Would you believe that over the last eleven years small caps outperformed large caps in ten of the eleven years (per comparison of the Russell 2000 with the Russell 200)? Furthermore, small caps were nearly 10% less volatile than the large caps.
Would you believe that a dollar invested at the beginning of 2000 in small, mid, or large caps would be worth $1.79, $2.04, or just $0.90 respectively at the end of 2010? A surprisingly strong showing for small and mid caps especially considering that portions of six of the last eleven years were in bear markets!
The booming 1990s led to a crescendo marked by the PE of Lowe’s peaking at 61 (spurred in part by the now infamous mantra of “real estate: they ain’t making any more land, so it’s gotta go up”), Wal-Mart’s PE peaked at 59 and the PE of Microsoft topped out at 83 (because the internet was going to change the world, which was true but did not justify a PE of 83). Currently stocks of companies like Lowe’s, Wal-Mart, and Microsoft are trading with PE’s that are only some fraction of their peak levels. One could argue the current PE’s are ridiculous. Lowe’s, Wal-Mart, and Microsoft are just examples of how stocks can go from one extreme to the other. The industry positions of these companies have improved to the extent that earnings per share have more than doubled and should double again in a reasonable number of years through a tortuously boring combination of 1-3% sales growth and using exorbitant amounts of cash generated through operations to buy back stock. It is true that there is nothing sexy about the prospects for windows for a home or Windows for a computer, but a highly likely doubling of earnings per share over a reasonable period of time is a modern day Aphrodite.
These extremes can occur when the preponderance of market participants behave according to Adaptive Expectations Theory. By this theory, people expect that what has happened will continue to happen. This works opposite to the Rational Expectations Theory that forms the basis for so many prevalent models. By this theory, agents all make forecasts about important economic variables and make no errors in aggregate. According to JP Morgan, about 65% of people think the US economy is still in recession, how can these be rational forecasting agents?! Everything you need to know to properly value a security has not happened yet, but it seems most people are looking backwards- which itself is backward. This creates opportunity. A more subtle point is that common perceptions about the risks associated with large, mid, and small caps have not been true for the last eleven years, a time where perceptions were especially important. The main point we want to express is that the topics relating to the attributes of investment categories are simply bunk. The same sorts of thinking went into reductionist arguments that gave birth to the style box (an extreme of Adaptive Expectations Theory) and the models that started with mortgages and created mortgage backed securities which morphed into economic cancer cells (an extreme of Rational Expectations Theory). Unfortunately for America, these bogus lines of thought will not change and will continue to be sought. In a similar way, people have little faith in weather forecasts, but still check the ten day weather forecast and pass along to others what the weather is “supposed to be”. At least the weather is directly relevant to the experience they will have, whereas one who has opinions about an investment category is far from guaranteed to experience the returns of that category.
The fact that we have been adding disproportionately to specific large caps does not mean anything about large caps. We do not care what happens to large, mid, or small caps. But we do care greatly what happens at the companies you own because it will eventually be reflected in the stocks you own!
Important Disclosures:
This blog is for informational purposes only. The statements contained herein are solely based upon the opinions of Redmond Asset Management, LLC and the data available at the time of publication of this report, and there is no assurance that any predicted results will actually occur. Information was obtained from third party sources which we believe to be reliable but are not guaranteed as to their accuracy or completeness. This blog contains no recommendations to buy or sell any specific securities and should not be considered investment advice of any kind. Past performance is no guarantee of future results. In making an investment decision individuals should utilize other information sources and the advice of their investment advisor.
