“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.