observations about small cap investing

If you live on the East coast, then you know that the big celebration in the spring is in DC where the cherry blossoms bloom. This year the city celebrates 100 years of the gift of the cherry trees from Japan. The opening ceremony was on March 25th but no one told that to the cherry blossoms which had pretty much left town by then. Rumor has it that the Japanese ambassador was praying for snow to slow them down. But forces of nature being what they are, all he could do was joke that coinciding the timing, though nice, would be like having Christmas and your birthday rolled into one. Better to baloney-slice out the celebrations.

You may be nodding your head in agreement. Think about those sorry souls whose birthdays fall on Christmas and how they will forever be gypped of presents! Yes, most of us feel it is best to spread out the cheer; however, when we invest, don’t we pray for Christmas and our birthday on the same day?   When we buy a stock, we want all the good news to happen immediately. Sure there is a real opportunity cost to money. We want to cash out quickly so we can move on to the next great investment. Can all the stars align and we make our 50% upside in 2 weeks instead of 2 years? Maybe. But more times than not, we’re waiting longer than we’d like for the stock to go up.

Worrying and waiting for the stock to pop upon purchase is like hoping for a two in one celebration. Most of us wouldn’t want this in our personal life and expecting this in our investing life makes it harder to look beyond the short-term noise. We end up selling and often times too soon.

Investing takes patience and expecting Christmas and your birthday rolled into one is what drives us batty. While we’re certainly not going to pray for snow to slow things down, if you’ve done your research on the stock you own, then Christmas and your birthday should come around, they just may not be on the same day.

March – it’s when the madness begins. There’s an anxious anticipation in the air of what’s about to unfold in the months ahead. There’s a gleeful giddiness that you just can’t ignore. And that wild and wide eyed look? I see it in my mom’s eyes each March. She makes US college basketball fans look sedate. Yes I’m talking about gardeners, that nutty joyful bunch who each spring jump with delight when they see the beginning blooms of the bulbs planted last fall.

The apple fell pretty far from the tree when it comes to gardening, green thumb I am not. But I like to think that investing for the long term is a lot like gardening. We plant our investments months, even years in advance expecting that come spring the bulb grows up to be that rich ruby red tulip advertised on the packaging. There’s the daily tending to the garden, making sure the soil is replenished and the plants are watered. Also, the pulling out of the inevitable weeds that mange to creep in (hey, no one’s perfect and when it comes to investing you just want more right calls than wrong ones) and if you’ve followed your process and the rules of gardening, you get to enjoy the best part – the harvesting of the goodies.

Unfortunately, nowadays it seems like investing has become like the US college basketball single elimination game – you lose one game, you go home. A team’s had a winning season but then one bad game? Sayonara. It’s an unforgiving system that makes a decision based on one data point instead of seeing the data point in a greater context. Truly this is madness.

Even the best of companies slip up for one reason or another, so as an investor it’s your job to determine if the slip up is due to temporary and identifiable reasons. Investing is about recognizing patterns across multiple events not making conclusions based on a single one. Though sudden death games make for exciting television viewing, when it comes to investing let’s keep the madness where it belongs – in a sports bar and not in your portfolio.

I’m a sucker for to-do lists (Remember The Milk – best iPhone app ever) and the start of every new year has me writing down ideas and tasks at break-neck speed. Truth be told, I have a love-hate relationship with my lists. I love the potential they represent but hate the pain involved to get them done. And when I think about pain, I can’t help but reflect on the past few years in the market. But in this new year, talk about a rally! January was a huge positive month across the board for all the major indices. Sure, unemployment numbers didn’t get worse and manufacturing figures got better. The European Central Bank is still working on a bail out though most investors think that Greece will default. So why the huge move?

I think it’s like the feeling I get when I look at my to-do lists. There’s giddiness about the eventual gain despite the ongoing pain. Over the last few years, we’ve seen a “deleveraging” going on in the market (i.e., defaults). Whether it’s a never-to-be repaid credit card bill, mortgage payment or government bond, bad debt is making its way out of the system. A big reason for the market volatility. But for all its short-term outlook shortcomings, the market is a great discounter of already-known news. This is what investors mean when they say things like “Oh, that bad earnings report last quarter? It’s already baked into the stock”.

The great thing about the market is that it’s forward-looking; it’s not stuck living in the past. So as we work through this deleveraging process, risk is being taken out of the system, all else being equal. With less risk, investors are feeling less fearful of the future. Though I don’t think anyone really knows how much bad debt is out there, we have a few years’ worth of less bad debt on the books. And unlike my lists which have no system in place to limit the number of my to-dos, institutions and governments have been putting regulations in place so that, for example, people without income can no longer get six figure loans.

The credit crisis and subsequent deleveraging we’ve been seeing is helping take risk out of the market. With less chance of default, the market’s looking ahead to happier days. There’s still huge uncertainty out there and well beyond our borders – China’s economy slowing down or the Middle East’s political unrest, to name a few. But such temporary events serve up buying opportunities for the long term investor like me and other than checking things off my to-do list, nothing gives me more joy than buying high quality companies on sale.

I hope everyone had a wonderful U.S. Thanksgiving and that whatever drama occurred at the dinner table has disappeared along with the turkey leftovers. Like January which always elicits a New Year’s resolution list, November brings with it Thanksgiving reflection on all the things to be grateful for.

Now this year has been brutal for the bottom-up stockpicker. The correlation among S&P 500 stocks is at a record high of almost 0.80 (1.0 being perfect correlation). Believe it or not, this is higher than during the 2008 market crash when everything went down en masse.

A high positive correlation means that stocks move in the same direction – so whether you’re a consistent dividend paying market-leader or a junky debt-laden losing-market-share business, the stocks of both companies move in the same direction. There’s no differentiating between quality and junk and in such an environment, you can blindfold yourself, pick any number of stocks and they would all pretty much perform the same way. Whatever you owned would trade in the same direction, a scary thought to those who claim they can pick stocks!

When does this happen you ask? When macroeconomic factors overshadow company fundamentals. This year the stock market has been driven by macroeconomic factors (government stimulus programs) and global economic news (Eurozone crisis). These past few months, news out of Europe have been calling the shots – the market plummeting on days when the European Union waffles on a bail out of Italy and Greece, and soaring when the EU suggests they will step in. So in such a market environment, what does a bottom-up stockpicker like myself have to be thankful for?

Well, I am thankful for quality management teams who despite large cash balances, aren’t making ego-driven bad acquisitions and squandering cash. Instead they are reinvesting it into the company or increasing their dividend payout. I am grateful for managements who continue to cut waste, search for lower cost suppliers and streamline unnecessary or overlapping expenses. And I am appreciative of all the company employees who are learning how to do things more efficiently with fewer dollars and resources.

As the CEO of one of our portfolio companies said, they’re not going to get any tailwind from the global economy so they have to figure out a way to create their own growth. This means coming up with new and innovative products so that people will buy or offering better customer service so that customers will stay. This is what good companies do – they stay on course of continuous improvement through hell or high water.

So as a bottom-up stockpicker, this is what I’m grateful for because fundamentals always matter. If you can hold on to a longer term outlook and look beyond short term volatility, you too will be thankful for what high quality companies are doing when it seems like stock picking doesn’t count.

October was what I call a “straight up” month – the market soared over 10%. October also happened to be my birthday month so it was quite a gift this rally. Now don’t get me wrong, I’ll take positive returns any day of the week. You can’t buy birthday cake with relative performance. But while it’s great to see your stocks go up, not all positive performance is created equal – are your stocks rallying for the right reasons?

When I ask this question, I’m often met with an “are you kidding me?” look – do you need a right reason? Just be happy your stocks are going up, thankyouverymuch. However knowing why your stocks are going up when the market takes off will protect you on the downside when the market turns south.

These “straight up” months are often called “junk rallies”. Yes junk as in lower quality and these riskier stocks tend to lead the charge. In October, investors (a moody bunch) decided that the world wasn’t going to end (Greece got bailed out – hooray!) and when investors feel better about the future, they take on more risk. So they went shopping for lower quality/riskier companies like ones with more debt or more cyclical sales because the probability of bankruptcy goes down when things look macroeconomically brighter, all else being equal.

If you find your portfolio outperforming for non stock specific reasons, be careful – you may be holding a handful of junk. This will feel great in a month like October, but hurt when sentiment reverses and lower quality stocks drop like a cinderblock as investors do the inevitable “flight to quality” dance.

At SAM, we manage a portfolio of high quality stocks and in these straight up months, we tend to underperform – we will be up, but up less than the market. I’m happy to report that the portfolio is behaving the way it should. When a portfolio manager loses money, she’s in the hot seat because everyone wants to know what went wrong. But equally important is understanding the reasons when she outperforms. This is a great check on your money manager – is she sticking to her strategy.

Successful investing requires a disciplined strategy so call me crazy but when it comes to investing I will look a gift horse in the mouth.