US Managers win in small caps

We follow US small and micro caps and the managers who own them. We highlight an Indian film distributor EROS which ticks the boxes in the investment process followed by small cap growth managers.

Amidst all the noise about the forthcoming end of the bull market there are two facts that stand out which are the shrinking liquidity in many large cap stocks and the opportunities that emerge every week in small cap stocks.

Driven by tax concessions which have favored buybacks over dividends and the concentration in just a handful of leading stocks like Facebook Amazon Netflix and Google, that have driven the headline indexes, disenchanted investors have ended up in Exchange Traded Funds.

By comparison the small caps are underreported, under researched and many are underpriced.

So it is not surprising that the Russell 2000 (the bottom 2000 stocks in the Russell 3000 index) has lagged and now represents the best opportunity for funds managers to gain a lead on what must become a volatile market for big caps.

The Russell 2000 is the index by which small cap managers will be judged. The weighted average market cap in the Russell 2000 is $2.3 billion and the median market cap is $809 billion.

In the nine months to September, since the beginning of this year, the DowJones Index (30 large caps) is up 11 per cent versus 4 per cent for the Russell 2000.

Recent annual price rates were:

• 2016 Russell 24 pct versus Dow 26
• 2015 Russell Minus 6 per cent versus Dow minus 10 2014 Russell One per cent versus Dow 3
• 2013 Russell 40 pct versus Dow 28 2012 Russell 10 per cent versus Dow 7

Over the much longer periods of time, small caps tend to outperform which is why an equally weighted large cap index will usually outperform a market cap weighted return because the impact of smaller caps stocks is exaggerated. If you must hold a leading index hold the equal weighted rather than the market cap weighted.

Within the small cap index at present, it is important to note the dramatic weekly gains in certain stocks, the managers who hold them and the process by which they pick stocks. (It’s not just luck).

(Independent Research maintains constant contact with leading US managers and a database which enables us to correlate stocks with managers).

So let’s have a look at recent weekly price movements in stocks and see which active managers (not index huggers) own what.

September 1 (latest week)

• Eros EROS up 34 pct at $12.25 market cap $741 mln Gabelli Small Cap AAA Manager Gabelli
• Orchids Paper TIS up 28 pct at $12.90 market cap $134 mln Perritt Micro Cap Manager Perritt
• Maxpoint MXPT up 150 pct at $13.78 market cap $94 million Bridgeway Ultra Small Cap Manager Koziaeva

If we go back to August 21 the big movers during the week were all small cap and included Phoenix New Media FENG Skyline SKY Hallian Educ HLG.

Without exception, after a pause following an initial strong move all of these stocks have continued to advance.

The observation of Independent Research is that stocks in the current US market for small caps that have strong upward moves have several characteristics.

• Strong current earnings, that have followed several years of consistent growth.
• A unique market or business niche that gets publicity.
• A strong institutional following that creates a scarcity of supply.
• Relative market and share price leadership within a given sector.
• Winners are grinners.

A market that favours and respects small caps

Sudden and unexpected recovery from a loss making streak that catches the market and the short sellers by surprise.

The American attitude to debt is quite different to Australia. It is earnings that count in this market regardless of the level of debt. As one US CEO said to me recently “I don’t worry about debt because you never pay it back.” He sold his last company to an Australian company including the debt.

America is a very large place where bounties are paid by the SEC to dob in non-compliant investors. Security cameras are everywhere. There is no privacy. The coffee shop mentality of deals being done and information exchanged at lunch does not exist.

I recently invited a broker to lunch who informed me that he could not conduct any meeting outside his office especially if I was paying for lunch.

A good example of a recent mover in the above list is EROS, an Indian language film distributor whose peer group includes Netflix, Reading, Lions Gate and Gaia which clearly Mario Gabelli ( the Great Gabelli according to Barrons magazine) owns and likes. Since 2012 his small cap fund is up 88 pct versus 74 per cent for the Russell 2000 which he has never trailed.

EROS is expected to advance earnings in 2018 from 5 cents to 24 cents a share and 58 cents in 2019. Recent quarterly earnings have been rising at in excess of 200 per cent. The number of institutional holders has increased from 126 to 135 in the past 12 months and funds now own 35 per cent of the $750 mln market cap. The market is not worried by a PE of 163 times or 8 times the S&P 500. It’s not a stock that Warren Buffett would buy, rather James O’Shaughnessy except for the lagged response on sales by EROS. There have been questions raised about its trade receivables and how they are financed which have been highlighted by short sellers in the stock who represent 14 days current volume.

So for managers looking for outperformance in a volatile market US small caps offer outstanding opportunities that we will continue to follow.

Meanwhile, the future for large cap investors remains in the hands of managers like Blackrock who are on the receiving end of the waterfall of disenchanted retail investors seeking refuge from direct investment in stocks and mutual funds. It is all a bit reminiscent of 2000 at the height of the tech boom when the concentrated momentum effect of certain tech stocks overwhelmed the market. Stocks like Cisco briefly became more valuable than the biggest companies in the Dow Jones.