Tag Archives: investing ideas

Is It Time To Short Small-Cap Stocks?

By DailyAlts Staff Size matters to factor-based investors, as small-cap stocks have historically outperformed their large-cap counterparts. But throughout the equity market’s history, there have been periods of dramatic small-cap underperformance, and David Schulz, president of Convergence Investment Partners, thinks we may be headed into such a period. He and his team at Convergence are rare among small-cap managers in employing an active shortin g strategy as both a source of alpha and a way to reduce risk. The Convergence Opportunities Fund (MUTF: CIPOX ) reflects the views of Mr. Schulz and his team. The fund, which debuted in November 2013 and ranked in the top 9% of funds in its category in its first calendar year, lost 5.4% in the first nine months of 2015, but still ranked in the top quartile of its peers. Going forward, the fund should outperform if small caps underperform, providing a unique way for investors to diversify their portfolio risks. Why are Mr. Schulz and Convergence bearish on small caps? The firm sent out an alert late last month citing a variety of reasons pertaining to valuation: Roughly 27% of stocks in the small-cap Russell 2000 index have negative P/E ratios (i.e., they’re unprofitable), while this is true of only 8% of large- and mid-caps in the Russell 1000; About 9% of Russell 2000 stocks have a P/E ratio of 50 or higher, while less than 6% of Russell 1000 stocks have such high earnings multiples; and In total, 36% of stocks in the Russell 2000 have P/E ratios that are either negative or over 50 – and 10 stocks in the index have P/Es that are over 1000! Furthermore, increased volatility in the equity markets has been bearish for small caps, since conditions have led investors to “sharpen their focus on valuations,” in Convergence’s words. In the brutal month of August, the 25 small-cap stocks with the highest P/E ratios returned -8.83%, while the 25 stocks with the lowest P/Es returned -0.28%. Since there are many more small caps with high P/Es than with low valuations, this trend is bearish for small caps in general, but Convergence’s Opportunities Fund applies a long/short approach to capture the upside exposure to the best-valued small-cap stocks. The firm says so-called “hope stocks” are on its list of shorts – these are companies with “weak balance sheets; low or decelerating cash flow, earnings, and sales; and high expectations.” Convergence believes an active short portfolio can complement an active long portfolio, especially during particularly tumultuous times. The short portfolio can “cushion the fall” when the market is under pressure and “add materially to the overall return of the portfolio over time.” Ultimately, stocks are differentiated by their fundamentals, and with interest rates expected to rise soon, the most fundamentally sound companies should outperform those with weaker balance sheets and decelerating earnings. The Convergence Opportunities Fund seeks to capitalize by applying a flexible long/short approach to U.S. small-caps. Share this article with a colleague

Should We Fear Debt?

Summary Avoiding an indebted investment is short-sighted, because data shows that debt levels and returns aren’t always negatively correlated. By tilting to the segments that are more sensitive to movements in credit spreads, investors must be willing to accept the greater influence of the equity markets. Look at the data before you believe a strategist who encourages you to avoid indebted companies. By Chris Philips Late last year, Josh Barrickman, head of bond indexing at Vanguard, blogged about the smart beta movement in fixed income. Josh challenged the notion that a company or country could flood the market with debt, which would invariably harm market cap-focused investors. You’ve probably heard it before: “Why would anyone want to invest in the most indebted companies or countries? It’s just throwing good money after bad.” While this premise may seem logical and intuitive on the surface, as with many things we see or hear, a bit of logic and perspective can diffuse superficial arguments. First, some perspective from a unique source. I’ve been catching up on some reading, and one piece in particular stuck with me – an article referencing a story about astronomer Carl Sagan. When presented with “evidence” of alien abductions in the form of an individual who was convinced beyond doubt of having been abducted, the astronomer responded: ” To be taken seriously, you need physical evidence… But there’s no [evidence]. All there are, are stories .” So, should we believe the stories and fear debt? The answer is, it depends. But as a general practice, avoiding an investment simply because of its level of debt is short-sighted. For example, see Figure 1, which shows the relationship between a country’s debt-to-GDP level and the returns of that country’s bond market. Included is a mixture of developed and emerging market countries, with a requirement that each country report a debt-to-GDP ratio and 10 years of bond returns. I’ve highlighted two “groups” of countries – those that have seen low returns over the last 10 years and those with higher returns. Notably, there’s no apparent relationship within each group or across groups. Higher debt levels didn’t always lead to lower returns, and low debt levels didn’t always lead to higher returns. So, rather than take intuition at face value, as investors we must ask ourselves: “What causes one country with a low debt-to-GDP ratio to return 1.5% per year, another to return 4% per year, and yet another to return 7.5% per year?” Clearly, market participants are taking many more factors into consideration than just the perception that debt is scary and should therefore be avoided. Figure 1. Another consideration involves the actual portfolio ramifications of focusing on debt levels as a screening metric. The easiest strategy with which to evaluate the impact of debt involves weighting an index according to a country’s GDP instead of to its bond market. And if we compare the Barclays Global Aggregate Bond Index to the GDP-weighted Global Aggregate Bond Index, we see an immediate attraction: Duration is reduced marginally from 6.47 to 6.33, but the yield increases by close to 20% – from 1.72% to 2.06% – by moving to the GDP-weighted index.¹ Less risk and greater return? Free lunch alert! However, if we closely examine Figure 2, we can clearly see what’s going on. By moving away from market cap, you underweight the U.S. and Japan and overweight various emerging market segments. After all, the U.S. and Japan both fit the profile of the most indebted countries. One implication is that while both indexes are considered investment-grade, the GDP-weighted version has a noticeable tilt towards lower-quality bonds. Figure 2. Why is this important? Because as much as we’d like them, free lunches do not exist. Case in point: From January 1, 2008 through February 28, 2009 (the last notable equity bear market), the Aaa segment of the Global Aggregate Bond Index returned 0.2%. The Aa segment returned 5.8%, the A segment returned -17.1% and the Baa segment returned -14.0%.¹ In other words, by tilting to the segments that may be more sensitive to movements in the credit spreads, investors must be willing to accept the greater influence of the equity markets, particularly during really bad times. What’s more – and what’s important – is that a primary motivation for holding fixed income (at least in our opinion) as a consistent and meaningful diversifier for equity market risk may be marginalized (see: Reducing bonds? Proceed with caution ). My advice? Next time you hear a strategist, sales executive, or portfolio manager encouraging you to avoid indebted countries or companies, ask yourself whether you should buy into the hype. Indeed, as Sagan is famous for stating: “Precisely because of human fallibility, extraordinary claims require extraordinary evidence.” So, let’s all take a deep breath and repeat: “I’m not afraid of debt, I’m not afraid of debt.” Source: Barclays Global Aggregate Bond Index. Notes: All investing is subject to risk, including the possible loss of the money you invest. Bond funds are subject to interest rate risk, which is the chance bond prices overall will decline because of rising interest rates, and credit risk, which is the chance a bond issuer will fail to pay interest and principal in a timely manner or that negative perceptions of the issuer’s ability to make such payments will cause the price of that bond to decline. Securities of companies based in emerging markets are subject to national and regional political and economic risks and to the risk of currency fluctuations. These risks are especially high in emerging markets. Duration is a measure of the sensitivity of the price (the value of principal) of a fixed-income investment to a change in interest rates. Duration is expressed as a number of years.

The Paradox Of Risk: Central Planning Is Linear, Reality Is Non-Linear

You thought it was safe to drive 90 miles an hour on a rain-slicked narrow road while you were tipsy because the airbag would save you, but it still hurts when you crash. I first discussed the Paradox of Risk in August 2008, just before the stock market melted down : The Unintended (Risky) Consequences of “Backstopping” Risk (August 12, 2008). This is the Paradox of Risk: the more risk is apparently lowered, the higher the risk we are willing to accept. I recently covered a related topic, The Dangerous Illusion That Risk Can Be Offloaded Onto Others (October 2, 2015). The paradox is that believing risk has been eliminated leads us to take on insane levels of risk – levels that we would never have accepted before, levels that essentially guarantee our financial destruction. I recently had the opportunity to discuss these topics with Max Keiser: Keiser Report: Global Paradox of Risk (25:40 – I join Max and Stacy in the 2nd half) 1. The Fed Put, the belief that the Federal Reserve will never let stocks decline by more than a few percentage points before it steps in and saves the market from any further decline. 2. The belief that hedges dependent on counterparties paying off when the market craters have effectively transferred risk to others. 3. The belief in Modern Portfolio Management, i.e. that risk can be hedged or reduced to near-zero by diversifying one’s portfolio, investing in assets with low correlation, etc. All of this is nice, but fatally flawed. Max and I discuss the reality that markets are not linear, they are fractal. Central planning is linear, but reality is non-linear. The net result is the Fed can do whatever it wants, whenever it wants, and markets will still crash from time to time. That markets crash is predictable, but not when they crash. I’ve prepared a chart that depicts the downside of the Paradox of Risk: everyone who believes in the Fed Put, hedges or Modern Portfolio Management will view any decline in stocks as temporary. As a result, they won’t sell as markets plummet. When markets finally hit bottom, believers will assure themselves that the Fed is going to push stocks higher any day now, because they have always done so in the past. When central planning efforts to push stocks back up falter, the believers that risk has been banished grow frustrated; come on, Fed, do whatever it takes! Alas, the Fed has done whatever it takes but it has failed to produce the desired effect. Now the market starts another slide to fresh lows, and the believers finally start recognizing that risk has not been disappeared: counterparties start failing, hedges don’t get paid off, and a sense that events are spiraling beyond the control of central planning is spreading. Sorry, believers that risk has been banished: it’s too late, you’re wiped out. You thought it was safe to drive 90 miles an hour on a rain-slicked narrow road while you were tipsy because the airbag would save you, but it still hurts when you crash: Keiser Report: Global Paradox of Risk (video).