Monthly Commentaries

Why are people betting on small cap stocks? – May, 2010

In May, the optimism that investors felt disappeared. The month turned out to be the worst for equities since 1940 with major markets down from 4% to 9%. As a result, most equity markets erased their gains for the year. However, the only place where optimism remains alive and well is in the small-cap sector. At Toron, what continues to surprise us is the performance gap between large-cap stocks and their small-cap brethren. Generally, small-cap stocks perform better during the early part of an economic recovery as businesses start to grow and add workers. Measured by the Russell 2000 Index, year-to-date small-cap performance is up 7% and better than the S&P 500 Index of larger companies. This index now trades at 26 times forward earnings and its dividend yield is a miniscule 1.2%. This compares with the average Toron portfolio that trades at an average price-earnings ratio of 14 and a dividend yield of 3.4%. We believe that small-cap investors may be severely disappointed in the future for a number of reasons: 1) Large-cap stocks have a better borrowing advantage. The largest companies often have investment grade credit ratings - the smaller ones do not. With the massive inflow of investment capital into fixed income during the past year, there is significant demand for investment-grade credit.

Large-cap stocks enjoy the advantages of lower interest rates and few, if any, loan covenants. For small-cap stocks, however, it's often the opposite - higher rates and more restrictive covenants are the norm. This difference both in cost and restrictions gives the large-cap segment a significant advantage. This is particularly the case for the Toron stocks. Many have very low debt levels or no debt at all. 2) Large-cap stocks have a yield advantage. Currently, the U.S. 5-year government bond yields 2.15% and the Canadian 5-year bond yields 2.70%. By investing in small-caps, an investor gives up 1% in yield compared to a risk-free government bond. The Toron portfolio earns an extra 1% in yield compared to a 5-year bond and more than 2% compared to a small-cap stock. By forfeiting this yield, small-cap investors depend more on price appreciation to generate returns. 3) Large-cap stocks have a margin of safety. With a higher dividend yield and a lower price-earnings ratio, the Toron stocks offer a better buffer against the inevitable ups-and-downs of the economy. The average market price-earnings ratio over the last century has been about 16. A reversion to the historical average would be devastating for small-cap investors (a potential 38% drop) but pleasant for Toron portfolios (a 14% increase).

Similarly, if the market moves sideways, the Toron portfolios reward investors with dividends that have a higher yield than government bonds. Both dividends and valuation support avoiding small-cap stocks and investing in large-cap equities. No matter how you look at it, small-cap stocks have many paths that lead to disappointment and only one path to reward - higher stock prices. For the Toron portfolios, both time and value are on your side. Arthur Heinmaa, CFA Managing Partner