In the last post, I discussed the opportunities for impressive investment returns offered by cyclical companies. When utilizing that strategy, the total assets under management (AUM) effectively defines the universe of investable candidates. This gives “smallish” investors manifold advantages in seizing opportunities. Rather than spreading assets all over the board (a.k.a. “closet indexing”), absolute return value investors will invest only in their best ideas. For the sake of deep familiarity with each choice, a manager may limit the portfolio to, say, 25 equally-weighted companies, allocating 4% of AUM to each. A manager of any size could purchase a stake in the largest companies, but positions in small- and mid-cap companies are a different prospect. It is generally accepted that trades can be completed without major price concessions if a firm holds less than 5% of a company’s float (the portion of shares outstanding not owned by insiders). Managers with $1 billion in AUM spread over 25 positions are generally limited to companies with floats greater than $1 billion if they are to remain under that 5% threshold. Of the 2,924 companies included in the S&P and NASDAQ indices, however, only 1,200 have a market cap greater than $1 billion. One third of the total—1,050 companies—have a market cap between $1 billion and $100 million. Therefore, a “smallish” quantity of AUM—for example, $100 million—nearly doubles the universe of investment opportunities.
In Stocks, Bonds, Bills and Inflation—Roger Ibbotson’s annual study dating back to 1926—small company stocks outperformed large company stocks by a factor of five. The trade-off, however, was much higher variability in their annual returns. That variability means smaller companies are often beguilingly cheap in bad times and absurdly expensive in euphoric ones. To the novice investor such extreme price fluctuations often lead to misfortune. By contrast, the enterprising investor converts that greater variability into an opportunity for additional alpha—the excess returns a manager earns above and beyond his benchmark index.
Today, the search for return has driven investors to turn over rocks in previously unexplored investment landscapes. True bargains among the aforementioned 1,050, like the sales rack at Walmart on Sunday, will be scarce. Today there are more value traps than values. When caution and fear again predominate over the complacency that has yielded such unguarded optimism of late, a buyer’s market will return. “One man’s trash is another man’s treasure.” Well-managed and well-capitalized small- and mid-cap companies—often years if not decades away from bureaucratization—will be available at prices well below intrinsic value to those investors not pigeonholed into minimum-market-cap silos.
Taking advantage of that situation is certainly not mechanical. In the act of buying and selling, temperament is every bit as important for success as the size of AUM. Any transaction must match buyers and sellers that agree on the price and quantity of shares to be exchanged. But the relationship between buyer and seller is dynamic and condition-specific. The value investor will surely fare better if he remains steadfastly rational when exchanging his cash for a risk asset. This is particularly so when the seller is desperate to convert his equity investment to the very cash the value buyer possesses. Every trade is a two-sided competition of skill and wit. In this instance, the advantage unmistakably shifts to the value buyer. The seller’s desperation could be rooted in unexpectedly discouraging company news, exogenous shocks like a generalized bear market, or a convergence, as in late 2008 and early 2009, when the two worked in agonizing and amplifying concert. What makes this scenario especially appealing to the value investor is that the dollar amount of shares being frenetically offered often exceeds the demand (for reasons more emotional than practical). It is the buyer’s bid, not the seller’s offer, which holds the most sway over the price at which the transaction is consummated.
The confluence of size and temperament are a winning combination, one fully exploited by Warren Buffett. In 1979, Buffett wrote to Berkshire Hathaway shareholders saying he would commit a large percentage of his insurance company’s net worth to equities only when “we find (1) businesses we can understand, (2) the favorable long-term prospects, (3) operated by honest and competent people, and (4) priced very attractively. We can usually identify a small number of potential investments meeting the first three requirements, but (4) often prevents action.”
In 1971, equity investments at Berkshire’s insurance subsidiaries amounted to $11.7 million at market. Buffett observed that though there were excellent companies available, very few sold at interesting prices. Never missing an opportunity to point out the absurdity of conventional thinking, he cryptically added the following: “In 1971, pension fund managers invested a record 122% of net funds available in equities—at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.” Do you hear echoes of 1971 today?
Not many years later, at year-end 1978, it was a different story. Berkshire’s insurance subsidiaries held equities with a market value of $216.5 million, realizing gains of $112 million since 1975. Noting that during that three year period the Dow Jones Industrial Average declined from 852 to 805, Buffett effused: “It was a marvelous period for the value-oriented equity buyer.” (See my post highlighting Buffett’s heydays from 1975 to 1985.)
Back then Berkshire was a speedboat compared to the battleship it is today. Success forges its own anchor as Buffett often acknowledges. Investments that are meaningfully accretive to growth in Berkshire’s book value must now register in the billions, dramatically shrinking its universe of significant opportunities.
Perhaps, in time, that will also be the challenge for those able value investors who are currently smallish today.