Is it a Small Caps World, After All?

I always want to follow my strategy when it comes to investing, but I also think it important to recognize when shifting allocation tactics allow me to take advantage of market dynamics, and irrationality.

For some time (starting in mid 2005) I became concerned about the returns I was achieving with small cap stocks. I started allocating away from small caps, but, I was early. Too early. The Russell 2000 has continued to set new all-time records, and has returned nearly 14% since the beginning of the year. This is terrific for holders of small caps (I still have about 20% of my portfolio dedicated to small caps), but the stocks were already expensive. Small cap stocks are trading at 40 times trailing earnings, and 2.6 times book value. Earnings projections (which are usually optimistic), are projected to be about 15% per year.

Small cap stocks now face significant challenges growing earnings. Most small cap stocks do not issue debt, they borrow from commecial banks at rates indexed to the prime rate, which has been rising with federal funds. Higher borrowing costs mean higher interest expense, and slower asset growth, or lower leverage.

Small caps have had a run, because the prime rate dropped to 4.5% in 2003, and during that period smalls could add debt to finance rapid growth. That will become far more difficult. However, small caps' run has been so strong, and persisted for such a long period, many investors comparing mutual fund returns are concluding that "small caps are where its at" at precisely the wrong moment, when small caps will be at significant disadvantage to large caps in terms of capital costs. I heard this morning on Bloomberg radio that retail funds flows into small cap mutual funds was larger in the first quarter of 2006 than all of 2005 (this compares with returns, which were as large in the first quarter of 2006 as all of 2005).

It is therefore time to exit lower quality stocks and move to more defensive territory. Large stocks with strong cashflows and dividends are likely to outperform in the years ahead, both because of economics and also demographics (boomers need dividend income in retirement).

I note that small caps run is likely to continue, at least one more quarter. But sooner or later, thsi is going to end, and potentially painfully. I am reminded of the trader who said to the amateur, "you can have the first 30% and the last 30% [of a price move] and I'll just keep the nice safe 40% here in the middle". Even if the Fed doesn't keep raising rates, smalls will have difficulty gaining access to cheap capital. If the Fed sees the necessity of continuing to raise rates, bank financing could become downright expensive, and profits could actually fall, rather than simply grow slowly.

I will be moving money from smalls to large and international stocks, though I will be holding my most promising small cap stocks.