distinctions between small-caps and mid-caps, so the common view is mega-caps, large-caps and everything-else caps. As examples of the opportunities that result from that, the two top-performing picks in the above list are both mid-cap companies (MTW and TRN)."

That comment is out of context here, so I'll clarify that "the Fed kick" refers to the "smaller firms in the social media and biotechnology industries" part of the recent Fed report [pdf] and follow-up comments from Fed Chair Janet Yellen, which many interpreted to mean that all everything-else caps are in a bubble.

More specifically, I was pointing out the fact that the Russell 2000 small-cap index has bottomed twice so far in 2014, and both bottoms were at the 1,100 level the Russell 2000 was approaching when I made the comment.

(click to enlarge)Source: Google Finance

By the way, the S&P 600 small-cap index has exhibited similar behavior so far in 2014, though with each bottom a little higher than the previous bottom.

(click to enlarge)Source: Google Finance

In any case, the rest of the article title, "Know What You Own, And Why," is a paraphrasing of this famous Peter Lynch quote:

"Know what you own, and know why you own it."

― Peter Lynch

Know What You Own, And Why You Own It

Mr. Lynch wasn't referring specifically to small-caps or mid-caps, but I believe his sentiment is even more prescient when it comes to "everything-else caps," which brings me to the main point of this article. I'll state that main point in a way that incorporates the three sub-points within it -- especially in regards to everything-else caps, it is important to understand: [1] not only the individual businesses that we invest in, but also [2] the general characteristics that apply to all everything-else caps, and [3] the reasons why it can be beneficial to own some everything-else caps in a well-balanced portfolio. I'll start with the third sub-point, since the rationale progresses better when built upon in that order.

[3] Earnings Growth

The main reason I buy everything-else caps is to add growth to portfolios and balance the relative stability that large-caps offer. Because smaller companies typically have more room to grow than larger companies, small- and mid-cap companies sometimes offer earnings growth rates that are harder to find in a large-cap without excessive risk. For example, 10-20% EPS growth per year over a five-year period is attractive to me as a long-term investor, especially when in an industry I like and from a company that I believe is undervalued.

Please note that I have written out specific valuation opinions for each of the following stocks, and all except two were significantly cheaper just a couple of weeks ago [Intercontinental Hotels Group (NYSE:IHG) and Manitowoc Co. (NYSE:MTW)], so my use of these stocks as examples here does not supplant my detailed valuation opinions specific to each individual stock.

With that said, below are the consensus next-year and next-five-year earnings growth projections for each of the small-cap and mid-cap stocks that I cover.

Company (Exchange:Ticker Symbol)

Next-Year EPS Growth

Next-Five-Year EPS Growth

Aceto Corporation (NASDAQ:ACET)

13.00%

24.00%

CECO Environmental (NASDAQ:CECE)

14.10%

18.00%

Consolidated Water (NASDAQ:CWCO)

70.00%

9.00%

Compressco Partners, LP (GSJK)

8.30%

N/A

HealthSouth Corporation (NYSE:HLS)

6.20%

8.96%

InterContinental Hotels [ADR]

10.10%

9.40%

Mueller Water Products (NYSE:MWA)

48.40%

10.00%

Manitowoc Company

17.90%

24.10%

Raymond James Financial (NYSE:RJF)

12.10%

17.00%

Standex International (NYSE:SXI)

15.20%

14.00%

Trinity Industries (NYSE:TRN)

-4.10%

10.00%

Source: Yahoo Finance

Yes, there are large-caps and mega-caps with EPS growth projections that are comparable or even far higher, but they also tend to have characteristics that these everything-else caps do not. For example, none of these examples have a 500x P/E ratio, negative earnings or are in either the biotech or social media industries that some consider in bubblicious territory. That is not to say there is anything inherently wrong with owning those types of stocks -- I have in the past, but that was many years ago and I'm not getting younger, so it just does not suit my current risk tolerance, time horizon, investment strategies, etc.

Company

Market Cap

Dividend Yield

Trailing P/E

Forward P/E

Aceto Corporation

$527.46M

1.31%

17.91x

16.33x

CECO Environmental

$361.28M

1.71%

14.89x

12.39x

Consolidated Water

$171.53M

2.57%

32.39x

17.15x

Compressco Partners, LP

$757.37M

7.37%

18.69x

18.69x

HealthSouth Corporation

$3.47B

2.13%

19.56x

17.72x

InterContinental Hotels

$8.90B

1.81%

24.77x

21.51x

Mueller Water Products

$1.43B

0.78%

33.26x

19.52x

Manitowoc Company

$3.74B

0.29%

20.03x

15.02x

Raymond James Financial

$7.29B

1.23%

15.71x

14.44x

Standex International

$891.88M

0.57%

18.14x

15.35x

Trinity Industries

$6.87B

0.91%

11.63x

11.19x

Source: Yahoo Finance & Dividend.com (as of 8/15/2014 market close)

Please note that I'm using these examples to help illustrate the broader points that I'm trying to make in this article, so conclusions shouldn't be drawn from a single data point out of context. For example, what can be considered a high or low P/E ratio varies a great deal among different industries, and the details of each company can also make a big difference. For example, a company can have a high trailing P/E, yet a forward P/E that is low relative to the historical or industry range, if the company is coming out of a period of low earnings for some reason or another. And, that cuts both ways, since consensus estimates can sometimes be skewed by one extremely optimistic or pessimistic estimate.

[2] Volatility Benefits

"Never think that lack of variability is stability. Don't confuse lack of volatility with stability, ever."

― Nassim Nicholas Taleb (professor who coined the term "Black Swan")

It's true that most large-caps won't lose 20% or more within months, absent a market-wide correction, but it's also true that most large-caps won't gain 60% within months, before retracing 20% of an initial 60% gain. When it's all said and done, a small cap that gains 60%, then gives back 20%, has still gained 40%. That's 20% per year, without dividends. In fact, when outsized returns are achieved in only a matter of months, the returns are actually higher when annualized (i.e., 20% gain in a few months might be 50% annualized, without dividends). Perhaps the best way to make my point is to offer an example.

I open a new small-cap stock position at $15; X months later, that stock is at $18 (20% above $15); another X months later, the stock is back down to $14 (7% below $15); another X months later, the stock is at $16 (7% above $15); and another X months later, the stock is $20 (33% above $15).

The final outcome obviously depends on what value we use to replace each "X" for the number of months, but to keep the math simple in the example, I'll use 6 for all of the time periods. That makes the total time period for the example exactly two years so, with the original buy price of $15, the result is a 16.5% annual return on one holding for two full years in a row (excluding dividends).

By the way, if one had bought equal amounts of the stock when first opening a new position at $15, again when the stock dropped to $14, and again when it rose to $16; the outcome is the same -- the average price is still $15. Staging into a stock position with several separate buys not only makes each buy price less critical to the average cost basis, but it also provides opportunities to exit positions with minimal capital risk if we change our mind. Buying stocks via a staging/scaling/averaging method is detailed in an old Instablog of mine, but at least note that it's very different from dollar cost averaging, which is buying fixed dollar amounts at predetermined intervals, regardless of share prices.

The average dividend yield from all of the stocks listed above is 1.88%, so I'll round that down and just call it 1.5%, which makes total return 18% per year for two full years (including dividends). I consider an 18% annual return more than acceptable, especially since it is usually difficult to achieve even half of an 18% annual return with most large-cap stocks in a typical year.

To the contrary, if the reaction to a drop down to $14 is to panic and sell out, the investor loses 7%, instead of gaining 18%. Dividends are not added back into the loss estimate because there is only a chance of receiving one dividend payment when the stock is only held for a few months, versus the practically guaranteed receipt of all eight dividend payments (thus, the full annual yield) when the stock is held for the full two-year period of the example.

The point here is that most everything-else caps are inherently more volatile than large-caps, but that is not necessarily a bad thing. One reason for the added volatility is that the share prices of small- and mid-caps are generally far lower than large-caps. That makes the everything-else caps much more susceptible to the whims of short-term traders and inexperienced investors who have far less conviction in their decisions, so shares get shaken out of weak hands far more easily. That's precisely when I aim to be a buyer.

For me, it is important to remember that the example above is actually a very short-term oriented scenario. As a long-term investor, what truly interests me is not where the share prices of my everything-else caps will be in X months, or even two years. What I really care about is where those share prices will be in five, ten and twenty years. That may seem ethereal to some investors, but those are the kinds of time frames that many investors think about when we discuss "long-term" investing. I don't expect to be around in twenty years, but I have done well holding some stocks for decades, and many lives have been changed dramatically by passing investments from one generation to the next.

[1] Investment Theses

The need to understand the businesses in which we invest is self-explanatory, so I won't spend as much time on it. However, that should not give the wrong impression, since the subject is even more critical with everything-else caps.

Of course, the belief that the share price will appreciate over time is a central part of the reason for owning any stock, but it is not an investment thesis. By definition, small-cap companies have fewer resources than larger companies, so they are often more difficult to get detailed information about.

One of my frustrations in trying to research small-cap companies is that their investor relations websites often have far less information about the company (i.e., downloadable presentations are rare). Small- and mid-cap companies also tend to have far less analyst coverage from research firms. However, neither of those hurdles is insurmountable, and can actually be beneficial.

What I mean is that one of the main things that can drive a small-cap stock to realize its true value is when major research firms initiate new coverage. The typical large-cap already has a dozen or more analysts covering the company, so the addition of one more usually has a muted impact. On the other hand, a small-cap with only three or four analysts covering the company can see a big boost in both exposure and investor confidence when one firm adds coverage.

Similarly, one reason it's usually more difficult to achieve outsized returns with large-caps is because literally everyone already knows about the stock. Over my years of investing, my experience has consistently been that most of my highest gains are from sparsely-covered everything-else-cap companies that most investors had never even heard of. Resources like Seeking Alpha help fill in gaps in research on under-the-radar stocks, so most investors can benefit by expanding their horizons to consider under-covered everything-else caps.

I said "most" investors because small-caps are not necessarily suitable for all investors. Since due diligence is typically more difficult with small-caps, and they also require more due diligence, it may not be appropriate for an investor who does not have the know-how, time and interest in researching the stocks in which they invest. In fact, I would argue that such investors are better off to invest through a financial adviser and/or via indexing, rather than buying individual stocks. Personally, in most cases, I do not believe everything-else caps are appropriate for retirees or other particularly risk-averse investors, nor for small portfolios that only include a small number of holdings and that are not well diversified across market-caps, sectors, etc.

For example, my portfolio has about twenty five positions, which is much more than manageable or appropriate for most individual investors. About 40-50% is large-caps, 20-30% mid-caps and 20-30% small-caps. It's also very diverse across sectors and industries, as well as types of stocks and their roles. Some holdings are for wealth creation (growth stocks), others for income generation (dividends) and others capital preservation (defensive stocks). As a long-term investor with a fairly large portfolio, I manage both my risks and my returns at both the individual holding level and the portfolio level. One of the many ways I accomplish that is through diversification, including varying market-caps.

However, that only describes part of my risk-management approach in regards to individual equities, and my equities portfolio does not represent the entirety of my investments. For the record, I do not consider only owning individual stocks to provide adequate risk management for total investable assets.

Conclusions

While I obviously believe it's important to understand and consider the various characteristics of stocks that relate to market capitalization, I also don't want to overstate the importance of market cap. The cut-off between mid-cap and large-cap is $10 billion, and several of the mid-caps in the list above are in the $6-9 billion market-cap range. It is not as though the companies will magically and suddenly become better investments when they cross over the $10 billion threshold on a consistent basis to be re-classified as large-caps.

With that said, I also believe there is long-term opportunity in everything-else caps. As I wrote in my recent mid-year market outlook article, which a link is provided for toward the beginning of this article:

"When all small-caps are randomly sold at lows, as has been happening for months, the good ones that are already undervalued are sold off with the rest. This is an opportunity that was already brewing and, with a little help from our Fed, is near-ripe for picking by long-term investors."

I said I consider the opportunities "near" ripe for picking because, if we get a market-wide correction before small caps recover, that would be a most ideal combination of factors to create bargains. I shared that same opinion in my article Corrections Come, Corrections Go on February 5, which turned out to be one of the two bottoms for the Russell 2000 this year, down to the day:

"It's important to know that all small-cap growth stocks tend to get hit in "risk-off" scenarios. That does not mean that a stock is broken so, if you "know what you own, and why you own it," don't get spooked too easily and sell at bottoms, instead of buy at bottoms."

While I'm far from among those who have been calling for a deep market-wide correction every day since 2009, for only the second time in about two years, I had been saying for the last two months that I believe a correction is near. I actually think a correction started around July 31, and I'm not entirely certain that it's over yet, though it appears that way so far. In either case, I believe a correction would be brief, mild and in the context of a secular bull market that will continue at least a few more years, if not many. Thus, my opinion is that averaging into positions is as important as always right now, if not more. In fact, that is one of the central points of this article -- while it is certainly most appropriate to question and re-evaluate our investment thesis and valuations when a stock drops in price, that is not the same as panicking and selling at a short-term bottom, instead of buying for the long-term at short-term bottoms.

The first week of July was the worst week for the Russell 2000 small-cap index in over two years and, as mentioned earlier, that index was recently very close to the 1,100 level that turned out to be where both of the two bottoms so far this year have occurred. I believe that could mean long-term opportunities.

At the same time, I'm not arguing that the level of other recent bottoms in the Russell 2000 will necessarily be the level for all future bottoms. It remains to be seen whether the recent market-wide pullback and the subsequent rebound turns out to be just a bounce in what could develop into a full correction in the coming weeks or months, or that pullback and subsequent rebound turns out to be the extent of the market weakness and the broader uptrend resumes.

Personally, I think it could go either way in the short-term, and I think which way it goes in the short-term will ultimately be determined by how the current geopolitical issues play out. Over the longer-term, I'm confident that investing in everything-else caps will continue adding significant returns to my overall portfolio, and I encourage other investors to consider the possibilities.

Thank you for reading. Consider the "Follow" button at the top of the page to see my new articles on your SA home page, since many are only free for thirty days. I apologize in advance that I can no longer dedicate time to reading and responding to comments beyond the opinions I offer in my articles. As always, every reader is free to dismiss any or all of my opinions. Or, as SA words that: "Read. Decide. Invest." I wish you the best with the rest of your due diligence.

I wrote this article 8/4-8/17.