Small Cap Valuations: Market Cap Bias and the Dangers of Headline P/E Ratios

       Using headline valuation metrics as a barometer can be particularly dangerous and misleading, especially for the Russell 2000 Index.  In addition to distorting the index, a market cap "blind spot" has created persistent inefficiencies (and opportunities) at the smaller end of the small cap universe.  Our small cap strategy, with a current median market cap of roughly $350 million, concentrates on smaller companies because this is precisely where thorough research matters the most.  

  

      During our recent conversations with institutional investors and consultants, we have frequently heard that "small caps look expensive."  Indeed, the Russell 2000 currently sports a headline P/E ratio of nearly 30x trailing earnings compared to around 14x for the S&P 500.  Is this conclusive evidence that small caps are overvalued -- especially relative to large caps?  

      We have been somewhat puzzled by this conclusion, as it contradicts what we have been seeing "on the ground."  As bottom up investors, we spend our time researching one company at a time.  While we are inherently intimidated by high valuations, we continue to come across plenty of small, well-run enterprises which appear to be both undervalued and out of favor.  Likewise, many of the quarterly earnings conference calls we tune in to have continued to garner muted interest at best (with some having no Q&A participants at all)--not exactly a sign of "irrational exuberance" for small caps.  Both of these observations are confirmed by the most recent additions to our small cap portfolio which are valued well below the Russell 2000 Index by most metrics.  So...what gives?

      One part of the explanation lies in the structural market bias we have previously referred to as the "market cap blind spot."  A majority of sell side analysts and professional money managers concentrates on the largest companies in the small cap universe and ignores the smallest ones.  This stubborn reality is reflected in the holdings data for buy-siders:  the average small cap mutual fund in the Bloomberg universe has a median market cap of $1.8 billion - a full three and a half times the $491 million median of its Russell 2000 benchmark.  In addition to creating persistent inefficiencies in the small cap marketplace, this bias has distorted valuations within the index itself.  An average of the valuation metrics presented indicates that the largest quintile of the Russell 2000 is 20% more expensive than the smallest.  This relationship underpins a counterintuitive dynamic in small caps, namely, the size of the company--not necessarily the merits of the business--is often the determining factor of its valuation.  This contrasts sharply with large caps, where size generally plays no discernible role in company valuations.

Evidence of the Blind Spot

 Russell 2000 Median Valuations by Quintile (10/31/2012)*

	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts
1 (Largest)	1,642	18.6	15.2	13.5	10
2	854	16.7	14.1	12.4	8
3	491	16.3	13.9	13.3	7
4	269	16.4	13.6	11.8	5
5 (Smallest)	150	14.9	13.2	11.3	4

 S&P 500 Median Valuations by Quintile (10/31/2012)*

  

	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts
1 (Largest)	56,433	15.2	13.2	12.3	28
2	19,999	14.7	13.8	12.4	24
3	7,722	16.4	13.8	12.2	19
4	7,668	16.8	14.5	12.2	19
5 (Smallest)	3,932	15.5	12.8	11.5	16
*We chose to use median data to eliminate the effect of extreme numbers and also believe it is more representative of company valuations found in each quintile. Data assembled from Bloomberg, L.P.

      Because of market cap bias, the Russell 2000's headline P/E (a weighted average) is inflated, as the most expensive companies have the greatest representation in the index.  This dynamic is further compounded by the fact that the Russell 2000 has more than twice the proportion of companies with exceptionally high P/E ratios* (often caused by marginal recent profitability).  In our view, median data produces a far more meaningful comparison because it is less affected be these distortions.  We also believe that median data is more indicative of the valuations of a "typical" company in the index and also more representative of the characteristics which an active manager is most likely to uncover during his or her research.

*10% of Russell 2000 names have a P/E ratio over 40 compared to only 5% of S&P 500 names.     

Median Data Comparison (10/31/2012)
	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts	Sales Growth	Earnings Growth
Median R2K Company	491	16.9	14.2	8.9	7	5.5%	7.0%
Median S&P 500 Company	12,495	15.9	13.6	9.0	23	2.4%	4.5

      When examined on a median basis, the valuation disparity narrows substantially: small caps are only 4% more expensive than their large cap counterparts despite appearing twice as expensive on a headline P/E basis.  We think that this slight valuation premium for small caps is more than warranted considering their stronger sales and earnings growth characteristics (in red). 

Mis-Impressions

I’m a huge golf fan. I’m a bigger Ryder Cup fan. So Friday morning was the start of a golf fan’s “best 3 days”. The TV was on but I was not tuned in. I had to work.  I looked up every once in a while to see how my American favorites were doing against their European counterparts, and every time I did something bad was  happening to the  Americans. I saw Tiger hit balls into the woods, I saw Furyk “ lip out” putts, so I naturally assumed we were getting our “collective American butts” kicked in the morning session. Much to my surprise this was not the case. Americans and Europeans were tied when the morning session concluded. It occurred to  me that this must be how many  individual investors feel about stocks and the stock market.

Research points out that this is exactly the case. Franklin Templeton surveyed one thousand Americans in 2010, 2011 and 2012, and asked them how they thought the stock market had finished at the end of the previous year. For the year 2009, in which the S&P 500’s total return was 26.5%, 66% of the thousand respondents said that it had been down or flat. For 2010, when total return was 15.1%, 48% of those surveyed said that it had ended down or flat. For 2011, the return was 2.1%, and 53% of respondents said that the market had been down or flat. What’s worse is that, based on these “embedded impressions” and the continuous negative media drumbeat, these same folks are likely deferring investments or vacating well thought out financial plans. Over $300 billion has been withdrawn from actively managed equity mutual funds since the market bottomed in March of 2009(The S&P 500 is up 115% since then). The money is still trickling out because when people glance up at the screen it looks like Phil or Tiger missed another putt.

I guess the  choice is to pay attention or turn the TV off. 

Institutional Bias and the Story of Allied Capital

Over the past weekend, I started and finished the real-life tome Fooling Some of the People All of the Time by famed hedge fund manager David Einhorn of Greenlight Capital.  You could be forgiven for reading the book and thinking it fiction, as the story takes some unexpected twists and turns and at times reads more like a detective novel than a financial narrative.  It's a quick but thrilling read (although that may be over-selling it; I'm the kind of guy whose blood starts pumping when reading a really good 10-K).

The heart of the story is this: really smart hedge fund guy uncovers accounting irregularities at said public company and wages a years-long campaign to raise awareness of the likely-fraud and to ultimately force regulators to intervene.

While the mere existence of practices of aggressive accounting, management opacity, and outright fraud at a public company are distressing, unfortunately they are more common than many investors think.  Mr. Einhorn has done an exception job over the years of rooting out other public companies with such questionable practices.

What is more distressing to me was the burning, unanswered question I was left with at the end: why did it take so long--years, in fact--for the issues at Allied Capital to ultimately be recognized by its shareholders, by the market, and eventually by its regulators?  The stock price of Allied over the ensuing three years from May 2002 (when allegations were first made public) did not visibly discount this information (except in short blips) and actually outperformed the S&P 500 by over 7% per year.

More simply, it paid to be an investor in a company that had decent odds of being fraudulent!

I think the answer to my question, at least in part, lies in the "institutional biases" that motivate many shareholders, private and professional alike, and prevent markets from being perfectly efficient.

To wit:

1.  Few investors do their homework.  While the nitty-gritty details of Allied's accounting practices were laid bare for all to see in the company's regular SEC filings, few investors were willing to roll up their sleeves and do the analysis that ultimately proved incriminating.

2.  Investors love a check in the mail.  Allied's shareholder base had a large contingent of individual shareholders who, as long as they received regular, predictable dividends, did not pay much attention to how those dividends were generated.  They ate the sausage and didnt really care to see how it was made.  These dividend payouts also formed the basis of valuing the company.

3.  Wall Street is a deal machine.  Despite evidence of "irregularities" that should have been as plain as the nose on the face of your average Wall Street analyst, bulge-bracket analysts defended the company "to the death."  Addicted to Allied's regular and lucrative securities offerings, these analysts did not dare to jeopardize investment banking revenues for the sake of honesty.

And so it was, with this biases cemented in the minds investors and professionals alike, that Einhorn's allegations were taken less-than-seriously, and the stock was allowed to work its magic.

*     *     *

In our own search for investment ideas, we constantly remind ourselves to be on the lookout for these biases in other investors.  They are the means by which securities become over-priced and by which they become under-valued.  They are the reason that markets always have been and always will be inefficient.

Many times, these recognizable biases can be a starting point for finding undervalued securities:

Companies with complicated financials whose small but meaningful nuances dont make it into the quarterly press release.

Companies that dont pay dividends in an industry where all of their peers do.

Companies who have no interest in playing the Wall Street game: no continuous equity offerings, unending road shows, or investment bankers on the payroll.

These biases lead other investors to shortcut their decision-making process, usually reaching a conclusion as to whether they should or should not own a stock based on reasons that don't always relate to the fundamental value of the company.  That is our opportunity, and one we seek to exploit every day.

Stock Market Inefficiency You Can Set Your Watch To

It's that time of year again.  The time of year of which every small cap money manager is acutely aware: the annual rebalancing of the Russell 2000 Index.


The Russell 2000 is the de facto standard in small cap equity benchmarks.  It's tracking ETF, the iShares Russell 2000 (IWM), has a whopping $15 billion in assets.  That's a lot of money moving around in what can be a very illiquid asset class (the smallest stock in the index today has a market cap of only $7.7 million).  So when Russell makes its once-a-year additions and deletions to the index at the end of June, it can create some very interesting movements in stock prices.

Consider this: while the Russell 2000 Index overall is up 3.3% year-to-date, the 123 stocks being deleted from the index are down an average of 23.9% and the 189 stocks being added are up 49.0%.  While companies that have seen their stock prices decline over the past year are naturally the ones who are most likely to be booted from the index, these stocks have seen accelerated selling pressure ahead of the rebalancing as investors anticipate the event.

All of which creates an interesting quandary for the efficient markets crowd: what happens when stock prices move significantly for reasons clearly not related to the economic value of a firm?

Perusing the list of stocks that have been sorely punished for the simple reason that they will no longer be included in a passive index, we have found numerous examples of extreme mis-pricing.  Several stocks trade below their net working capital (liquidation value).  Several others trade at low single-digit multiples of cash flow.  A few have seen consensus estimates of their sales and earnings rise recently while the stock was falling precipitously.  These are not rational valuations but rather the result of mindless trading.

While the stock market is efficient much of the time, there are periodic pockets of inefficiency that are often easily distinguishable and predictable.  In the small- and micro-cap universe, these pockets are more frequent and generally of greater magnitude.  To the patient and intelligent investor, these occasional moments of insanity are the fun parts.

Winona? Who would ever go there?!?

Want to know what the best performing stock in the U.S. has been over the past twenty-five years?  No, it’s not Apple.  Or Microsoft.  Bloomberg Businessweek recently reported that Minnesota’s very own Fastenal (NDQ: FAST) holds that distinction, rising 27% per year since 1987.  That’s double the annual return of Apple and triple the S&P 500.

Fastenal, the Winona-based* distributor of nuts and bolts, is a fascinating story.  Founder Bob Kierlin started the business with a single store, a used car, and boxes of nuts and bolts in the late 1960s and through years of hard work and drive, the company has quietly grown to over 2,500 store locations and 15,000 employees.  It is an all-American story that warms our capitalist hearts.

Fastenal is pretty well-known among investors today, after this amazing period of creating significant wealth for its shareholders.  In fact, it is what you might call a “darling” stock, especially among growth-oriented money managers.  But how well-known was it back in 1987, and what characteristics back then might have led an astute investor to join the party before the run began?

As it turns out, not many investors were paying attention at the beginning.  In 1987, Fastenal had a market capitalization of a mere $50 million, small enough to put it in the bottom decile of public companies at the time and well below the radar of most professional money managers.  Moreover, it was based in a small Midwestern town that most New Yorkers had likely never heard of, and much of its stock was held by employees of the firm.  Far from being the latest, greatest technology company, its operations served a very basic purpose: get nuts and bolts to the people on the manufacturing line who needed it.

The reason that we bring up Fastenal is that there are hundreds of small public companies around the country that share many of the same characteristics as the Fastenal of 1987, many in our own backyard.  These are companies that serve basic needs, are run by honest and hardworking folks, and quietly generate significant returns to their shareholders over long periods of time.  And yet because of their size, or their location, or their unwillingness to play the Wall Street game, their stocks remain below the radar of most investors. 

They are the reason we get excited about investing in small- and micro-cap stocks.

*Several years ago we met with a well-healed investment consultant on the east coast and happened to mention the hamlet of Winona, Minnesota, when talking about a portfolio company.  The consultant, oblivious to how arrogant he was about to appear, exclaimed: “Winona?  Who would ever go there?!?”  Sometimes the best companies come from the most unknown places—just look at Fastenal.