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Lessons from the Great Depression

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Navigating the smaller end of the equity markets is particularly hazardous and  Joseph Mariathasan assesses whether the past can offer a compass

Positioning portfolios in a recessionary environment is fraught with problems. Fund managers are faced with a once-in-a-lifetime opportunity in terms of valuations, but with an uncertain period before they might be able to profit from them. And the possible losses should valuations become even more attractive once they have invested could mark the end of their investment careers, whatever the underlying longer-term logic.

US equity markets have experienced falls that mirrored the 40% or more declines witnessed across the globe. Not surprisingly, investors are looking back to the period of the Great Depression for guidance and perhaps even inspiration.

In early November, Merrill Lynch chairman and CEO John Thain voiced the fears of many when he told investors: "This contraction is not like 1987 or 1998 or 2001. It's going on is bigger than that. We [need to] look back to the 1929 period to see the kind of slowdown we're seeing now."

While the hope is that this time central banks and governments will be much more proactive in attempts to avert a depression, the actions of the US authorities last year, and allowing Lehman Brothers to go bankrupt in particular, have not increased confidence.

Like that of president Franklin Roosevelt in 1933, the new US administration will take office on a wave of hope. But it took until World War II to stimulate the US economy. The fate of the US and global equity markets may well depend on how many lessons Barack Obama's administration will have learnt from that experience.

Interpreting the recent past may provide more confusion than illumination and can be heavily dependent on the time periods examined.

Historically, large caps outperform during a recession, finds David Daglio, (pictured left) portfolio manager at value manager The Boston Company. However, Jack Fockler, managing director at Royce & Associates, also a value manager, finds the opposite: "Historically, small caps do better coming out of a recession. And this applies especially when small caps are coming off from a market bottom when returns are more robust and the average returns tend to be higher than large cap."

Daglio is surprised that so far in this recession small caps have outperformed large caps. He argues that it is the large-cap companies' economic exposures to emerging markets that have caused them to suffer more. "All capitalisation ranges have attractive valuations," he says. "However, large caps will perform better if emerging markets stabilise quicker than the market thinks. If not, small caps will do better as the economy stabilises. If we can buy companies trading at recessionary valuations we will buy them."

But Jeffrey Kautz, (pictured right) CIO of small-cap value specialist Perkins, Wolf, McDonnell & Company, is cautious. He has 10% of his portfolio in cash, down from a high of 15-16%, and has bought protection through put spreads on the Russell mid-cap indices. "We are not positioning our portfolio for a positive return," he says. "When the market goes down, we will go down less, and in better times we expect to post solid absolute returns. In this way we expect to outperform substantially over a full market cycle." 

Accounting for styles

Small cap is generally defined as companies with market capitalisations ranging from $500m (€392m) to $2.5bn, with mid cap between $2bn and $20bn. A few fund managers invest in micro-cap stocks with a capitalisation of less than $500m.

US small and mid-cap specialist managers appear to have relatively few European clients but there is some academic evidence in their favour. "Many economists believe small-cap and value stocks outperform because the market rationally discounts their prices to reflect underlying risk," notes Dimensional Fund Advisors in its literature. "The lower prices give investors greater upside as compensation for bearing this risk."

Fockler finds that the structure of the marketplace has changed over the last 15-20 years. "First, 10 years ago, small cap would have been defined as anything up to $1bn," he says.

"Second, going back to the 1990s, there arose a natural bifurcation between small and micro cap, with a different set of characteristics in
terms of trading, investors and so on. Micro cap is historically what people thought of as small cap, with not much research, illiquidity and so on. The small-cap market itself looks a lot more like large cap now, with lots of liquidity and some mature companies."

Joe Joseph, (pictured left) head of Putnam's international small-cap team, sees a huge distinction between small-cap and mid-cap companies: "Something happens when you look at companies with revenues of more than $1bn. They are completely different, with better management and much lower volatility. Once a company reaches mid-cap status it starts to attract good talent and that starts to show itself."

At the other end, Joseph sees the odds of a micro company going bust as very high.

Fockler gets round this problem by having a very diversified micro-cap portfolio of 200 names in an attempt to capture what the academic evidence suggests is a ‘micro-cap effect'. In contrast, he has a more stock-specific approach to small cap, with a concentrated portfolio of 60 names.

However, it is not only value investors who are active in small and mid-cap investing. The sheer size and diversity of the marketplace allows every conceivable investment approach to germinate and in some cases flourish while many others die when the external environment becomes unfavourable, a fate likely for many smaller specialist managers who might find their revenues have halved.

Some firms encompass more than one style. Putnam has three separate boutiques within the organisation, running US small-cap value, US small-cap growth and a US small-cap core portfolio, says Joseph, who runs the US small-cap core portfolio.

The problem for small-cap investors is that companies are at the bottom of the food chain and are constantly being squeezed on prices, margins and in raising capital by the people they supply, Joseph says. Moreover, many large companies will not add a new supplier if it is very small. Not surprisingly, Joseph sees that US small-cap companies tend to stay small and the chances of a small-cap firm becoming a mid-cap stock are very low.

Fockler agrees: "The life story of a small company often starts with a single product or service that develops over time, gets attention and competition and generally grows. But the move from micro cap to large cap never happens."

Joseph argues that this is why growth investing in small cap is difficult. "The key to growth investing in small cap is to know when to jump off," he says. "They all blow up in the end. Only 3% of companies with above-average growth manage to sustain it. The others collapse and either recoup, or settle for slower growth."

By contrast, Joseph looks for companies with stable cashflows that are more than 10 years old. A typical company would be a dead company in many senses. "They don't grow but find a niche that they are active in and while their prices may change, the company's activity remains stable," he says. "Maybe 3% get very successful and become mid or large companies and we may miss that, but I can live with that."

Glenn Fogle, a growth manager at American Century, emphasises that deciding when to jump off is a critical part of the investment process. He says he agrees with the late investor and philanthropist Sir John Templeton who said: "It is impossible to produce a superior performance unless you do something different from the majority." Fogle adds that American Century's philosophy is to look for changes in growth rates rather than just high absolute growth rates, and to seek out companies moving from good to better and from bad to good.

"The market is pretty efficient and is good at processing slowly changing information," he says. "But it is bad at discounting changing information."

The approach is based on price momentum. "A positive price momentum stock tends to outper-form over time," Fogle explains. "If a stock has positive momentum over six to 12 months it will usually outperform and those with negative momentum will usually under-perform."

With a 200% annualised turnover between 2001 and 2006, price momentum means a lot of stocks are bought and sold over 60-90 days because the changes did not materialise, while others are kept for two to three years.

Understanding the performance of such a strategy very much depends on the time period looked at. "Price momentum has bad periods such as in January and July/August when the market was giving up on global cyclicals," says Fogle. "Price momentum has problems in that it can punish views in the short term. Investors need a long-term approach and we try to manage on a three-year basis and on a trailing three-year basis the performance is very good."

But investors are faced with the issue as to whether the next three years will favour growth or value and how large the dispersion of returns is likely to be. If the dispersion is large, a good stock picker may still be able to produce positive results even if the market is down.

Indexation and passive approaches

The dramatic market falls that followed a sustained period of small-cap outperformance means that historical performance figures are of little value in assessing what may be attractive strategies and management teams for the next few years. One way round this would be to adopt a purely passive approach, although, given the illiquidity of the stocks, sticking rigorously to a broad-based index may be expensive in turnover, while a narrower index might not be representative of the market as a whole.

Dimensional Fund Advisers runs strategies that entail buying all companies that fall within its screen. So its US Small Cap Portfolio buys securities of US companies whose size falls within the smallest 8% of the total market universe.

Active quant firms such as Axa Rosenberg seek to outperform indices through the utilisation of quantitative analysis that can be applied systematically to thousands of stocks in a way that no fund manager would have the resources to do.

A more recent development in this vein has been the launch of small-cap ETFs by Spa ETF, which is owned by London and Capital Asset Management. Essentially, it is an active quantitative approach based on a 100-stock index produced by independent US-based research provider MarketGrader.

According to Spa ETF head of research Neil Michael, (pictured rigth) this rebases the index quarterly based on four signals of value, earnings growth, profitability and cashflow, with earnings growth being the largest signal in 2007 leading to a strong tilt towards energy and materials and a strong growth bias. Such an approach offers ‘active quant' at a lower price. However, the issue is whether it will be successful over very volatile market cycles, which the quarterly rebalancing approach may find hard to keep up with.

But how useful are the indices for active managers in the small-cap space? Managers like Fockler see them as a useful reference point to report results but would claim to pay little attention to them in stock selection.

More disconcertingly, as Fockler finds, there can be problems when it comes to style indices as these can vary significantly. "There are value indices produced by Russell, S&P, Wilshire, Rogers Casey and others and all define value differently," he says. "The portfolio returns can be dramatically different and the results can vary by as much as 100-600 bps per year by virtue of how they define value. So there is probably not a single value index to use and it is better to use three or four indices in a blended way."

Private equity

The public and private markets in the US small-cap equity space overlap and have long danced a pas de deux. But a distinguishing feature of private equity has been the extent of leverage utilised by private equity firms in making acquisitions of small and mid-sized companies.

That market collapsed with the drying up of credit. "Private equity firms all have to restructure," Daglio says. "Even the Harvard endowment fund is liquidating a lot of its private equity endowments. Public company valuations are very compelling, balance sheets are generally stronger and liquidity positions are much higher than the private equity market. So why not stick to businesses on the stockmarket, which have lower risk than private equity?"

The extent to which leverage allowed private equity to drive up prices in the listed markets is uncertain. "The lack of private equity has taken the bid price down on M&A candidates but M&A by other companies in the industry continues," Daglio adds.

"Small cap always has a fair amount of M&A but a year ago there were unrealistic levels of M&A because of private equity," says Fockler. "Acquiring some smaller companies will always be one way for a large company to get bigger."

One firm that has danced a lot closer than most with the private equity industry is Brown Advisory, and that reflects its heritage as a wealth manager for over 12 years before it developed an institutional investment business. It has more than $700m invested for high-net-worth clients in private equity funds run by Silverlake, Bain Capital, New Enterprises and other highly regarded private equity managers, says Chris Berrier, co-manager of its US smaller companies fund. As a result, it has developed close relationships with these firms and is able to swap intellectual capital in areas such as the valuation of a company if an IPO takes place, and on specific sectors on which private equity firms have done the due diligence.

In addition, Berrier gets information on early stage companies that could be in competition for their own investments in the future. 

To invest or not

The Great Depression also provided the background for David Dodd and Benjamin Graham, who taught Warren Buffett, to write the bible of value investing, Security Analysis, in 1934. It has been the guiding philosophy of many fund management firms ever since.

Royce Associates was founded by Chuck Royce, a student of Graham Dodds at Columbia University, who applied the ideas of value investing to small-cap stocks. There have been many revisions and editions of Graham and Dodds' classic work. The most recent, edited by Seth Klarman, was published last year.

Asked in a recent interview what advice Graham and Dodd would give to today's investors, Klarman replied: "Their focus would probably be on not worrying about where something trades tomorrow or next week. You need to worry about where the company and the stock will be in three to five years. If you can buy something today with little chance of permanent impairment and a high likelihood that you'll double your money over the next five years, you should go ahead and do it."

This advice is perhaps, particularly apt for the US small and mid-cap marketplace, arguably the marketplace on which Graham and Dodds based their original work.

"If you need money over the next year, I would not be aggressive in US small and mid cap," notes Kautz. "At the moment, at best, they are fairly valued relative to large cap, but there is at least as much risk on the downside as upside and the credit crunch could prolong the pain. However, there are good opportunities to start building positions slowly."

For European institutional investors, it might be true that the US small-cap market currently offers better value than at any other period in the modern investment era. The problem they face, is that so do many other asset classes.

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