Our year-end roundtable rolls into 2020 with a look at small-cap investing.
While the indices have lagged the large-cap ones, our panel sees opportunities available out there.
Some of that is reversion, but some of that is knowing what to look for and where.
2019 finishes with an extra kick for investors. Part of that is the continued strong run of the market, erasing memories of last year's near bear market and extending the decade-long bull. There also are plenty of market headlines and events that have sprung over the end of the year, from Phase 1 trade deals to M&A to political whirlwinds and more.
More trivially, the 2010s are ending and the 2020s begin. It has been quite a decade for equity investors, with the S&P 500 returning more than 250% in that time. Even underperformance could leave a portfolio in good shape, and any alpha that was found would really leave investors well off.
Where does that leave investors and the markets for 2020, at the start of a new decade? That's what we try to answer in our annual Marketplace Roundtable series. We are publishing roundtable discussions featuring more than 80 authors from across the spectrum of investing styles and focuses you find on Seeking Alpha: Macro to value investing, small cap to energy, gold to quant and alternative strategies, and more.
Today's discussion focuses on Small Caps, which rebounded from last year's brief bear market but still lagged their larger peers. We're featuring the following panel:
- Ruerd Heeg, author of Global Deep Value Stocks
- Joseph L. Shaefer, author of The Investor's Edge
- The Value Pendulum, author of Asia Value and Moat Stocks
- Safety In Value, author of Microcap Review
The stock market has had another strong year, recovering from last year's Q4 correction. The S&P 500 has returned 10% annualized over the last two years, as of early December. Yet there's still a sense that the music is due to stop among many investors (see the theme of "most hated bull market"). Where do you fall out?
Ruerd Heeg: I agree the music is about to stop. I think, going forward, we will see the negative effects of flexible monetary policies. In particular, the Fed has started to be more flexible again. In 2009, with unemployment at over 10%, such policies were needed. Now, with unemployment below 4%, such policies could trigger high inflation.
Joseph L. Shaefer: I care - but not that much. I will continue to stay long, and I will continue to enter trailing stops under my long positions. If the market rises, I will continue to enjoy the ride. If it falls, I will only see a slight dent in our profits. As I aggregate cash from those sales, I will place it in less volatile income issues. I believe that the low interest rate environment provides a serious boost to what is "seasonally" a so-so year, so my "opinion" is that it will be an up year. But my opinion and that of a million others is worth far less than my conviction to let my profits run until Mr. Market changes direction.
The Value Pendulum: There are cheaper markets outside the U.S. The MSCI AC Asia ex Japan Index trades at 13 times P/E and 1.4 times P/B, on par with 10-year historical average P/E and P/B ratios of 12 times and 1.5 times, respectively. In contrast, the MSCI US Index trades at 18 times P/E and 3.2 times P/B, vs. historical 10-year average P/E and P/B of 15 times and 2.4 times, respectively. Investing legend Peter Cundill had a habit of travelling to the place with the worst stock market in the world in the first 11 months of the year to find new investment opportunities, and he would have considered Asia (half the returns of the U.S. market year-to-date). All valuation metrics are based on consensus forward 12-month estimates and share prices as of December 3, 2019.
Safety In Value: I don't spend much time thinking about the level of the overall market. The beauty of investing in micro-cap stocks is that there's always some that are out of favor at any level of the market. I also think the highs the US market is experiencing aren't universal, so foreign markets are a potential source of outperformance going forward.
What's a lesson you learned in 2019?
Ruerd Heeg: The low settlement in the GCVRZ (Sanofi) lawsuit surprised me. The reason for this low settlement is a recent verdict in another, similar case. This Holland-Loader verdict sets a much higher bar for proving damages from contract breach. I think it kind of overrules a verdict in a much older case. Because of the new verdict, it will be difficult to enforce modern contracts using concepts such as "best efforts" and "diligent efforts." I consider this as a setback for business in the US. In today's complex society, it would make sense if contracts with such general but still meaningful terms can be enforced without too much hassle. So, the lesson is judges can decide something different from what makes sense, even if society is much better off with a different decision. I wonder whether there's a political angle to the Holland-Loader decision.
Joseph L. Shaefer: Use trailing stops. Flexibility is the watchword of survival.
Safety In Value: I'm a value investor. One consequence of that lately is that I have often been too early and too conservative to my best ideas. One example of this was my position in iStar (STAR). I took a position there in the summer of 2018 and added it to my portfolio for subscribers with a start price of $10.91. This was too early, and the shares didn't bottom for another nine months or so. However, I made the company my top idea for subscribers in March 2019 after they had declined to $8.53. I bought out of the money call options ($10 strike) at that time as the discount was very large. However, I sold those call options when the shares hit $11. The return on the options was very significant, but the shares were still very cheap (which is why I bought them at $10.91 initially). I kept the equity position, and the shares are now above $13, but keeping the options would have provided additional leverage. The lesson here is that great ideas often seem played out to a value investor when the general market is only just waking up to them.
I wish this question would not be relevant, but small caps continue to lag, at least on the index level. Is this just a matter of indices not being reflective of the sector, temporary (if persistent) underperformance, or something more secular?
Ruerd Heeg: A subscriber of my newsletter sometimes computes returns of the global nanocaps I find with my quantitative algorithms. These are the very smallest smallcaps. He found a return of 23% for the best 20 ranked nanocap stocks from my ranking made in December 2018. For the best 30 stocks, it was 15%. For the best 20 ranked nanocaps with market caps below $10 million, he even found much better returns. So, maybe US-listed small caps lag, but I do not think global nanocaps lag. Almost all extra returns from stocks with small market caps are found with market caps below $25 million. With larger smallcaps investors still get extra returns from the effect of lower trading liquidity with small stocks. Maybe in late stage bull markets, these larger smallcaps also trade with greater liquidity resulting in lower returns. Anyway, for better returns, I rank stocks of each strategy on trading liquidity. The nanocaps (market cap below $25 million) are also ranked on market cap.
Joseph L. Shaefer: Temporary underperformance. In these days of some companies at or above $1 trillion in market cap, the old $2 billion as a general marker where small caps become mid caps is outdated. I consider small caps to be more in the $5 billion range and mid caps as high as $20 billion. I am "not" a small cap advisor or investor! But, this year, I see their temporary underperformance as a sign that these quality firms with smaller market caps are ready to break out as many investors refuse to pay ever more for a well-known name. That is why, for 2020, I'm a small and midcap fan.
The Value Pendulum: I focus on Asian stock markets with a bias toward small caps. Small cap underperformance is a familiar story in most global markets, and not just in the U.S. The MSCI AC Asia ex Japan Small Cap Index also has underperformed the MSCI AC Asia ex Japan Index by more than 10% in the first 11 months of 2019. I have no idea if and when the trend of small-cap underperformance will reverse. But under-valued stocks are driven by either fear or neglect, and small caps haven't been that neglected and undervalued for quite a while. I continue to find interesting small-cap stocks in Asia where the degree of their undervaluation is not justified by the discount attributed to their size (or lack of).
Safety In Value: I think there are a few things at work here. Indices are much less representative of the investing universe in the small and micro cap areas for a few reasons. A big one is that they tend to be capitalization weighted, and small caps tend to be an area where there are a lot of terrible companies trading at absurd valuations. So, when those companies find their way into an index and subsequently perform terribly, it makes the index look bad. The other factor is that small-cap indexes have lower weightings toward emerging technology companies because the "unicorn" type firms tend to stay private until they are big enough to be in a larger capitalization index. Since FAANG-type stocks have been a huge portion of the market's movement, that has penalized small-cap indices. I think the outperformance of venture capital type technology businesses is likely cyclical, but the headwind of terrible businesses in small-cap indices is likely permanent, which makes stock picking more important.
On the one hand, there are more and more investing information and investors in the world, and fewer publicly-traded companies to invest in, so that it would seem harder to find an edge. On the other side, pressure on sell-side research means even large caps may generate less coverage, never mind small caps. What do you think of the opportunity set for investment ideas today, and how has that been changing?
Ruerd Heeg: There's indeed a lot of information available with just a few mouse clicks. With all this information, it's a great time for investors who are willing to do a minimum amount of research. You could call that an edge. What's important is that such an edge also consists of knowledge about what kind of information to look for. For me, that's any information suggesting higher returns on a statistical basis. Unfortunately, such an edge is smaller for an investor investing only in US-listed companies than for those investing also in foreign companies. Fortunately, investors willing to do the hard work can adapt: They can invest abroad much easier than 20 years ago. When they adapt to investing globally, the number of opportunities is bigger than ever.
Joseph L. Shaefer: The fewer Wall Street analysts covering a company, the better I like it. Texas Pacific Land Trust (NYSE:TPL) is a great example. Getting information is not easy, most analysts are too lazy to tear into SEC-required documents. Yet that's often the only place you can find solid information on some companies. Low-float "small caps" like TPL and JG Boswell (OTCPK:BWEL), dripping with value, are two examples. Sshhh, don't tell Wall Street. The opportunity set for those of us willing to find the beautiful flowers among the weeds has never been better - or more rewarding.
The Value Pendulum: Counter-intuitively, the opportunity set for investment ideas in small caps has gotten larger, as investor funds are increasingly allocated to large caps. More funds are flowing into large-cap stocks due to their outperformance (chasing performance), smart small-cap fund managers migrating to the large-cap space as their AUMs grow, passive investing (ETFs mimicking market cap-weighted indices) and other factors. As the share prices of an increasing number of small-cap stocks remain depressed and they do not migrate to the mid-cap and large-cap segments, the small-cap stock universe expands, resulting in a larger opportunity set. More importantly, the investing edge in small-cap stocks is a behavioral edge rather than an informational one. It becomes harder (mentally) to invest in small-cap opportunities when your peers are doing better buying large-cap stocks and your portfolio holdings are not the "Cocktail Party Stocks" you wished they were.
What's one thing you do to learn about a new company when there's less readily-available information on it?
Ruerd Heeg: As a quant, I do not believe in stories, so no problem if there's not enough information for a story. Instead, I believe in consistently comparing stocks with each other. So, just like I make my quantitative rankings, I try to do research in a consistent way. So, I always investigate the same things such as basic financial data, multiples, signs of financial distress, corporate governance, payouts, shareholder ownership, related party transactions and management compensation. This information is available from the financial reports. If a company does not publish financial reports or if financial reports cannot be machine translated, I won't research it.
Joseph L. Shaefer: (1) Call my friend EDGAR - the Electronic Data Gathering, Analysis and Retrieval system used by the SEC for submissions by companies and others who are required by law to file information with the SEC. (2) Scan local newspapers where a company I find of interest is headquartered or has a sizable workforce. I often find that these great companies flying below Wall Street's radar are big news in towns where a large number of employees are located. And, the writing is often less ponderous, too!
The Value Pendulum: I try to learn about a new company via multiple sources, including but not limited to corporate access events, company earnings calls, news articles, third-party industry research reports, customer product review, employee reviews, recruitment ads, Google tools such as Google Trends and Google Earth, buy side fund manager letters, sell-side analyst reports, and social media. This is especially relevant with regard to investing in Asia-listed companies, where annual reports are usually less informative and detailed compared with U.S. companies' 10-Ks, and companies have no obligation to provide the public with access to quarterly earnings calls or results briefings.
Safety In Value: I think the size range where companies are underfollowed is actually getting larger because of less analyst coverage as well as more investors moving funds to passive mandates. Investors chasing performance (which has been in large caps for a number of years) also is a factor because that puts less eyes on small caps, making the market even less efficient. The size of businesses I've been finding what I consider mispriced opportunities in has been getting larger.
What was a big story for 2019?
Ruerd Heeg: During the summer of 2018, the Turkish lira and stock market crashed. Even more so, the smallest Turkish stocks. While the general Turkish stock market has rebounded only partly, the smallest Turkish stocks have rebounded strongly. It pays off to look for maximum pessimism in sectors and countries.
Joseph L. Shaefer: The willingness of a US government to do what it takes to make certain the totalitarian and mercantilistic People's Republic of China understand that actions have consequences. Like, for instance, that property theft, intellectual theft, industrial and defense espionage, bullying, and cheating on trade will be met with sanctions, tariffs, and a reduced GNP. That's the story of 2019 that will reverberate for many years.
What are you focused on in 2020?
Ruerd Heeg: Apart from researching the best-ranked stocks from multiple strategies, I try to keep my subscribers up to date on important news. For example, by pointing them at countries and sectors with very high market pessimism. As I have seen several times before, the smallest stocks rebound extremely well after a period of very high market pessimism.
Joseph L. Shaefer: Remaining diversified, remaining safe with a portfolio that welcomes all asset classes, keeping the income flowing no matter what the market is doing and finding the occasional flowers hiding among the weeds.
The Value Pendulum: My favorite quote from Peter Lynch is "the person who turns over the most rocks wins the game", and that's my investment philosophy as well. Focusing on specific sectors and themes with the aim of identifying trends and timing the market is dangerous. I prefer to learn about as many companies as I can and pick the best investment candidates by casting a wider net. I make it a point to study at least one new Asia-listed company every week.
Safety In Value: One big focus for me in 2020 is special situations. There are always opportunities at any market level, especially among small stocks. However, as markets have continued to move up the expected return on many stocks has come down. On the other hand, that has also generated more special situation ideas, as mergers and tenders among small stocks have been increasing. My focus is moving more and more to these ideas, where I believe there's significant outperformance. I consistently write up 4-6 small stock special situation ideas for my subscribers every month, and I have begun releasing ~1/month publicly on my blog, which is delivered to my public site followers.
What's a favorite idea for 2020, and what's the story?
Ruerd Heeg: As a quant, I do not have many favorite ideas. More generally, I warn against investments with attractive stories. Instead, it's better to invest in a basket of stocks with high returns on a statistical basis such as net-nets or cheap nanocaps. US-listed examples are JLM Couture (OTCPK:JLMC), TOR Minerals International (OTCPK:TORM), Aerpio Pharmaceuticals (ARPO), P&F Industries (PFIN) and Westell Technologies (WSTL). In December 2018, I mentioned the Genzyme Contingent Value Right (GCVRZ) as my best idea at $0.5, in a similar roundtable article. Now, it's about $0.858. I expect a final payout of $0.88 most likely already before the end of 2019. So, despite having gone up so much, this is now an arbitrage opportunity with a huge annualized return.
Joseph L. Shaefer: Texas Pacific Land Trust. I have now purchased it four times in the low 600s, once at 595 - and sold as it went to 690 or 700, always retaining a few shares of ''the house's money" I took off the table. This has to be the least sexy stock out there. They own land. Their charter says they have to sell off the land at propitious times and good prices. There's no mandate to sell anything by a certain time, however. So, the value of their holdings in the West Texas Permian Basin just keeps rising. They may sell a couple acres here or there, but, frankly, they are making more money leasing the land to oil and gas companies for a royalty override. Now, they have added the sale of some of their 100%-owned water to these same companies. When you are sitting on a gold mine, you only have to sell a little to pay expenses and let the world come to you. TPL is sitting on a metaphorical gold mine.
The Value Pendulum: One of my favorite ideas for 2020 is Hong Kong-listed Hong Kong-listed Far East Consortium International (OTC:FRTCF) [35:HK], a diversified property conglomerate. Far East Consortium deserves to trade at a premium to its Hong Kong and China peers which have assets concentrated in Hong Kong or Mainland China, and derive most of their earnings from the cyclical and volatile property development business. Firstly, the company is diversified geographically with properties in Hong Kong, Australia & New Zealand, Singapore, Mainland China, U.K. & Continental Europe, and Malaysia. Secondly, Far East Consortium generates a high proportion of its earnings (56% of FY2019 YE March core cash profit) from recurring income generated by its hotels, car park and facility management businesses, and other investment properties.
Far East Consortium trades at 0.72 times P/B, and 0.30 times revalued net asset value per share or RNAV (adjusting for the market value of its hotel portfolio) based on its share price of HK$4.00 as of Dec. 13, 2019. The stock also offers a consensus forward FY2020 dividend yield of 5.5%. The company announced on Nov. 28, 2019, that it was considering a potential spin-off and IPO of certain of its overseas hospitality properties located in Australia, Singapore, Malaysia and the U.K. in the form of a stapled trust group comprising a real estate investment trust and a business trust (Hospitality Trust). The planned IPO Hospitality Trust by the end of 2Q 2020 (calendar year) will allow Far East Consortium to unlock part of the revaluation surplus associated with its hotels (recorded at historical cost on the company's books) which should lead to a positive re-rating of Far East Consortium's valuation.
Safety In Value: Alexander's (ALX) is a REIT with assets in New York City and surrounding area. By far, their biggest asset is the square block of midtown Manhattan they own, which contains the headquarters of the Bloomberg company. There are a few other assets, mostly retail properties in the NYC area. The tenant roster of the retail properties is reasonably strong (Home Depot (NYSE:HD), H&M (OTCPK:HNNMY), Costco (NASDAQ:COST), Ikea for example) but they did have a Sears (OTCPK:SHLDQ) store which gave back its lease as part of that firm's bankruptcy. However, Ikea has taken most of the space for an additional store, which will open next summer. The new rent for that space will improve results as it was vacant for all of 2019. The bigger catalyst (and the reason I own this) is the Bloomberg lease. I was reading the lease, and noted that the rent resets every four years. So, instead of small increases yearly, every fourth year, there's an 11% increase in the base rent paid by Bloomberg. As it happens, that anniversary comes in January 2020, so this catalyst is timely. The combination of the Ikea and Bloomberg rents should add more than $12 MM per year in payments to the firm. I estimate they are trading at about a 7% trailing cap rate at the current price (as of Dec. 18th) of $317, and I think the assets are easily worth a 6% cap rate. Combining that multiple with the extra rent gives me a price target of $430, and they pay a 5.7% yield as well. Shares traded around $430 approximately two years ago prior to the Sears vacancy, so while this is quite a bit of upside, it isn't a stretch by any means.
Thanks to our panel for sharing where they're looking for small-cap ideas. You can read more of their work here:
- Ruerd Heeg, author of Global Deep Value Stocks
- Joseph L. Shaefer, author of The Investor's Edge
- The Value Pendulum, author of Asia Value and Moat Stocks
- Safety In Value, author of Microcap Review
We conclude our year-end roundtable series with two value investing installments and then the compilation of our top picks, so stay tuned for those editions, and thanks for your time and readership! Wishing you a successful 2020 and beyond!
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Additional disclosure: Ruerd Heeg is long GCVRZ.
Joseph L. Shaefer is long TPL and BWEL.
The Value Pendulum is long Far East Consortium International [35:HK].
Safety In Value is long STAR, ALX, COST.