What follows is a section from the “Looking Ahead” portion of my monthly letter to investors at T11. I have created an email list that sends this report out at the beginning of each month to those interested. The full report contains commentary about the general markets and individual positions held in managed portfolios, as well as overall performance. To be added to the list email me at mail@T11Capital.com
The Macro
Small company investing has taken on a malicious slant in 2014. In what has become a prosperous time for the S&P, Dow and Nasdaq, the Russell 2000 has been stuck in the mud for a significant portion of the year, elegantly reminding investors that Wall Street takes joy in changing locks to doors that investors become all too familiar in passing through with great ease.
For a good deal of the year we managed to avoid any correlation to small-cap indices as our holdings functioned independently of the averages. However, in Q3 it became apparent that our holdings were not immune. The immunity was not compromised by any company specific events. In nearly every case, our names are simply in a mode of “wait and see” what happens with respect to developing special situations. Rather, the holdings that occupy the portfolios have become victimized by a distinct environment of disinterest.
The cyclical nature of disinterest that exists in the small-cap world is not just a micro phenomenon that causes bids to trickle lower as trading thins out over a period of time. It also speaks to a more macro issue of general investor disinterest in equities. At the core of illiquidity in companies with market caps under $500 million is the simple reality that there is not enough interest in the markets and therefore, not enough capital to spread itself into issues that require a deeper process of discovery.
What does that disinterest signify in a broader sense and how does it influence the markets in the years to follow? Let's look at some statistics going back to 1980. The first study will look at periods of disinterest in the Russell 2000 as defined by a Russell that is either positive or negative by no greater than 3%. Essentially a sideways trading range, similar to what we have experienced in 2014:
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Periods of Disinterest (Russell +/- 3% for year) What Happens to S&P 500 in Following Year? What Happens to Russell in Following Year? 1981 +2.03% 1982 +21.55% 1982 +24.95% 1994 -1.82% 1995 +37.58% 1995 +28.45% 1998 -2.85% 1999 +21.04% 1999 +21.26% 2007 – 1.57% 2008 -37% 2008 -33.79%
The second study will focus on periods of small-cap disinterest defined by a Russell 2000 that is negative for the year while the S&P 500 is positive. This type of divergence has only occurred four times since 1980. If the current trend continues, 2014 will make it five times:
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Periods of Divergence (Russell negative for the year while S&P 500 positive) What Happens to S&P in Following Year? What Happens to Russell in Following Year? 1984 RUT -7.13% vs. S&P +6.27% 1985 +33.31% 1985 +31.05% 1987 RUT -8.80% vs. S&P +5.25% 1988 +16.61% 1988 +25.62% 1998 RUT -2.55% vs. S&P +28.58% 1999 +21.04% 1999 +21.16% 2007 RUT -1.57% vs. S&P +5.49% 2008 -37% 2008 -33.79%
The last study will focus on periods of pure negativity in small-caps, as defined by the Russell 2000 suffering a down year. Here is what happens in the year that follows:
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Down Years For Russell 2000 What Happens to Russell 2000 in the Following Year? 1984 -7.13% 1985 +31.05% 1987 -8.80% 1988 +25.62% 1990 -19.48% 1991 +46.04% 1994 -1.82% 1995 +28.45% 1998 -2.55% 1999 +21.26% 2000 -3.02% 2001 +2.49% 2002 -20.48% 2003 +47.25% 2007 -1.57% 2008 -33.79% 2011 -4.18% 2012 +16.35%
One of the most well regarded traits of any bull market is the fact that small-cap names will lead while outperforming mid to large cap names on the way up. That leadership and outperformance edge inevitably leads to periods of seemingly anomalous price behavior that can easily be misconstrued as a negative divergence to the untrained eye. Since small companies take on a leadership role within a bull market, they will also be the first segment of the market to underperform to a great extent while the rest of the market seems to only be getting stronger. This type of behavior should be seen for what it is: Standard rotation from a sector that has been abnormally large gains into sectors that have not.
As vividly displayed in the studies above, we can see that anomalous periods of price behavior for small-caps are invariably an outstanding buying opportunity during a variety of market conditions. The obvious outlier being during periods of severe distress, such as the debt crisis of 2008.
The message here is abundantly clear: Continued weakness in the small-cap names during Q4 will likely be one of the best buying opportunities for the sector during the entirety of this bull market, with a strong possibility of multi-year gains that average greater than 10% per annum.
Over the short-term, however, the approach to investing in any sector of the market should be cautious in nature. In last month's summary, I said the following:
These bearish views that I continue to see as legitimate concerns are not born out of thin air due to random analysis that says the markets are simply due for a pullback because of various valuation measures, sentiment or “overbought” conditions. The concerns I have are based on the technical merits of not just the general market averages, but a majority of individual stocks, as well. It is a situation where the amount of risk that has to be taken in order to achieve even moderate amounts of reward is as excessive as any point in this bull market. Essentially, the market needs a “reset” in order to create a condition where the amount of risk being taken is minor relative to the reward being offered.
We are presently in the midst of aforementioned the “reset.”. One of the fortunate features of any bull market is its ability to swiftly move through periods of bearish adjustment. I don't assume that this adjustment will move past mid-November. However, during that time the damage on the downside could be fairly extensive (5%+) for the major averages.
The chain of decisions that lead to outperformance during any given year can be directly attributed not to the simple periods where the seas are calm and smiles are many. But rather to the periods of adversity, where the choppy conditions create doubt in the minds of those who were once convinced of a certain outcome. It is during these moments where the markets are stretched both in terms of price and emotions that decisions are made possessing a much higher degree of variability than would normally be expected. It is that variability that creates the potential in the investment. It is also that variability that creates the inability to emotionally cope with such periods in an efficient fashion, leading investors to either overtrade or overthink the situation to the point of mental paralysis.
I'm fairly certain that the chain of decisions that I make in the coming quarter will dictate a substantial degree of our performance in 2015. With that said, the only way to assure that the chain of decisions will be efficient is to simplify to the greatest degree possible, which leads perfectly to the next point of discussion: The Micro.
