observations about small cap investing

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.

In the US, Labor Day happens once a year and it marks the end of summer and the beginning of back to school. But for us lucky folks in the investing world, we get to experience labor day every month (the first Friday to be exact, when the US government releases unemployment numbers). With so much fear right now of a double dip recession, markets will rise or fall on these numbers and lately there’s been more falling than rising. Pick any newspaper and you’ll be sure to find gloomy economic data, so I was surprised (literally stopped me mid-coffee sip) when I read the headline “Executives Aren’t Flinching Just Yet”.

The Washington Post had compiled comments in recent weeks by executives of more than three dozen large companies to see what they’ve been saying about the economy and the plans for their businesses. Though the CEOs aren’t talking about a massive hiring spree, they’re not closing up shop either. Even in my small cap universe, I’m hearing the same thing – choppy economy prompts caution not retreat. There seems to be a definite disconnect between Wall Street and Main Street.

Now I’m not one to quote accounting books, but in accounting there’s a term called “going concern”, the idea being that the company is assumed to be around 1, 5, 10, etc. years from now. Depending on how much cash you need when, this “going concern” concept certainly applies to you when it comes to investing.

You see, owning stocks requires a CEO mindset – you don’t close up shop because of short term stock market setbacks. You need to see the bigger picture and have confidence that the stocks you own will be around for the long term. However, investors are often told to hang in there because of a vague and frankly outdated argument that stocks outperform in the long run. Don’t tell that to people who over the last 10 years find themselves in the same place where they started.