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.

Housing Inventories Hit Record High

“The backlog of unsold new homes reached a record level last month, as sales slipped despite the warmest January in more than 100 years. The Commerce Department reported Monday that sales of new single-family homes dropped by 5 percent to a seasonally adjusted annual rate of 1.233 million units last month. That was the slowest pace since January 2005 and left the number of unsold homes at a record high of 528,000.”

The housing boom is over folks. Inventory data is crucial for real estate. There is no magic formula for calculating fair value of residential housing. You can’t run a discounted cash flow model, or dividend discount model. Housing prices are simply based on supply and demand. And supply is at an all-time high.

Even here in St. Louis, hardly a booming market, I am seeing more and more houses going up for sale, even though others have been on the market for months. Mortgage rates are up and millions of ARM loans readjust this year. Home equity loan rates are also on the rise. Fed Funds will hit 5% this year, which puts the prime rate at 8% and most home equity loan rates at 9%.

It’s not a complex scenario. Supply is high as the inventory numbers show. Interest rates, the cost of money, are going up and will adversely affect demand. Not a good combination. Housing stocks may look attractive with low P/E ratios, but don’t forget why housing stocks always have low multiples; because the cycle always ends.

It’s Tough Not To Like These Guys

For those of you who follow energy companies, and Chesapeake Energy (CHK) more specifically, I highly recommend you listen to the company’s fourth quarter earnings conference call that was hosted this morning.

The company’s shares have been weak lately as natural gas prices have been cut in half and the company’s co-founder and chief operating officer, Tom Ward, suddenly announced his retirement from the company at the fairly young age of 46 years old.

I can’t recall a more impressive conference call this quarter. They even had Ward on the phone to address any concerns over his unexpected departure. You don’t see that type of focus on shareholders’ interest every day from management teams of publicly traded companies.

Loyalties Aside, ESRX is Bloated

Shares of my former employer, Express Scripts (ESRX), a leading pharmacy benefits manager in the U.S., are going to fall a few points this morning. Earnings reported last night were 2 cents above expectations but the momentum traders wanted more.

Express Scripts had beaten estimates by a fairly wide margin in recent periods, and bulls were undoubtedly hoping for another “beat and raise” quarter. They got the “beat”, but not the “raise”.

Full year guidance remained at $3.10 to $3.22 per share in earnings. ESRX rarely misses guidance, so they will be fairly conservative. They don’t raise guidance often, and when they do, it’s usually only once per year.

At $93 per share, the stock was trading at 30 times 2006 earnings coming into the latest report, historically an astronomical multiple for a PBM company. It’s true that accretive acquisitions are boosting growth rates above competitors like Medco (MHS) and Caremark (CMX), but 30 times earnings for ESRX is too rich, in my view.

As a result, profit taking is in order, and investors have already begun that process this morning.

Rising Commissions? Since When?

I had to double check to make sure what I heard over the weekend was correct. A.G. Edwards (AGE), a St. Louis based firm with 7,000 brokers nationwide, is planning to raise their commissions by 5 percent beginning on March 15th. In addition, their postage and handling fee is jumping 10 percent to $5.50 per transaction. Yes, that is correct. The company will charge customers $5.50 to mail them each trade confirmation. BrownCo actually only charges $5 to make a trade, so you can see how out of whack these fees really are.

Amazingly, full service brokers continue to thrive, even when they are ripping off millions of investors. AG Edwards stands to bring in an estimated $50 million in incremental revenue from the price hike, as they generate $1 billion per year in commissions (40 percent of total sales). Now I understand investors take comfort in having a personal broker with whom to work with, but at what point does one think twice about paying these astronomical fees? After all, it costs next to nothing to execute trade, which is why discounters can charge less than $10 and still make a lot of money.

The statistics have shown that analysts aren’t good stock pickers (sell-side research generates the investment ideas brokers in turn recommend to their clients) and the majority of mutual funds lag the market, so the buy side isn’t that great either. Meanwhile, discount brokers now offer all kinds of stock research reports, the same research high-priced brokers are using.


Why then are investors content to pay a 2 percent commission to full service brokers? Think about it this way. Let’s say you hold your average stock for a year. If you are paying 2% when you buy it and another 2% when you sell it, you’re 4% behind the market’s return assuming your stock picks are average performers.

With valuations where they are today in the U.S. stock market, the S&P 500 is likely to only average a mid-to-high single digit annual return for the rest of the decade at least. So, a full service brokerage customer is going to make about 4% per year net of commissions if the market returns 8% per year. Mutual funds will return about 7% in such a scenario, but transaction fees and loads could take that number even lower. No wonder index funds have become so popular. Compared with actively managed mutual funds and full service brokers, they are often a better option.

This current state of the investment advisory industry is exactly why I started Peridot Capital Management. The average mutual fund investor is going to underperform. The average stock broker is going to underperform. Investors who pick their own stocks often buy what they know and like, paying no attention to valuation. In doing so, they buy overpriced blue chips stocks that have done wonderfully over the last twenty years, and as a result, are set to underperform.

Unless you can earn above-average returns on your own, index funds are the best option of the four most common investment options, but by definition you can not outperform by owning them.

The answer, at least in my eyes, is pretty simple; investing with superior independent research from a personal investment manager, who is not working on commission, through an online discount brokerage account. Hence Peridot Capital was born.

Investment Banks Shed Profitable Asset Management Divisions

Last year’s asset swap between Citigroup (C) and Legg Mason (LM) looked like a great move on the part of Legg. After all, retail brokers are hardly the future. Individual investors can only tolerate absurdly high commissions for so long, I would hope. Trading their retail brokers for Citi’s huge asset management division, including Smith Barney’s mutual funds, should be a huge lift for LM shareholders, and the stock’s movement since the deal was announced bears that out.Now we learn that Merrill Lynch (MER) has decided to send Merrill Lynch Investment Management (MLIM) to BlackRock (BLK) in exchange for a 49% stake in the newly formed asset management giant. As was the case with Legg Mason, Blackrock stock has gone through the roof on news of a deal.

Evidently this Merrill deal was a much better alternative than the “let’s change our fund company’s name to Princeton Research and Management and see if that helps get us more business.” Once Morgan Stanley’s deal to acquire BlackRock fell through, Merrill swooped in and decided it was a much better idea to hand over MLIM to a somebody who could better run it. Doing so also rids Merrill of having the appearance of conflicts of interest with its investment bankers, research analysts, and mutual fund managers all under the same roof.

So in a matter of months both Legg Mason and Blackrock have strengthened themselves as pure play asset managers, a business that has great margins. With the growing popularity of hedge funds and international investment options, their fortunes will be much less tied to the direction of the S&P 500 than they were five or ten years ago.

The stocks have soared, and on current profit estimates they do look pricey. However, it is apparent that margin expansion will occur, both due to cost-cutting and an overall higher average profit margin across the business. Accordingly, current analyst expectations for profits (about $6 for LM in 2006 and $5 for BLK) will prove quite conservative.

And they better since LM is trading over $130 and BLK recently hit $150 per share. It is entirely possible that 2006 is a transition year for the integration of these very large deals, but come 2007 and 2008, they should be coining money. Add in the fact that asset managers have always traded at a premium to the overall market and financial services sector, and the stocks could outperform for the rest of the decade even after the recent run-ups we’ve seen. Of the two, Legg Mason looks cheaper than Blockrock, however.

 

Bernanke Reign Begins

The markets really aren’t reacting much, if at all, after newly appointed FOMC Chairman Ben Bernake answered questions on Capitol Hill today. Aside from Bernanke’s preference to avoid partisanship, his answers and views on the economy were very similar to Greenspan’s. As far as interest rates go, I continue to think we’ll see 5% Fed Funds this year.

Implications for the stock market aren’t very bullish in such a scenario. Stocks tend to be flat to slightly down after the last hike of a rate tightening cycle, and any move above 5% Fed Funds would indicate inflation is fierce enough to further crimp corporate profit growth. All in all, there are many excellent investment opportunities out there, but index funds won’t fall into that category in the short-to-intermediate term, in my view.

Vonage Files for $250M IPO

Phone service upstart Vonage Holdings has filed initial paperwork with the SEC, the first step toward a possible IPO that aims to raise up to $250 million. Given the recent appetite investors have had for well-known consumer-related initial public offerings (Chipotle, Under Armour, to name a couple), the timing of this filing makes sense from the corporate perspective.

So, does the stock make for a good investment? Should the IPO come to fruition, we’ll likely see a huge first day spike, allowing all of the investment banks’ best clients to make a bundle. However, a closer look at Vonage’s financials shows that any after-market valuation might be too high. For the first nine months of 2005, Vonage lost $190 million on sales of $174 million. Marketing costs totaled $176 million, a staggering figure.

IPO proceeds would undoubtedly go toward more marketing. While Vonage does have 1.4 million customers, how much are they actually worth? The Vonage service is a commodity, offering no differentiation from Comcast’s service or anyone elses. Vonage is under cutting the competition on price ($24.95 for unlimited long distance calling to the U.S., Canada, and Puerto Rico) but there is no reason to think larger players won’t attack that advantage in the future, and company’s like Skype are focusing on free consumer voice services.

Much like other data and voice services, more competitors will enter the market, pushing prices down. Without a differentiated product offering, Vonage shares will likely be overpriced by retail investors should the IPO go smoothly.

Time to Unload Commodities?

Days like Tuesday don’t feel too great when you have bets in the energy and industrial metals sectors. Many stocks were down as much as 6 percent yesterday alone. Despite the huge moves we’ve seen dating back to last year, the combination of strong fundamentals and low valuations continue to explain my bullishness.

Commodities are cyclical, and one day the party will certainly end, however I think the bull market in energy and materials still has ways to go. Really, it’s simple supply and demand. Even at today’s elevated prices, demand worldwide should remain strong. On the supply front, there is no reason to believe the world is going to all-of-the-sudden find lots more oil. Metals such as copper and gold take years to be mined, and unmined supply is fairly limited as well.

The stocks will always be very volatile, as a one-year chart of any company in the sector will show, but I can’t help but think sell-offs like the one we saw Tuesday are opportunities for those who have yet to jump in.

Take Anadarko Petroleum (APC) as an example. Late Monday, the company reported earnings of $3.88 per share on sales of $2.25 billion, easily surpassing estimates of $3.35 and $2.09 billion. In fact, actual results even beat the highest printed estimate on the Street ($3.77/$2.23B). However, the stock fell more than $3 to $102 per share as crude oil prices dropped by a decent amount.

APC also announced a 2006 capital expenditure budget of $4 billion versus $3.4 billion in 2005. Production growth is expected to be in the 4-8 percent range this year. It’s not just an oil price story, but production is growing too.

After seeing last quarter’s results, I have no reason to think the highest 2006 estimate coming into that report, earnings of $15.73 per share, is unattainable. That would put the stock’s forward P/E at 6.5x. Most investors will tell you such a multiple signifies peak earnings, and they’d be right. Price-earnings ratios are always lowest at cyclical tops and highest at cyclical bottoms. The bullish case for Anadarko centers around the idea that 2006 might not be the top.

If China and India continue to grow as a percentage of the world economy, and other nations follow their lead, oil could reach at least $100 per barrel by the end of the decade. That might not happen, but I think it very well could, and the odds of $30 oil anytime soon are very, very low. Energy and materials represent 10% and 3% of the S&P 500, respectively. I think investors should be overweight these areas for the next several years.

Disney’s Pixar Buy Looks Even Better

Investors might have been worried when Disney (DIS) announced it would shell out $7 billion for Pixar. However, not only does the animation studio have $1 billion cash on its balance sheet, but Disney announced Monday that it is selling radio station assets to Citadel for $2.7 billion. All of the sudden, DIS only has to cough up about $3 billion of its own money to fund the Pixar acquisition.

Swapping terrestrial radio for a piece of Pixar seems to make sense. By ridding itself of huge licensing payments, Disney should reap much fatter margins on future animated hits. Combined with strong earnings just reported, do recent events make Disney stock a buy?

While Bob Iger’s moves seem to be the right ones, DIS shares don’t look like much of a bargain. Paying 17 times forward earnings for DIS looks steep to me. Plus, the company’s dividend yield is a paltry 1.1 percent, far below the S&P 500’s yield. Investors hoping for great things might be disappointed, but at least the company is making moves.