This week’s reading and viewing list covers the market at mid-year 2023, why a Japanese company banned late-night work and Kyle Bass On China: ‘We Sit At A Hinge In History Right Now’.
This week’s reading and viewing list covers, what Richard Bernstein is seeing that is making him bullish, Professor and Hedge Fund Manager Chris Beggs, conquering your fears with Tom and Jerry, techs big bets and a keynote by Howard Marks amongst others…
Bank of America Merrill Lynch (BofA) recently published a research paper showing that small cap stocks are now trading at a 20-year low versus their large-cap peers. In fact, the only other time in the last 50 years that small cap stocks were this cheap relative to large companies was during the dot-com bubble surrounding the year 2000.
They currently trade at a 30% discount to their-long term average, or for the finance nerds, 2 standard deviations below the average since 1979. Does this signal a huge opportunity for investors over the next few years?
What’s a Small Cap Stock?
The definition varies a little between sources, but a small cap (short for capitalisation) stock usually has a market capitalisation (that is, shares outstanding times the share price) in the range of $250 million and $2 billion (for example, Forbes says $300 million as a minimum, whereas Investopedia says $250 million). It’s worth remembering that while this might be small for a company listed on a stock exchange (particularly in the United States), they’re still much, much larger than your local neighbourhood store. Many will have sales each year in the millions (or even billions) of dollars!
What’s So Special About Small Caps?
Some investors focus almost exclusively on small cap stocks, and for good reason. They are often underfollowed by the investment community and have very little ownership by large funds and institutions. Because they are so small, investors with a large amount of money (think superannuation funds or big money managers) can’t invest enough to make an overall difference to their portfolios. For example, according to its website, AustralianSuper currently has more than $230 billion in assets under management. Investing in a company that has a market cap of just $300 million would be just 0.1% of their total investments–and that’s if they bought the whole company!
Another factor is that large investors often get their investment research from the brokerage arms of investment banks, which don’t usually provide coverage of small companies. Investment banks make most of their money from debt issues, equity raisings and mergers, and small companies don’t do as many of these–certainly not of the size that interests the global megabanks.
Because there is less research and large investors often avoid them, small caps can often be bought a lot cheaper than the larger, more well-known companies. It can also be a great opportunity to find companies that operate in a small market niche but are highly profitable. (The largest companies are not always the most profitable or necessarily the fastest-growing, but they usually have big total addressable markets). Usually, small caps will be family-owned and/or family-run companies, they won’t have much debt, and will often pay a good dividend–to keep the other family members happy!
Are Small Caps Riskier?
One thing about small companies is that they generally have more customer and supplier concentration. Businesses often start out with just a few major customers or suppliers, and if the terms of these relationships change (the company loses a customer or supplier to a competitor), it can have a huge impact on the company’s financials. They are also more concentrated in geographic regions and have less product diversification. Large companies can have several different product lines and operate in different states, countries and even continents around the world.
It’s often said that there’s a reason that these companies are still small, which can sometimes be true. There may be a limit to the size of the market, the industry may be stagnant or declining, or management may have made some missteps in the past. These can all be said of larger companies too, though!
Small caps certainly are more volatile though (academics often equate risk and volatility, but this is a topic for another day). They are more sensitive to the economy and have historically outperformed larger companies in a strong economy and underperformed during recessionary periods. This could be a big factor in why they’re trading at such a big discount to large caps today.
Good Things Come in Small Packages
There’s been almost endless talk of a recession as central banks around the world have aggressively raised interest rates. Yet this hasn’t slowed the share market, which has remained “resilient” (finance speak for it hasn’t gone down). In fact, large (popular) technology stocks have been on a tear, with the Nasdaq 100 up more than 38% just this calendar year fuelled by the recent optimism about artificial intelligence. Small caps, on the other hand, have been left behind and are now the cheapest they’ve been in 2 decades. The reversal in trends was fast and furious after the dot-com bubble. Could this be dotcom 2.0 for small caps?
The Standard & Poor’s Homebuilders exchange-traded fund (ETF), XHB, has increased by more than 30% in 2023 and 40% over the last 12 months. A number of homebuilder stocks such as PulteGroup (NYSE: PHM) and renowned value investor David Einhorn’s Green Brick Partners (NYSE: GRBK) have substantially outperformed even this lofty benchmark. Building supply stocks such as Installed Building Products (NYSE: IBP) have also performed strongly, outpacing even the rapid climb in technology stocks.
This might seem surprising given the incredible demand for housing and renovation activity during the pandemic, and the dramatic rise in interest rates over the past 18 months. The cost of money has risen at the fastest pace on record and the interest rate on new and variable rate mortgages has nearly tripled. Shouldn’t higher interest rates make servicing a housing loan more expensive, reduce the demand for housing and renovating, resulting in lower prices and less homebuilding activity and therefore lower share prices for homebuilders and building products companies? Well actually, it depends.
Second-Level Thinking
Iconic fixed income investor and co-chairman of Oaktree Capital (now a part of Brookfield Asset Management following the merger in 2019), Howard Marks, highlighted the challenges of drawing direct cause-and-effect relationships in chapter 2 of his book “The Most Important Thing” (the book comes highly recommended, but for those who prefer more digestible content freely available on the internet, the majority of Marks’ teachings can be found in his “memos to clients” at no cost on the Oaktree Capital Management website. While they’re all valuable, the 2015 memo “It’s Not Easy” is the most applicable to this discussion).
Two of Marks’ most poignant examples of second-level thinking were:
“First-level thinking says, “The outlook calls for low growth and rising inflation. Let’s dump our stocks.” Second-level thinking says, “The outlook stinks, but everyone else is selling in panic. Buy!”
“First-level thinking says, “I think the company’s earnings will fall; sell.” Second-level thinking says, “I think the company’s earnings will fall far less than people expect, and the pleasant surprise will lift the stock; buy.”
Demand AND Supply
There’s no doubt that higher interest rates impact buyers’ ability to service larger loans. Ceteris paribus (all else being equal), this would lead to lower demand and lower prices for homes. Not all things are equal though, and this is only half of the equation. We know from microeconomics that the price and quantity demanded of a product or service depends on both the demand and its supply.
This is important because one difference between the United States and countries like Australia, Canada and the United Kingdom, is that buyers are able to obtain fixed-rate mortgages. Incredibly, these can be for up to 30 years! Understandably, there was a huge refinancing boom over the last few years as homeowners locked in incredibly low mortgage rates–a decision that will likely be one of the best of their financial lives.
Homeowner Mortgage Rates in the U.S. by Interest Rate
Source: Bloomberg
The only downside of locking in an extremely attractive interest rate for the next 30 years comes around if someone wants to move house. There needs to be quite a compelling reason to relocate when the average mortgage rate is now more than double what you signed on for 2 years ago–a very high-paying job or moving in with a partner, for example.
The outcome of this has been that less people are moving than ever before. This actually follows a bit of a long-term trend, and is a consistent theme in Australia as well: people are staying in their homes longer. To put some numbers on it, at its 2022 Investor Day, REA (owner of leading property website realestate.com.au) showed that the average property owner stayed in a home for 10.6 years, up 27% (or 2.3 years) from the 8.3 years 10 years ago. There’s a number of reasons for this change (including less desire to relocate for job opportunities), but no doubt the substantial amounts homeowners have spent renovating and furnishing their homes just the way they like it has a big impact.
Source: REA 2022 Investor Day
Other influences on why housing supply is limited include strong levels of immigration, short-term rentals (such as AirBNB), and smaller household sizes brought about by fewer children per family, higher divorce rates and work-from-home arrangements (that have encouraged larger homes with better amenities such as heating/cooling). The Reserve Bank of Australia (RBA) estimated that the number of people living in each home fell from an average of 2.55 in late 2020 to 2.48 by mid 2022. While this might seem like a small change, in just 2 years this meant an extra 275,000 homes would be needed to house the existing population.
The trend is no different in the U.S., where the average household size was 2.5 in 2022, down from 2.55 in 2012 (you may notice a slight bump during the Global Financial Crisis, when the challenging economic conditions forced young people to move back in with their parents and homeowners and renters to take on extra housemates). Multiply this by the size of the U.S. population, and you can guess the results. According to CNN, the US housing market has a shortage of 6.5 million homes.
Average Number of People per Household in the United States (1960-2022)
Source: Statista
The number of new homes being built is not putting a dent in this shortage. There has also been a dramatic level of underbuilding since the Global Financial Crisis–essentially as an overreaction to the extreme level of overbuilding prior to the crisis, which caused the huge bust. Locally, we have also seen a devastating impact from the supply chain challenges during the pandemic. A whopping 1,872 home builders declared bankruptcy in the 2023 financial year (up until May 14, according to the Australian Securities and Investments Commission). This is the largest number of insolvencies on record, and includes the likes of industry giant Porter Davis Homes, which went into administration in March with over 1,500 homes under construction at the time. In fact, since 2021, builders working on around 5,200 homes worth approximately $2.2 billion are estimated to have entered bankruptcy.
It’s Not Easy, But It Is Rewarding
It’s important to keep your investments simple and easy to understand. However, inexperienced investors can often draw false conclusions using first-level thinking–particularly about economic forces. This is why we have highlighted several times the success famous investors (including Peter Lynch) have had ignoring macroeconomic factors. As Howard Marks points out, it’s also essential to consider how the uncertainty and risk relates to the price of an investment. There’s no doubt that this is the most challenging part. As Berkshire Hathaway co-chairman Charlie Munger once said: “It’s not supposed to be easy. Anyone who finds it easy is stupid.” But that’s also what makes it so interesting, and what gives investors the great opportunities for outsized returns.
