Small-Cap Stocks Small-Cap Stocks: A Gentleman's Bet
by James Boric
The Daily Reckoning
September 4, 2003 James Boric explains why right now Small-Cap Stocks are definitely the way to go when investing. --------------------- Dow, S&P put in 15-month highs…"Are we 180 degrees wrong!?"…DR readers seek reassurance…and get it. The 'recovery': Will small caps lead the way again? (You can bet on it! below…) Schwarzie and Wag…staving off the Chinese bubble…fun with the French press…and more, more, more…and more!
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"Could it be that we have been facing the wrong way? Instead of gloom, are we about to be overwhelmed by a new growth phase across the world, with China as the new member of the trading economy? Will it mean prosperity for all? Can even the huge U.S. deficits be worked down under a huge wave of new growth? Will house price booms in the U.S., the U.K. and China be a harbinger of growth to come in the wider economy, rather than an unsustainable anomaly facing a massive correction? "Reassure me please! I have spent the last two years believing the world was going to change for the worse. Could it be going to change for the better?" We can almost hear them: "Well, what do you think now, Misters Smartypants?" They're talking to us. We said the world was going to Hell in a handcart. Instead, it seems to have risen to Heaven. What else could it be? Where else could you get rich by lending money to people who can't pay it back? American consumers' ratio of debt to income is at its highest level ever. Yet, they are expected to keep borrowing and spending forever. Last year, Americans borrowed $2.5 trillion in mortgage loans. This year, they're expected to boost the total to $3.2 trillion - or about $65 billion per week. With this borrowed lucre, they not only get new houses…but they also get to walk into auto dealerships and doughnut shops with money in their pockets. Krispy Kreme, for example, has seen its doughnut business rise nearly 30% in the last 6 months, with earnings up too. Investors seem to see no limit to the number of doughnuts consumers can put away, nor to their ability to buy them. The stock is priced at 50 times estimated earnings. Alan Abelson notes in Barron's that Krispy Kreme is buying up its franchises - paying between 3 and 10 times earnings before interest, taxes, depreciation and amortization. That is, it is willing to pay up to $10 for each dollar's worth of earnings in the doughnut business. Why then do investors pay two and a half times as much for Krispy Kreme stock, on the same accounting basis? Is the company wrong about what its franchises are worth? Or are investors wrong about what Krispy Kreme is worth? We have our opinion. The lumpen have theirs. There are 3 kinds of money on Wall Street, dear reader. There's the smart money, there's the dumb money…and there's the money so brain-damaged that it practically begs for euthanasia. For the moment, it's the dumb money that has the upper hand. While smart insiders get out, the dumb money buys…and prices rise, as they did again yesterday. And today's press brings good news from all over the planet; maybe the dumb money isn't so dumb, after all. The U.S. consumer…that stalwart shopper upon whom the entire world economy depends…is still digging himself deeper and deeper into his hole of debt. As a result, in America, the Fed gave an "upbeat assessment" of economic prospects in its Beige Book, says the Financial Times. Germany seems to be catching a break. Japan is finally on a upswing. But what's this? Mortgage applications fell again last week - the 4th in a row. People are still buying new houses - at a record pace - but, with higher rates, they're not refinancing the way they used to. Could it be that everyone is looking at figures from the recent past…instead of turning their faces to the future? The U.S. housing (and financing) industry was probably responsible for at least half the world's economic growth over the last 12 months. (The rest was military spending and doughnuts…) But what if the housing boom really were over? "The main force propelling residential real estate - the lowest interest rates in 40 years - is suffering a brutal reversal," FORTUNE points out. "Since June the rate on 30- year mortgages has gone from just under 5% to 6.1%. A new $500,000 home loan now costs homeowners $2,540 a month in interest, compared with $2,040 in June, an increase of 25%. Suddenly the throngs who rushed to refinance their homes at bargain rates are thinning. Weekly home-loan applications have already shrunk 80% from their peak in May, and that's no blip. The market scaled such outlandish peaks that a nasty fall is all but inevitable." We don't know, of course. Steve Sjuggerud argued in Tuesday's episode of The Daily Reckoning that the housing boom still has a long way to go. And maybe it does. But smart money is wary money. It wouldn't buy Krispy Kreme at these prices - even if they gave away the day-old doughnuts free to shareholders. And to our dear reader seeking reassurance, we offer it: even though things seem to be getting better, for the moment, they are actually getting worse. For the longer it takes to correct the debt bubble, the worse it will be. Housing may continue to inflate, or it may not. But it can only inflate by sucking the air out of householders' balance sheets…leaving them deeper in debt than ever before. Right, Eric? ------------- Eric Fry, reporting from Wall Street: - Well…for a second straight day, the stock market thumbed its nose at the ghosts of Septembers past, as the Dow Jones Industrial Average gained 45 points to 9,568 and the Nasdaq rallied 11 points to 1,853. - Cheery remarks from Cisco Systems emboldened investors to continue buying overpriced tech stocks, including "CSCO." Shares of the networking giant surged 3.3% to a fresh 52- week high after CEO John Chambers declared that the company's August orders were "better than expected." Chambers neglected to mention what was "expected," and investors did not seem to care about the specifics, as long as whatever happened at Cisco in August was "better than" whatever was supposed to have happened. - Generally speaking, conditions in the tech industry have improved very little. But conditions in the tech sector of the stock market have improved substantially. The Nasdaq 100 Index of non-financial companies has soared nearly 70% from the lows of last October, while the shares of Cisco Systems have more than doubled…Either investors are looking ahead - far, far ahead - to a period of substantial earnings growth, or they're looking behind, pining for the days when Cisco Systems was 'cheap' at 100 times earnings and boasted the world's largest market value. - Alas, the truth is sometimes hard to bear, but the Internet mania that fueled a once-in-a-lifetime stock market bubble is dead and gone. And when it died, a few trillion dollars of shareholder wealth also perished, and a few billion dollars of annual tax revenues vanished. Stocks may be rebounding on Wall Street, the tax collection is still mired in a deep bear market. - As of late March, state governments faced collective deficits of $94 billion…which isn't chump change. Just imagine all the wonderful things that $94 billion could buy. With that kind of money, the U.S. Army could occupy Iraq for almost one entire year! Or the state of California could plug its budget shortfall for more than two years! - "From Maryland to Oregon, governors are firing state workers or raising taxes - sometimes both - to meet spending cuts," Bloomberg News reports. "Maryland Governor Robert Ehrlich Jr. said he'd fire 82 employees and pare spending by $280 million from the current fiscal budget. Oregon Governor Ted Kulongoski agreed to reduce spending by $1 billion and raise taxes by $800 million in a two-year budget that lawmakers approved in late August…" - The cause of the tax revenue shortfall besetting the 50 states is hardly a mystery. For the last three years, states have been facing a toxic combination of falling employment and falling share prices. Meanwhile, the states' expenses continue their inexorable rise. - The parlous condition of state and municipal finances, epitomized by California's $38 billion shortfall, has caused investors to shy away from municipal bonds, especially those issued by the not-so-Golden State. "A California general obligation bond that matures in 2022 was priced Friday at $96.59 with a yield of 5.29 percent," says Bloomberg. "That's 44 basis points higher than Bloomberg's index for comparable AAA rated general obligation debt, which had a 4.85 percent yield Friday." - In other words, bond investors are a little bit wary about lending money to states that might not repay their debts. But they are only a LITTLE bit wary… - "Municipal bond volume appears to be on track for another record year of issuance," Dow Jones News reports. "With state budgets expected to continue confronting deficits, and with the flow of funds from the states to local governments severely pinched, candies, cities, towns in villages across the country will continue to have little choice but to borrow to meet essential project needs, even if they do cut back on other spending." Muni bond issuance could top $400 billion this year, which would easily top of the record of $357.1 billion that was just sat last year. - "The federal government will also set a new borrowing record this year," observes Doug Noland of the Prudent Bear Fund. "Corporate debt issuance, although remaining considerably below late '90s bubble levels, is picking up meaningfully. We are on pace for record junk and convertible debt issuance. In total, we are in the midst of record system credit growth." - Bravo for Mr. Greenspan!…The chairman's bubble- reinflation campaign is progressing very nicely. [If you'd like strong insights into the mind behind the reflation strategy, read John Mauldin's dissection of Easy Al's Jackson Hole speech given last Friday, here: The Greenspan Uncertainty Principle] --------------- Mr. Bonner, back in Paris… *** And what's this? China increased its reserve requirements for commercial banks from 6% to 7%. Why would we care? It's just that China is the latest bubble economy - puffed up by the Dollar Standard. Chinese officials have watched what happened in Latin America, Japan, Malaysia, Thailand and the U.S. - as a tidal wave of dollars made its way around the globe. Have they learned anything? Are they trying to let the air out of the bubble before it gets too big? Will they be able to do what Greenspan couldn't - spot a bubble and prick it? More on this and other things (including investment opportunities in China)… tomorrow… *** The front page of yesterday's Le Monde tells us more about the man who may be California's next governor. "In 1966, this couple (Wag and Dianne Bennett) dominated the London body-building scene. Wag was one of the judges for the Mr. Universe competition, in which a young 19-year- old Austrian - a good-looking kid with only rudimentary English - participated. "Instinctively, Wag realized that he was looking at a star. 'Schwarzie' went to live in their house on Romford Road where the Bennetts lived with their six children. 'Arnold had all the attributes to become a champion. His perseverance at training was incredible,' recalls Diane Bennett. "For two years, this native of Graz slept on the Bennett's couch. He rarely went out, avoided the pubs, and courted the young girls who worked out in the gym. Dianne made his shirts and his pants. Each morning, she prepared his breakfast, an omelet of 8 eggs and an enormous steak. "In 1968, following the Bennett's advice, Arnold emigrated to the U.S…" *** We often check the foreign press, just to see what they think of us. Also on the front page of Le Monde, Patrick Jarreau wonders about Americans' technical abilities: "No one dares doubt Americans' technical mastery and professionalism," he begins. Still, for the last three years, everything that could go wrong, technically, seems to be going wrong. First, he notes, even counting votes in Florida proved a challenge that had to be resolved by the Supreme Court. A year later, terrorists with box cutters revealed an extraordinary weakness in the nation's security systems. Then, in February 2003 the space shuttle disintegrated. And finally, he says, it's bad enough that they can't get the electrical system working in Iraq, but they were even unable to keep the lights on at home. *** The French press is still sweating the heat wave. Each week, it seems as though the tally of the dead rises. "A warning should have been issued earlier," says an article in the Figaro. We wonder what the warning might have said: "Attention, it's hot! Keep cool or you may die!" Perhaps the government should have organized squads of volunteers to go around and visit old people - forcing them to drink bottles of Perrier. *** Speaking of warnings, the French have become even madder than Americans when it comes to cigarettes. You can still smoke in most places, but now packs of smokes must carry a large warning: CIGARETTES KILL! Or SMOKING CAUSES LONG AND PAINFUL DEATH! Or, SMOKING CIGARETTES MAKES MEN IMPOTENT! No one seems concerned that the warnings are fraudulent. As far as we know, no one has ever shown that smoking a cigarette every once in a while is harmful. Nor do the warnings mention that smoking has some beneficial effects. When you feel like killing someone, for example, sit down; have a smoke. By the time the cigarette is finished, the fatal instinct may have passed. Or, if you believe the French warnings, you are dead anyway. *** A reader's comment: "We wallow in madness here in California. Vote for Larry Flint! Vote for Arnold! Vote for Gary Coleman! Throw a dart at the board and pick one of the 135 candidates! The sun didn't show two days ago - it must be Gray Davis's fault! A woman was killed last week by a Great White shark 10 miles from my home - maybe Gray Davis put it there - he certainly didn't protect us from it - recall him! Off with his head!" Sign up for The Daily Reckoning…
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by James Boric I'm not usually a betting man, but today I'm going to make an exception. I've found a group of stocks that will likely outperform every major index over the next 12 months - by at least 15%. The reason I'm so sure: it's happened time and time again dating back to the early 1920s. And it's happening now. I'll tell you about my winning stock idea in a second. But first I want to remind you of an article I wrote almost one year ago today for The Daily Reckoning. On Sept. 24 of last year, I told you to prepare for a recovery. I wasn't so bold as to say when. But I knew the market would recover, soon. More importantly, I gave you a plan of attack to make back ALL the money you lost from 2000 to 2002 - if you had stuck it out in the stock market while it crashed. At the time, it seemed like the financial world was going to hell in a hand-basket. The Dow Jones was down 35% from its all-time high in Jan. 2000. The S&P 500 was down 46% from its high in March of 2000. And the Russell 2000, the 'small-cap index,' was taking a beating as well. It was down 41% from its high in March 2000. Panic was in the air. Small-Cap Stocks: Small-Caps Lead the Way Despite the doom and gloom, I suggested last September, based on historical precedent, it was time to invest in fundamentally sound small-cap stocks. Why? One simple reason: for the last 100 years, small-cap stocks have led the way once the market turned from bear to bull. Let's take a stroll down memory lane… In the recovery years following the crash of 1929, small- cap stocks outpaced large-cap stocks by about 20% a year - for four years. Following the crash of 1973, small-caps rose 349% from 1975 to 1980. Their large-cap counterparts managed only 59% gains. And after the downturn in 1982, small-cap stocks jumped up almost 37% by 1983. Again, large-cap stocks lagged behind - gaining only 21%. The statistics are irrefutable. When the market turns from bear to bull, small-cap stocks have historically been the best class of stock to own - PERIOD. Always have been? Perhaps, they always will be. Take this most recent rally for example. On March 11, 2003, the Dow was at its lowest point since October 2002 (just after the Sept. 11 terrorist attacks). It was trading at 7,524. Since then, it has rallied up to 9,523 - a gain of 27%. Small-Cap Stocks: The Russell 2000 Not too shabby. But the Russell 2000's turnaround has been far more impressive. The Russell 2000 is a small-cap index. It hit a low of 345 on March 12. Today, it trades at 507 - up 47%. Just like in the 1940s, small-cap stocks are outpacing the blue chips by about 20%. In the last six months, had you invested in select small caps with sound fundamentals, you could have made back everything you lost in the 2000 fallout - just like I predicted. So why don't more investors forget about the slower-moving large-cap stocks and dump their money in the small-cap market? Risk. Most investors consider buying small-cap stocks 'gambling,' 'speculation' or very 'high-risk.' They are right to a degree - albeit a very small one. In the late 1990s, Sherman Hanna, a professor at Ohio State University, and Peng Chen, an associate at Ibbotson Associates in Chicago, did a study on small-cap stocks versus large-cap stocks. They wanted to show how they stacked up against each other in the short, medium and long term. Small-Cap Stocks: In for the Long Term Here's what they found… Using data from 1926 to 1996, Hanna and Chen found that small-cap stocks are riskier if you hold for shorter periods of time. For instance, if you picked the absolute worst five-year holding period between 1926 and 1996 to invest in a basket of small-cap stocks, a $1 investment in that basket would have been worth 26 cents at the end of the five years. Scary. But that's the worst-case scenario - the number doom and gloomers will use to convince you to head to the hills and never look back. It's not normal. So let's look at what is. In an average year, small-cap stocks outperform large-cap stocks 56% of the time. Bet you didn't know that! And the longer you hold small-cap stocks, the more impressive the numbers get. If you hold for 10 years, small-cap stocks will beat their large-cap counterparts 66% of the time. (Also, the 10-year mark is where the risk associated with holding small-cap stocks equals that of the large-caps. In other words, after 10 years, it's actually riskier to hold large-cap stocks!) And if you hold for longer than 10 years, forget about it. There's no comparison between small-and large-cap stocks. During any 15-year holding period, small-cap stocks will beat out large-caps 78% of the time. Over 20 years, they win out 94%. And over 35 years, small-cap stocks have always beaten out the blue chips. Always. Small-Cap Stocks: Fundamentally Sound Let there be no doubt - if you are looking for a long-term investment strategy, you would be foolish not to consider small-cap stocks. But the question everyone wants an answer to is: How can I make money now? I don't want to wait 20 years. I'll tell you the same thing now I told you last September. The secret is to look for fundamentally sound small-cap stocks. Right now, there are 8,880 active companies (large and small) trading on the major U.S. exchanges. Of those, only 101 are fundamentally sound, growing enterprises. How many do you think are large blue chips? Go ahead, guess. Twenty-five? Fifty? Seventy-five? Nope. Try 14! There are only 14 large-cap stocks that trade for 25 times earnings or less, 1.5 times sales or less, 1.5 times book value or less AND are growing their sales 10% quarter-over- quarter and their net incomes by at least 1% quarter-over- quarter. The remaining 87 fundamentally sound companies are all small-caps - with a market cap of $1.5 billion or less. These are your best investment opportunities over the next year, five years and beyond. In fact, I'm so sure of myself, I'll make you a bet - a gentlemen's bet. Over the next 12 months, those 87 fundamentally sound small-cap companies will outpace every single major U.S. index by at least 15%. Not only that, they will collectively beat the tar out of the 14 fundamentally sound large-cap stocks - by at least 10%. Am I nuts? Maybe. But I have 80 years of history on my side that says otherwise. I like my odds. And as long as the market remains in recovery mode, which it is in right now, small- cap stocks are the way to go. They will beat out every other class of stock. Sincerely, James Boric
For The Daily Reckoning P.S. This wouldn't be a fair bet if I didn't give you the list of 14 large-cap stocks and 87 small-cap stocks to see for yourself. If you are interested in the list, send me an e-mail at psfortunes@agora-inc.com with "send me your list" in the subject line. I'll send you a spreadsheet with all the data. Next September, I'll let you now how the 87 small-cap stocks performed relative to the broad market and the 14 large-cap stocks. Editor's note: James Boric is the editor of the small cap advisory letter Penny Stock Fortunes, where he looks for great companies at penny stock prices. James also writes a weekly e-mail called the CXS Alert. For more advice on how to profit from small cap stocks, see: Penny Stock Fortunes | 
