Why Large Caps Are Lagging

For years large cap stocks have been trounced by small and mid cap stocks. Coming into 2006, most experts were predicting a move toward large cap outperformance. So far though that has yet to come to pass. In fact, the Russell 2000 small cap index gained 10 percent at the outset of the year, about triple the gain of the S&P 500.

Now it is true that historically larger companies do not advance as much as smaller companies. Small caps do best, followed by mid caps, with large caps bringing up the rear. This trend though has been even stronger than normal in recent years. Why is this true, and will it continue?

Stock prices in general are richly valued today, based on price-earnings ratios. As a result, stock price appreciation has not come from multiple expansion this decade, as it did in the 1990’s. Rather, earnings growth has been the only way to see outsized share price gains as multiples have either remained the same or contracted.

Common sense tells us that small and mid cap stocks will have an easier time growing earnings. After all, they are growing off a much smaller base of business. A $100 million company need only add an incremental $10 million in business to grow 10%, but Wal-Mart needs to add tens of billions of dollars in sales to reach the same level of growth.

Will small caps and mid caps continue to outperform? Over the long term, absolutely. However, the gap in performance may not be maintained at the levels seen in recent years. As you can see from the charts below, small and mid cap stocks are soaring, hitting new all-time highs.

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S&P Mid Cap Index (MDY) vs S&P 500 – 10 Years

Mid cap stocks have doubled the returns of large caps over the last decade.

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Russell 2000 Small Cap Index vs S&P 500 – 3 Years

Small cap stocks have also outpaced large caps by a factor of two…

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Equal Weighted S&P 500 vs Market Cap Weighted S&P 500

Even the smaller stocks within the S&P 500 index have outperformed the mega caps that dominate the index.

Does Size Really Matter?

Over the last week or two, CNBC coverage has focused a lot of its time on the large cap versus small cap debate. Dozens of professionals have been dragged on air to give the arguments for why they think large caps will outperform in 2006, and an equal number to make the opposite case for small caps.

Please ignore these conversations. Investing in equities should not focus on such a debate. The point of investing in public companies (or any company for that matter) is to get a good deal; to buy something that you feel is undervalued now and will ultimately be worth more in the future. Looking at company-specific issues is how you should go about doing this.

Focusing on how big a company is has nothing to do with the potential for it to be a good investment. Now I know many investors are of the “passive” type and only buy indexes. In determining how to allocate their funds, they will try and figure out which of the many asset classes they should overweight and underweight, small cap value, large cap growth, and the list goes on.

Passive investors will spend time looking at the valuation disparity between large cap and small cap stocks, compare their growth outlooks on the whole, and try to figure out which one is the relative bargain. Rather than simply guess how well a set of hundreds of companies are going to fare collectively, I think it’s a much better use of one’s time to get to know a handful of companies really well and determine if they represent good value.

Whether we’re talking about micro caps, small caps, mid caps, or large caps, there are always going to be great investment opportunities in each segment of the market. Buying an entire asset class is really nothing more than speculating, given that you aren’t really analyzing whether or not any of the companies in that large subset are actually good investments or not. I’d be willing to bet you’ll be more accurate predicting relative value of individual companies than you will entire indexes based on company size.

Performing A Tax Loss Selling Analysis

Since it is historically the weakest month of the year, I do my tax loss selling for taxable accounts during October. Prices tend to be weak, so you can maximize your capital loss offsets by selling any losers you have in your portfolio, and thereby minimize your capital gain tax bill the following April. This also frees up cash to put to work before the seasonally strongest six-month period for stocks (November through April).

Something else I do myself, and recommend for all of you, is to carefully analyze those stocks you sold at a loss. Don’t simply try to purge them from your memory. Instead, study them and figure out what common themes those positions possessed. That way, you can learn from your mistakes. We’re all going to make them, but it’s great if you can figure out why they didn’t work out the way you thought they would, and most importantly, use such knowledge to maximize your future investment performance.

Delving into the Conventional Wisdom

There are two reasons the market is down so far this year; energy and interest rates. The question we need to ask ourselves is “Are the stock market reactions we are seeing correct?” Since the market is mostly psychological, investors need to take a deep breathe and focus on reality, not simply psychology or perception.

Stocks are being held down by underperforming names in the financial services and consumer discretionary sectors. Together, those 2 areas represent 31% of the S&P 500. That’s a huge chunk. Regardless of how strong energy, materials, and health care stocks act in times of higher interest rates and fears of an economic slowdown, they won’t be able to carry the market on their shoulders. Why not? Energy and materials are only 13% of the market. Health care is another 13%, but that only gets us to 26%, less than the 31% of weakness we need to offset.

The weakness in financial services is real and very much warranted. Banks are going to struggle with a flat yield curve. If you were running a bank and your borrowing costs were risng faster than the lending rates you could charge, your profit margin would be squeezed. No doubt about it. Until the Fed is ready to stop, financials are not right here, so let’s hope once Greenspan is gone in early 2006 that rates stabilize.

Conversely, the sell-off in consumer discretionary sectors is a little less warranted, in my opinion. As gas prices have gone from $2 a gallon to $3 a gallon, drivers will need an extra $60 per month to fill up their cars if they have a 15 gallon tank and fill up once a week. The question we need to ask is, where will that $60 come from? I don’t doubt that it will be taken out of another area of one’s personal budget, but where? It won’t come out of every other place.

One of the conclusions I’ve come to is that it won’t come out of food expenditures as much as the restaurant stocks are telling us. I still think the trend toward eating out, not cooking at home, is here to stay, regardless of gas prices. Families might not go out and spend a lot of money on food, but they should still eat out at a reasonable price. With major restaurant chain share prices at 52-week lows, that’s an area I would strongly consider buying as prices continue falling.

What Kinds of Market Returns Should We Expect?

You hear a lot about the “Fed Model” when discussions break out about valuing equities versus bonds. Larry Kudlow loves talking about this strategy on CNBC to back up his never-ending bullish stance on stocks. The model, simply speaking, compares the earnings yield on the stock market to the 10-year treasury bond yield.

If the S&P 500 trades at a 20 P/E, it’s earnings yield is 5% (100/20). Since this compares favorably with the 4% treasury yield, Kudlow will argue that stocks are more attractive than bonds, and therefore should be bought. The thinking goes that if both investments were fairly valued, relative to each other, then their yields would be equal.

However, there is a problem with this so-called model. The equity market and the bond market hardly ever “yield” the same amount. As a result, any model that aims to make them equal is inherently flawed. If stocks and bonds were supposed to be relatively equal in value, it would make sense to base investment decisions on any discrepency, such as 4% versus 5% yields. If such discrepencies are extremely common, there is little reason to conclude they signal relative attractiveness or unattractiveness.

Let’s show some evidence to further conclude that the Fed Model shouldn’t be used as a powerful investment tool. When bond yields are historically low, as they are today, the Fed Model would predict a high level of attractivenness for equities as an investment class. After all, the lower the yield on bonds, the more likely stock earnings yields would surpass them.

Below you will see various ranges for the 10-year Treasury bond yield since 1965, along with the actual total return that the S&P 500 achieved over the following 10-year period. As you can see, low bond yields have not resulted in attractive stock price returns. In fact, one can argue the exact opposite.

10-Year Bond Yield —–Subsequent S&P 500 returns
——— 0-5% ——————— 4.3%
——— 5-6%———————- 5.5%
——— 6-7% ——————– 10.5%
——— 7-8% ——————– 13.2%
——— 8-9% ——————– 16.7%
——— 9-10% ——————- 17.5%

Small Caps Shine

History shows that small cap stocks outperform large caps over the long term. There are several reasons why this is true, perhaps most notably the growth potential for smaller firms contrasted with the law of large numbers catching up to big companies over time.

What is interesting is the stark contrast between the performance of these two groups in recent years. Since 1999, the S&P 500 has lost about 2% of its value. During the same period, the Russell 2000 index has gained an astonishing 56 percent. In fact, small and mid cap indices have been hitting all-time highs this year, even as the S&P 500 remains 20% off its 2000 high.

After the split of investment banking and research was solidified by New York AG Eliot Spitzer, small and mid cap research has become even less a focal point than it once was. The result has been many public companies flying under the radar screen despite excellent financial results. Now, even more than ever, a focus on undervalued small cap stocks can pay huge dividends for investors. And that’s despite the fact that the market, as judged by major market indices like the Dow and S&P, haven’t done anything in the way of advancement since this decade began.

The Roth 401(k) is Coming

While I’m surprised we have not heard more about them, I suspect that as 2005 comes to a close individuals will hear a lot more about the Roth 401(k) plan, set to be instated in 2006. The Roth IRA has truly been a boon for investors, allowing them to contribute as much as $4,000 per year in after-tax dollars to an account where profits are tax-free at age 59 1/2. Investment principal can even be withdrawn early tax-free with no penalty.

As great as this deal is for investors, the Roth IRA’s glaring limitations (namely annual contribution limits and income limits that don’t allow the wealthy to participate) do provide some discontent. However, beginning in 2006 employers will have the option of offering their workers a Roth 401(k) plan, which can take the place of an employee’s traditional 401(k) retirement account.

The Roth 401(k) will have similar contribution limits to a regular 401(k), $15,000 per year in 2006, which far surpasses the Roth IRA limits. As with regular 401(k) plans, there will not be income limits with the new plan. Contributions will be treated just like a Roth IRA, meaning after-tax dollars are used (as opposed to the current plan that uses pre-tax dollars) and withdrawals after age 59 1/2 are tax-free.

For those with extra income who are looking to invest for their retirement in a tax-efficient way, the Roth 401(k) could be the single best way to accomplish that feat starting next year. That assumes of course that your employer will choose to offer it as an option, as it will be strictly a voluntary offering.

Examining Changes to the Dow 30 Components

Every few years investors hear of impending changes to the Dow Jones Average, the broad index of 30 industrial stocks created by Charles Dow in 1897, widely used as a stock market barometer. For the majority of the 20th century, changes to the index’s components were rare. Only when one of the 30 stocks was acquired by another company would they be replaced, and the new addition would usually be in the same industry as its predecessor.

However, with the bull market of the 1990’s, Dow Jones & Company (DJ), the publisher of the index, began changing the group of 30 stocks even without any news of a merger. With stock prices rising at a rapid pace, cheerleaders for stock ownership were everywhere. Dow Jones & Company figured it could boost stock prices even more by replacing underperforming companies with better ones.

Rather than saying they wanted to boost the Dow’s performance, those who orchestrated the changes justified such actions be claiming that the new index “better represented the country’s ever-changing economy.” Basically, even though we still filled up our cars’ gas tanks at Chevron stations and wrote on paper made by International Paper, these companies really weren’t good gauges of the so-called “new economy.” With the advent of the digital camera, somehow Kodak no longer deserved to be in the Dow, despite billions of dollars in annual sales and owner of one of the country’s more prominent brands.

Were these changes really necessary? I was never a big fan of them. Companies go through ups and downs. Businesses are cyclical. When oil prices are low, companies like Chevron won’t make very much money and their stock prices won’t perform very well. Does that mean we should boot them from the Dow? Probably not. Nonetheless, since 1999 exactly 7 of the Dow’s 30 stocks have been replaced due to economical irrelevency (read “bad stock performance”).

Not being a big proponent of bandwagons as far as stocks are concerned, I am truly excited to have discovered yet another contrarian indicator for stocks. Think about it. Dow Jones boots a poorly performing stock and adds an elite name to the index. Isn’t this the perfect contrarian indicator for someone who loves buying out-of-favor stocks? After all, if you get booted from the Dow, your company must really be down in the dumps. And if you are the lucky company to be named a replacement, you really must have done well lately.

So, the next time a change is made to the Dow Jones Industrial Average, I will be trading on the news. I’ll short the stock that gets added and pair that trade with the purchase of the company that got the axe. Will this strategy work, you ask? Well, let’s take a closer look at how the aforementioned 7 alterations since 1999 have fared after the changes took effect.

On November 1, 1999, four stocks were removed from the Dow; Chevron (CVX), Goodyear Tire (GT), Sears (S), and Union Carbide (UK). Not surprisingly, they were replaced by some bull market high-fliers; Home Depot (HD), Intel (INTC), Microsoft (MSFT), and SBC Communications (SBC).

Less than five years later, in April 2004, more changes were announced. This time 3 companies were replaced. American International Group (AIG), Pfizer (PFE), Verizon (VZ) took over for AT&T (T), Eastman Kodak (EK), and International Paper (IP).

Dow Jones & Company, as well as most investors, were probably thrilled with the decision to replace these “old economy” stocks with newer, faster growing market darlings. The great news (if you’re looking for contrarian investment opportunities) is that the performances of the two groups of stocks has been quite a dichotomy, just not in the way many would have expected.

Of the 7 stocks deleted from the Dow since 1999, 3 of them were either acquired or are in the process of being acquired (Dow Chemical bought Union Carbide, Sears is going to be bought by Kmart, and AT&T is going to be purchased by fellow Dow member SBC Communications). All told, on average, the seven deleted stocks have risen by a staggering 227% since their removal. That equates to a return of more than 32% each.

While those returns are impressive, they won’t make for much of a contrarian investment strategy unless the ones that replaced them gained less than 32% on average. Amazingly, the 7 stocks added to the Dow haven’t gone up at all. In fact, they’ve lost a combined 155% since they were added to the index, for a loss of 22% each. Only one of the seven has risen in price (Verizon) and its shares are up a meager 2%.

Hopefully more changes to the Dow are coming, for contrarian investors’ sake anyway.

A Pair of Growth Stock Ideas for ’05

The majority of investments found in Peridot-run portfolios could be classified as either contrarian plays or undiscovered value stocks. Nonetheless, sometimes there are growth companies out there that look so attractive that even Peridot will be more than willing to “pay up” for them and watch their businesses grow like wild fires over the course of several years.

While forking over 30 times earnings for stocks is rare for us, in recent weeks we have been accumulating shares of small-cap restaurant chain Buffalo Wild Wings (BWLD) and mid-cap clothing retailer Urban Outfitters (URBN). In both cases, the tremendous growth potential over the next three to five years gives us comfort, even though the high multiples of these names make the stocks very volatile.

From a p/e-to-growth rate (PEG) perspective, you can make the case that 30x 2005 estimates is not too high, given that both companies are slated to grow 25 percent a year, for a PEG ratio only 1.2, compared with 2.0 for the S&P 500. If both BWLD and URBN are able to maintain their growth, which we believe they can, there is no reason both stocks cannot hold above-market multiples for years to come. In fact, both of these stock could triple in the next five years, for a compound annual growth rate of more than 20 percent.

The main reasoning for these growth assumptions is the combination of an extremely popular concept, in addition to a relatively small store base in place at the current point in time. Customers are raving about both Buffalo Wild Wings restaurants and all three concepts that Urban Outfitters is rolling out (Urban Outfitters, Anthropologie, and Free People). BWLD owns and operates 290 units, with ab0ut a third of them in the state of Ohio alone. The company sees the potential for at least 1,000 restaurants in the U.S. URBN still only has 71 Urban stores and 62 Anthropologie stores, or fewer than 1.5 of each per state.

As both of these companies continue to grow, in both popularity and sheer size, both stocks should reflect such growth, making them excellent stories to hold for many years to come.