Small-Cap Predictions: The Golden Rule of Investing

Jan 19th, 2006 | By James Boric | Category: Investing Strategies, Macroeconomics

James Boric explains why he pays no attention to Small-cap Predictions, and why you shouldn’t, either.

Here we go again. All the small-cap naysayers are coming out of the woodwork like termites that have had their fill of rotted wood. Once again, no one thinks our beloved small-cap friends can beat the market for what seems like the millionth year in a row.

CNNMoney says, “After beating the big boys for five years in a row, the small stock miracle may be ending — for now.”

President and chief investment officer for Merrill Lynch Investment Managers Robert Doll predicts, “Growth outperforms value and large cap outperforms small cap for the first time since 1999.”

Small-Cap Predictions: The Unimportance of Predictions

TD Bank Financial Group declares:

“U.S. small caps will underperform broad market indexes – U.S. small caps will be negatively impacted by the disappearance of the valuation gap between them and their large-cap counterparts. Tighter credit conditions will also be a negative factor for small-cap companies.

“Investors should therefore consider underweighting U.S. small caps in their portfolios.”

You know what I say?

Predictions are for fools. Predictions are made by people who want others to pat them on the back and say, “Nice call!” And as we all know, if you make enough predictions, eventually, you will be right — about something.

But predictions don’t make you a dime in profits in this or any market. So screw ’em! They aren’t worth your time or mine.

The truth of the matter is you make money on Wall Street by investing in solid companies at fair prices.

There’s a reason Lynch’s Fidelity Magellan Fund grew from $20 million in assets in 1977 to $14 billion in 1990. There’s a reason Warren Buffett is worth $30.5 billion today. There’s a reason Ben Graham, Forrest Berwind Tweedy, Ralph Wanger, T. Rowe Price and Joel Greenblatt all made millions and millions on Wall Street…

You think those guys spent all day making predictions? Hell no, they didn’t. Peter Lynch said, “If you spend 13 minutes per year trying to predict the economy, you have wasted 10 minutes.”

Warren Buffett declared, “I don’t make guesses [regarding the economy], and when I do, I don’t pay attention to myself. Charlie and I never talk about macroeconomics. It’s fashionable for banks to have economists making forecasts. So they say that GDP will grow by 4.3%, instead of 4.6%. So what?”

Small-Cap Predictions: How Small-Caps Fit into the Big Picture

Look, I’m not saying you should totally ignore the big picture. The truth of the matter is that the small-cap sector isn’t as attractive as it was a few years ago. The average company on the Russell 2000 (the primary “small-cap” index) trades for 19.5 times earnings and 2.31 times book value. Meanwhile, the average company on the Russell 1000 (an index of the 1,000 largest companies on Wall Street) trades for 17.4 times earnings and 2.84 times book value.

The argument our bearish “experts” are making is simple. The price gap between the small- and large-cap sectors has diminished. And all things being equal, they are betting money will flow out of the riskier small-cap sector and into large caps.

I have two things to say about that…

First, who cares? There are thousands of small-cap stocks. I’ve said it a million times, and I will say it again. There will always — ALWAYS — be fantastic opportunities to make money as a small-cap investor. All you have to do is look. For instance…

This weekend, I was reading the prospectus for the Third Avenue Small-Cap Value Fund, run by Curtis Jensen. Jensen is a proven staple in the small-cap world. His small-cap fund has averaged a 12.95% compounded annual return since its inception in 1997. That’s great. But what I really like about this fund is how well it did when the small-cap market wasn’t doing so hot.

In 2000, when the market in general started crapping out from the tech collapse, his fund made 17.18%. In 2001, the Dow lost 6% and the Russell 2000 rose only 6%, but Jensen and crew made 15.27%. And in 2002, when the Dow fell 17% and the Russell 2000 dropped 21%, Jensen kept losses much lower, at just 10.89%.

Small-Cap Predictions: Jensen’s Philosophy

So how does he do it? What’s his philosophy?

Jensen looks for “well-financed, well-managed small companies believed to be priced below their intrinsic value.” In other words, he buys good businesses on the cheap and doesn’t care what the overall market does or what lame predictions are made by so-called macro experts. He knows the golden rule of investing…

If you buy good businesses for a discount to their true value, you will make money. The key is patience and sticking to your guns — two things most investors don’t have or do.

As we enter 2006, I suggest you take 15 minutes out of your year to think about what your investment philosophy is. If you are willing to park your money in good small-cap companies that have a margin of safety built in (a la the stocks Jensen looks to own for his fund), then you have nothing to worry about.

Forget the predictions. Forget the doom and gloom. Good companies rise over time. Stick to your guns.

Happy investing,

James Boric
January 19, 2006

P.S.: Just to prove predictions are worthless, here is Mr. Doll’s 2005 prediction for the small-cap market…

“The average stock will underperform its index’s median for the first time since 1999 as large-cap and high-quality stocks outperform small-cap and low-quality.”

Well, as it turned out, 2005 was another good year for the small-cap market. The Russell 2000 rose 5%, while the S&P 500 only managed to eek out a 4% gain and the Dow was flat.

Forget predictions. Your time is better spent looking for good investment ideas. And here at Penny Sleuth, we’ll keep looking for you.

James Boric

James Boric began his finance career by successfully picking winning stocks. With time and experience, James realized his goal- to figure out how an average, everyday investor with little capital could become wealthy. The trick, he discovered, was to look to the quickest moving, most exciting and lucrative group of stocks in Wall Street history — small-caps.

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