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Is Small Cap Value The Key For 2008? |
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Written by Value Seeker
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Friday, 25 April 2008 |
Small cap stocks have greatly underperformed large cap stocks in 2007. While the S&P 500 is up 4.2% YTD, the Russel 2000 is actually down by 1.8%. In particular, small cap value stocks have been hit hard. The ETF IWN, which aims to invest in small cap value stocks, is down by a whopping 11.1% so far in 2007.
Many articles have been written espousing investing in small cap value stocks for the long run. There seems to be reliable data that, over time, this group of stocks outperforms growth and large-cap stocks. The reasoning seems to be mainly psychological. Growth stocks, both large-cap and small-cap, have a sort of sexy appeal to them. People hope that they are buying the next Microsoft or Google. This often causes the shares to become overvalued.
Large-cap value stocks also have the appeal as being “safe.” People who are hoping for consistent returns and low volatility are attracted to blue chip stocks like Johnson and Johnson or GE.
In contrast, small cap value stocks do not have any special appeal to them. To most people, there’s nothing particularly appealing about a $1 billion company with limited growth prospects. People view these stocks as “risky” with limited upside. Because of this, small cap value stocks are often ignored and con sometimes become good buys.
This article isn’t about why small cap value stocks make good investments over a ten to twenty year timeframe though. I think small cap value has a good chance of outperforming the market in 2008, reversing what occurred in 2007. This is mainly due to the recent Fed cuts and prospects for future Fed cuts.
In his book, The Only Three Questions That Count, Ken Fisher describes how bank lending mirrors investor psychology. When banks are limited in who they can lend to, the first type of company that gets the shaft are the small mom and pop stores. Prior to the Fed cuts, we had a slightly inverted yield curve in the US, meaning long-term interest rates were actually a bit lower than short term ones. This produced a climate making it more difficult for small cap value companies to get favorable financing.
With the recent Fed cuts and the prospect of future cuts, the yield curve is more favorable, with short-term interest rates well below long-term interest rates. This makes it more in a bank’s interest to loan to small cap value companies, since the bank can borrow at the short-term rate and then loan to the company at the long-term rate. This will help many small cap value companies pursue expansion and acquisition strategies.
There a couple of ways of investing in small cap value stocks. The first is buying a mutual fund. The second is buying an ETF. Targeting small cap value stocks through an ETF is a bit tricky since it’s difficult to define exactly what a small cap value stock is. One ETF I bought in the past, IWN, uses price/book value. While price/book is helpful, it will tend to result in the ETF investing in capital intensive industries over other sectors, such as technology.
The final method, and the one I plan on using, is just investing in regular stocks. Right now, I’m actively looking for solid small cap value stocks to invest in. A few I like that I already have money in are Luby’s (LUB) and Jack In The Box (JBX). Both of these companies are regional restaurant chains.
Luby’s is a cafeteria chain that is primarily located in Texas. Luby’s, with a market capitalization of just under $300 million with no debt and valuable real estate holdings (P/B is listed as 1.75). It’s forward PE is around 20, which is not that low but considering its lack of debt and real estate holdings, I view this stock as a pretty cheap stock.
Jack In The Box is a fast food chain that primarily operates in the West. Jack In The Box also operates Qdoba, which is a burrito chain similar to Chipotle. Unlike Luby’s, Jack In The Box does have a fair amount of debt, though it’s PE/, P/B, and P/S are all quite low. I can see Jack In The Box using lowered interest rates to help it push its fast food chains more in the East and to continue to expand its Qdoba chain.
Disclaimer: Author currently owns shares of Luby’s, Jack In The Box, and Chipotle.
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