Small-Cap Alpha Without Small-Cap Risk
I hope everyone had a great weekend. After a busy couple of weeks, I finally linked together two relaxing days and found time to read the paper at home. I had forgotten how nice this was, and while not all of the news these days is positive it was still nice to relax with a cup of coffee and digest world events.
I thought I’d start off this Monday by digesting the big news events in the world. Small cap stocks are following the macro-economic trends - so we need to keep an ear to the ground and understand what's going on.
***BP (NYSE: BP) has been dominating the news cycle, and whispers of potential bankruptcy remind investors of the all too recent recession. Today we should learn if the company will suspend its dividend and if (and for how much) President Obama will get the 'safety net' escrow account he is seeking. If this account is news to you, the President has asked the company to put aside cash to ensure it is available for liability payments. A fair request, at least conceptually, since it would be a tragedy for those whose livelihoods have been destroyed to not receive any restitution if the worst case scenario for BP plays out.
The real tragedy of course is all of the oil in the Gulf of Mexico - and the prospect that it might take years if not a decade for the fragile ecosystem to recover. Unfortunately the estimates for how much oil is pouring into the ocean keep getting revised upwards. Finally electronic sensors are being sent down to the freezing depths to see if they will help scientists determine the flow rate.
***Besides the ongoing bad news from the gulf, reports on foreclosures and retail sales point to a not as of yet recovered economy, and gold has yet to find a ceiling. So the flight to safe assets appears to still have legs.
On the other hand, there was a piece of good news in the Wall Street Journal. Companies are flush with cash. Right now, U.S. companies are banking more cash than ever. The reason for companies’ increase in green is likely the same as for gold’s meteoric rise - both management and investors have been nervous about economic conditions and want to have money in the bank for whatever comes next.
For many small-cap companies, the increase in cash represents good management - and a good opportunity for investors who want to buy shares in stable companies. Right now, small-cap companies are building up the kind of bullet-proof balance sheets once reserved for only the largest of large-caps. That means these cash rich companies could achieve the outsized returns, or alpha, only available through small-cap investments, but have a measure of security usually associated only with large-caps.
In other words, it appears investors can now get small cap alpha, but only take on large-cap risk. That's a good place to be for those looking to add shares of companies in this asset class to their portfolio.
***For small cap investors, there are many cash-rich companies to choose from. I recently added an Israeli company to my portfolio. It’s a micro-cap with a terrific, cash-rich balance sheet and great growth prospects. For a full review of this tech stock, along with a few other small-caps capitalizing on this cash trend, check out Small Cap Investor PRO by clicking here. During the economic down-turn, firms cut costs to the bone to survive. It's amazing how recessions can do a good job encouraging natural selection as companies are forced to be much more efficient. That’s especially true of small companies, the most vulnerable sector during tough times.
To survive the crisis, companies developed lean, aggressive cost structures. They took meat cleavers to the liabilities side of the balance sheet. Last week I discussed LTX-Credence (NASDAQ: LTXC), a semiconductor testing company that used a stock offering to retire almost all of its debt. The move signaled a shift of philosophy by management, and is further evidence of the debt-shunning trend among small-cap companies.
There is one negative trend to the lean and mean business model, and this has given rise to a real criticism of the recovery - unemployment is still high. While this is clearly bad for those without jobs, it's yet another signal that companies are committed to lean operations.
Employment is lagging growth because firms are protecting their new recession-born business practices, and aren't going to go out and invest in tons of manpower when they can continue to do more with less. Can we blame them? Of course not, sustainable business models require that periods of savings proceed periods of capital investments.
These companies are also reporting positive earnings, and in many cases margins have never been better. Firms are flush with cash, and looking for ways to grow their businesses.
***So what does that mean for small-cap investors?
One of the reasons I like small-cap stocks is their outsized percentage gains. But those increased rewards come with risk - small-caps simply aren’t too big to fail.
But with a lot of cash on hand and capital structures that now show very little debt, many of these companies simply look too good to fail.
In the short-term, these cash-rich companies are supremely stable, and can easily withstand another drop in demand should a double dip recession play out. Once things settle down, and even the grizzliest of bears is placated, shareholders will pressure firms to lower their cash positions.
As companies look for ways to reinvest, we could see an explosion in the small-cap mergers and acquisitions market. This is something we need to be on top of as we look for profitable small cap investment opportunities.
I’ll discuss M&A, and how it can be the best thing to happen to small-cap shareholders in a future issue of Small Cap Investor Daily. Today I'm out of time.
If you see any companies that you think are ripe takeover targets, or are potential acquirers, send me a note, my address is: editorial@smallcapinvestor.com.
The current news cycle highlights the uncertainty prevailing in the market. But for small-cap companies and their investors, loads of cash on the balance sheet means that outsized gains could come without the normal attendant small cap risk.
