June 10, 2008
DIVING DEEP FOR VALUE
The idea that smaller companies can potentially generate bigger rewards is an old one, although it's forever new in creating hope.
In 1981, Rolf Banz formally introduced the concept of a small-cap risk premium into the academic literature. For the 43 years through 1974, small cap performance left large cap stocks in the dust, his study found.
The news probably wasn't surprising to financial economists. Modern portfolio theory, forged in the 1950s and 1960s, teaches that higher returns are a function of higher risk, and by that simplified reasoning the higher performance identified by Banz looks like compensation for higher risk.
In the years after Banz's paper, small cap research has became increasingly sophisticated, as well as controversial. As evidence, one need only review the debates that are still raging in the wake of the Fama and French research that identifies small-cap and value risk factors as fundamental drivers of equity returns generally.
Certainly there's plenty of risk in small cap stocks. On that, we can all agree. There's even more risk in the micro-cap equity realm, which includes the smallest of the small. Does the higher risk translate into even higher returns? Perhaps, although this world isn't for the financially squeamish. But if you can stand the heat, and you have an eye for value, there may be opportunity at the low end of the capitalization scale.
Exactly how much opportunity is debatable. In search of more context, Jon Heller recently created an index that tracks a basket of the "deep value" spectrum of micro-cap value stocks: the Cheap Stocks 21 Net/Net Index. It's far too early to make definitive judgments on such a short track record, but that doesn't stop us from looking.
If you're curious, pay a visit to Heller's blog, Cheap Stocks,where he comments on value investing far and wide. Yet for all his enthusiasm for poring over thinly traded microcaps in search of value, he's also mindful of the dangers. As he wrote last week, there's no shortage of hazards lurking in the murky waters of deep value microcap investing. That may be why the rewards can be so extraordinary. Nonetheless, the traps "are especially prevalent in the land of net/nets (companies trading below net current asset value) where we expend a great deal of research effort," Heller warns.
Heller, by the way, is an analyst by training. Holding both a CFA and an MBA, he's president of Newtown, Pa.-based KEJ Financial Advisors, LLC, his recently launched fee-only financial planning firm. Previously, he spent 17 years looking at the numbers for Bloomberg, L.P., in various positions, including overseeing the firm's equity research department for several years. He's also worked at SEI Investments. This reporter had the good fortune to witness Heller's impressive analytical skills up close, when our paths crossed at Bloomberg. For all his abilities at reading balance sheets, deciphering income statements, and otherwise looking for financial pearls among swine, he has also has a healthy respect for portfolio diversification and the power of multi-asset class portfolios. In short, Heller is that rare breed who knows how to navigate the micro and macro waters when it comes to investing strategies and financial analysis.
As such, we were intrigued when we learned that our old pal has been dabbling in an indexing project targeting micro caps that look undervalued. Relatively little is known about how this group acts as an asset class, if we can call it that. That makes Heller's forays, tentative and experimental though they are at this point, worthy of closer inspection. Inspired to learn more, we recently conducted an email interview with Heller on his new index. Here's an excerpt:
Q: What does your Cheap Stocks 21 Net/Net Index tell us about the world of micro-cap equities?
A: We’ll know more when we get a bit more history under our belt. But I believe what it will end up telling us is that Ben Graham’s technique of buying companies trading on the cheap, relative to their net current assets, still has merit. Perhaps, then, there’s value in “indexing” these small lost souls of the market that comprise our index.
Q: The implied assumption here is that the markets aren't efficient.
A: While the markets are pretty efficient in certain areas, such as large-cap stocks, they are far from perfectly efficient, I believe, in the micro cap space. While this may not provide much opportunity for institutional money, it may be beneficial for individual investors.
Q: How so?
A: The markets tend to throw the baby out with the bath water, and that’s probably truer within micro land.
Q: What's the design philosophy for your index?
A: It's constructed using companies that are so beaten down that they trade at less than their net current asset value. All else equal, if the assets have value, and the company is not insolvent--two big ifs in net/net land--the stock may be dirt cheap.
Q: What are the specific criteria for companies to get into your index?
A: There are several:
* A market cap that's below net current asset value, defined as: current assets less current liabilities, and then subtracting all the other long-term liabilities, including preferred stock and minority interest where applicable.
* A stock price above $1.00 per share.
* Companies that have an operating business, and so acquisition-oriented firms are excluded.
* A minimum average 100-day volume of at least 5,000 shares. And, yes, that's light as volumes go for the stock market generally, but it's fairly high in the wonderful world of net/nets.
* Index constituents are selected by market cap, meaning that the index is comprised of the “largest” companies that meet the above criteria.
Also, the index doesn't discriminate by industry weighting and so some industries may have heavy weights while others may have minimal weights, if any.
Q: How many companies are in the index overall?
A: It’s The Cheap Stocks 21 Net Net Index, so you’d think that there would be 21, right? When I launched the index, there were 21. When Renovis (RNVS) was bought out, however, I made the decision not to replace that company in the index and therefore, in essence, keep that piece in cash.
Q: How is rebalancing handled for the index?
A: It's rebalanced annually. Companies no longer meeting the net/net criteria will remain in the index until annual rebalancing. Otherwise, the only cause for deleting a company prior to the scheduled rebalancing is due to bankruptcy, delisting or the firm's acquired by another company. We may also continue to track the original index over time, perhaps labeling them in vintages, to see how original net/nets perform several years out.
Q: How has the Cheap Stocks 21 Net/Net Index performed, and how does it compare to, say, the small-cap Russell 2000 and the Russell Microcap indices?
A: The results are very interesting and arguably encouraging, so far. But take that with a grain of salt since the inception date of my index is only February 12, 2008. In other words, we have less than four months under our belt and that's too short a period to make any real conclusions. That said, since inception (through 6/6/08) the Cheap Stocks 21 Net/Net Index is up 14.11%, while the Russell Microcap Index, the closest thing to a comparable benchmark, is up 0.74%. The Russell 2000 is up 5.41%, but I’m not sure how relevant that comparison is. In terms of performance of the index members, we’ve already had one company get into trouble (Handelman: HDLM) and another one was acquired (Renovis: RNVS). We’ve also had others, such as Finish Line (FINL), and Anadys Pharmaceuticals (ANDS) that have doubled or tripled in price.
Q: What's the rationale for targeting the stocks in your index? How would you expect their risk/reward profile to differ from other corners of the equity market?
A: When companies trade below their net current asset value, there are three potential reasons. The first is that the company is going under. The second is that the market just doesn't care. The third is some combination of the two.
Meanwhile, history has shown us—based on the few studies that have been done, plus our own research--that net/nets tend to outperform the markets. While it’s true that some individual net/nets are on the way to bankruptcy, a.k.a. cheap for a reason, others will recover. In that case, either business conditions improve, the company's acquired, or the market wakes up to the overlooked value in the firm. What’s difficult to do in some cases, however, is tell the difference between who will survive, and who won’t. As a result, taking an “index” approach and buying a whole portfolio of net/nets may prove to be a fruitful endeavor. Out of 20 companies, you may end up with a bankruptcy or two, a bunch of names that do nothing, and a handful of big winners. Without taking a broad portfolio approach of indexing, however, you may not have been able to single out the winners in the first place.
Q: What types of companies populate your index? For example, do they tend to come from the same industry? Are they usually profitable?
A: It depends on what's happening in the markets, but often you see tech, biotech and retailers, to name a few. A few are profitable, and these also tend to have a lot of cash and trade at very low prices relative to book. For instance, at inception, the average price-to-book ratio of the companies in the index was 0.58. Meanwhile, the companies in the index currently average $58 million in cash and short-term investments, while the average market cap is just $103 million. These are tiny companies that may be burning cash, but the good news is that they have plenty of it—cash, that is, relatively speaking—and with slow burn rates.
Posted by jp at June 10, 2008 8:01 AM