Consider the following warning signals right now:

1) Rising interest rates
2) Geopolitical turmoil
3) High valuations in nearly all sectors — especially in the small caps

John Hussman, president of Hussman Investment Trust, noted this week that “Tornadoes are more likely to strike when a tornado warning is in effect…And not surprisingly, financial tornadoes are more likely to strike when such tornado warnings are in effect.”

He goes on to explain…

“When you’ve got a tornado warning, you don’t necessarily conclude you’ll actually get hit by a tornado, but you also aren’t surprised if it starts raining. And even if the rain gets heavier, or the wind blows, you aren’t surprised again and again. Once you get the tornado warning, you basically allow for the possibility of a tornado. You pack up the garden party and head inside for a while. Bad news doesn’t surprise you. You don’t count on it, but you have a subtle expectation that it might arrive.”

These are words of wisdom all good investors will take to heart — and will not ignore. And right now, there is a tornado warning in effect for the entire small-cap sector. Consider the signs for yourself:

Higher interest rates: Access to cheap capital (a.k.a. loans) is the lifeline of any company. As interest rates fall, capital becomes cheap and banks are willing to take more risks by lending to smaller, riskier companies. This is exactly what happened from 2001-2005. But with interest rates on the rise, capital is becoming more and more expensive. In other words, that lifeline that was once available to nearly every small-cap company is no longer. That spells doom for many to come.

Geopolitical turmoil: As you have seen in recent weeks, investors (both retail and institutional) prefer safer, larger stocks in times of political unrest. Since the beginning of May, the S&P 500 is down 3% while the Russell 2000 is down 8%. And with no end to the war in Iraq and the possibility of new skirmishes in Korea and Iran, I doubt the political scene will be smooth for some time.

High valuations: At the peak of the 2000 rally, smaller companies were dirt-cheap. The smallest 50 companies on the S&P 500 traded for just 10.1 times earnings. Meanwhile, the 50 largest companies traded for 35.6 times earnings. Since that time, small caps have rallied and blue chip stocks are down 15%. And today, the smallest 50 companies trade for 22.9 times earnings, while the 50 largest have a much lower P/E of 17.9. In other words, small-cap stocks (as a whole) are expensive.

Generally, when the market is up against rising rates, geopolitical unrest and high valuations, stock returns have not been satisfactory. And when you couple these three signals with clear signs of mania binge buying (as I’ll show you next), it should not be hard to understand why a tornado warning is in effect for the small-cap sector.

All week, my intrepid intern, Jimmy Nelson (aka “Intern Jimmy”), has been crunching numbers, building charts and working in Excel. I asked him to build a list of both fundamentally sound and unsound small-cap stocks on the NYSE and compare their returns over the last six months. I wanted to see what kinds of stocks investor have been buying of late. Are they buying solid companies with lots of cash? Or are they buying crap companies worth less than the paper their stock is printed on?

What we found gives credence to my fears about the chance for a small-cap tornado.

Intern Jimmy and I used the following criteria to screen for both groups of stocks:

Fundamentally Sound:

1) Market cap <= $1.5 billion
2) Trades on the NYSE
3) P/E <= 15
4) Free cash flow >= $1 million
5) Revenue growth >= 1%
6) Net income growth >= 1%
7) P/B <= 1.5
8) P/S <= 1.5

Fundamentally Unsound:

1) Market cap <= $1.5 billion
2) Trades on the NYSE
3) Earnings per share <= $0
4) Revenue growth <=15%
5) Free cash flow <= $0
6) P/B >= 2

After running the screens using a Morningstar database, we ended up with a group of 20 fundamentally sound stocks and 16 “garbage” stocks. From there, Jimmy tracked each stock’s performance and created an index to represent both the fundamentally sound and unsound groups. He then backtracked each index and showed their real returns since the beginning of January. Take a look at the chart below to see how each group fared:

As you can see, the garbage stocks have risen 6.21% this year, while the fundamentally sound group of stocks is down nearly 17%. These returns are indicative of a late-stage rally. Let me explain…

Small-cap stocks have outperformed their large-cap peers handily since 2000. In the beginning of that rally, investors bought because small-cap stocks were cheap (recall they traded for 10 times earnings in 2000). In other words, they bought for fundamentally sound reasons. But recently, fundamentals have all but been forgotten. Speculators (not investors) have been buying small-cap companies with great stories but nothing in the way of cash, earnings and revenue.

This kind of irrational buying behavior typically happens in the late stages of a rally. For a recent example, just think back to the dot-com orgy.

At the end of the day, this kind of binge buying cannot go unpunished. Terrible stocks that have been bid way up will come crashing down. And the people holding them will be surprised to see their fortunes wiped out.

Please do not be one of those “surprised” investors.

You need to know that the conditions are right for a financial tornado (a major drop in the small-cap sector). That does not mean a tornado will strike. But it does mean you might want to start bringing in the patio furniture. You may want to make sure you have enough food and water to last a day or two should the power go out. And you should come up with a plan so you are prepared if a twister does hit.

Now is not the time you want to be holding garbage stocks. Make sure you are prepared.

Regards,

James
July 20, 2006

Are You Prepared? was originally featured in the Penny Sleuth.

“Access to capital and cost of capital could be considered the lifeline to a firm.”
– Satya Pradhuman, Small-Cap Dynamics

From the late 1990s until recently, small-cap companies have been humming right along. Between 1999 and today, the small-cap Russell 2000 is up 85%, compared with the S&P 500’s rise of only 23%.

It has been a great seven years for us small-cap investors. I mean, how can you possibly complain? Just about everything is up from where it was a few years ago.

Fundamentally sound companies are up. Growth companies are up. Even companies that lost money and boasted the ugliest balance sheets you could imagine are up. Truth is, with a combination of guts and patience, you should have made a profit in the last few years.

But I warn anyone who is feeling a bit cocky these days. The day of reckoning will eventually come.

End of the Small-Cap-Rally: Cheap Money for Secondary Companies

One of the main reasons for the recent small-cap rally has been the access to cheap and easy money. Between May 2000 and June 2004, Alan Greenspan and company lowered the federal interest rate from 6.5% to a meager 1%. This loosening of the fiscal purse had a tremendous effect on small-cap companies. Namely, they had no problem getting cash.

When it doesn’t cost much for “secondary” companies to borrow money, they can easily get loans to fund R&D projects, build new manufacturing plants, expand business lines and even diversify into new strategic ventures. Lenders are much more willing to dole out the dough to smaller, riskier companies when interest rates are low. Generally, it is a sign that the economic forecast is bright and the risk of a smaller company defaulting on that loan is lessened.

Of course, when rates start to rise and the economic backdrop isn’t so rosy, lenders become tight with their money. They only lend to the largest of blue chip companies — the ones with very low perceived risk and plenty of capital resources. For instance…

Between 1969-74, the Fed increased interest rates from 6% to 12%. The cost of capital (the cost to borrow money) doubled in five years. As you might expect, small-cap stocks got crushed. No one would loan them money. It was as if the doctor responsible for their corporate health turned off the life-support machine despite their loud cries to live another day.

The result was a slow and painful death.

For the entire five-year period between ’69 and ’74, small-cap stocks lost 4.6% a year and micro-stocks fell 10% a year. And between 1973-74 (the worst of the five-year stretch), our small-cap friends lost 26.5% and another 24.9%, respectively. Ouch!

But just as the doctor can take life away, he can also breathe life back into small-cap companies.

End of the Small-Cap Rally: What You Should Do When Interest Rates Rise

Between 1990-93, small-cap stocks kicked the crap out of their large-cap counterparts. And as you might have guessed, the Fed was once again responsible — at least partially. It conveniently lowered rates from 8.25% in June 1990 to as low as 3% by the end of 1993. The result was sweet for small-cap investors. They made a cool 28.2% a year for three years.

Once again, even marginal companies could borrow money, fund their businesses and grow. Life was grand. Now fast-forward to today.

Based on historical trends, interest rates are still very low, at just 4.25%. Yet they are rising. And that is almost never good news for small-cap companies. So the question is what do you do?

This isn’t a trick question. You should be looking at companies that can survive a period of fiscal tightening. You should look to invest in companies with the resources to grow their businesses even if (or when) the banks won’t lend them what they want. In other words, you should be seeking out — more now than at any point in the last seven years — companies with stockpiles of cash.

Cash gives any company flexibility. When times get rough (or even just a bit tougher than they were before), a company with cash can still manage to broaden its product lines, pay out dividends, fund R&D projects, buy back its own shares, make good on any liabilities, take advantage of an attractive acquisition target or even become a takeover candidate itself. But more importantly…

Cash-rich companies with solid balance sheets aren’t dependent on the Fed to create easy money for them to grow.

As rates rise in the coming months and years, cash-rich companies will immediately separate themselves from the marginal companies that could only grow when interest rates were low and money was easy to get.

This isn’t a prediction, ladies and gentlemen. It is a proven fact. It happened in the 1930s, it happened in the 1970s, it happened in the early 1990s and it is happening now. When the cost of capital rises, second-rate small-cap outfits take it on the chin. Or as Satya Pradhuman, author of the classic book Small-Cap Dynamics, put it…

“Credit conditions and the cost of capital are exceedingly important for all firms, especially smaller firms. Access to capital and cost of capital could be considered the lifeline to a firm. The cheaper the access to capital, the more likely that a firm can take on more projects and increase its chances of success. Access to capital, and therefore to the cost of capital (better access yields lower cost, and poor access implies higher cost), plays a critical role in the potential success of a firm.”

This is a critical time for small-cap investors. Now is the time to weed out the companies in your portfolio that have no cash, lots of debt and poor fundamentals. Now is the time to make sure you invest in healthy companies that are in no danger of having their life-support machines turned off.

Happy investing,

James
January 26, 2006

End of the Small-Cap Rally: The Lifeline of a Firm was originally featured in the Penny Sleuth.