Monthly Commentaries

Where the crowd is – November, 2009

During November, good economic news and positive earnings revisions translated into equity market gains. The TSX led the way with a gain of 4.9%, the US markets returned 4% and European equity markets trailed with a return of just under 2%. Over the last seven months, the stock market has moved from a level that priced in a severe depression to one where it is now predicting modest economic growth. What has been interesting has been which investments have attracted the most attention. The answer, surprisingly, is the small-cap stocks with weak balance sheets. From the March bottom, these smaller, weaker companies rose over 150% compared to only 65% for financially stronger firms. Essentially, investors bet there would be a significant turnaround in the fortunes of smaller stocks. The last time we saw this type of behaviour was in the late 1990s when stocks in companies that were losing money rose significantly more than those that generated profits. When the markets fell in 2000, the weakest companies dropped the quickest. We continue to believe that small companies are the riskiest segment of the equity market for the following reasons:

First, the availability of financing for small companies remains difficult and is unlikely to change in the near future. Even if small companies can borrow, it will likely be on punitive terms. Contrast this to larger corporations with strong balance sheets that have raised debt on extremely favourable terms thanks to the large amounts of money that continue to flow into bond funds. The availability of funding should continue to favour the stronger companies. Second, the relative out-performance of small-cap stocks is one of the largest on record. The average out-performance during rebounds from cyclical bottoms has typically been about 20%, or about of the performance differential that we have seen so far. For this situation to continue, the fortunes of those small companies would have to improve more than is already priced into the equity prices. That will be a tall order in a slower growth environment - the likely consequence of any disappointment may be a sharp small-cap sell-off. For many large companies, a slower growth environment will still generate healthy profits due to their diversity of products and markets.

Finally, the lack of liquidity in those smaller stocks not only exaggerated the upward move but would also exaggerate any future downward move. The speculators who buy into these companies tend to build their long positions over time. However, when they want to liquidate, it is usually within a short timeframe. It is the rush to liquidate that can cause dramatic moves in these smaller companies. If nothing else, these movements indicate that large financially strong companies are cheap relative to smaller, more speculative investments. We continue to invest in the financially strong companies because they offer a better return opportunity as they simply continue to build their businesses. For the smaller, more expensive and more speculative stocks to generate their returns, they need another speculator to buy the stock and push the price higher. We would rather focus on the company's fortunes rather than the speculators' next moves. Arthur Heinmaa, CFA Managing Partner