Left for Dead

Let’s say you have an asset class that peaked 20 years ago, had a massive bear market, and has been flatlining on the lows since. Nobody cares about it. Everyone has forgotten. Nobody can get excited about the chart because it’s in the lower right-hand corner. Pundits go on TV and talk about how it’s broken and never going to go up ever again. They have pretty compelling reasons too.

These are the kinds of situations I get interested in, when something peaked 20 years ago and nobody cares about it. I say that it is suffering from “benign neglect.” Situations where things can’t get any worse, and you have all this free optionality in case the trade starts to work.

I like to buy things that nobody else wants. I like to look in places that no one else is looking. I like to invest in stuff that people have given up on. You might call this a variation on deep value investing, or contrarian investing, but whatever you call it, it is usually a good way to stay out of trouble.

Small-Cap Value

The old-timers might remember that small-cap value had quite the bull market from 2000 to 2004—a bull market that made some people very rich—and then, after 2004, it entered a long period of underperformance against the S&P 500. Very, very long. Like 21 years, and it has continued to this day. Everyone has been investing in large-cap growth instead, which, of course, you know. Nvidia (NVDA) and Alphabet (GOOGL) and Apple (AAPL) and Microsoft (MSFT) and Tesla (TSLA) have been ripping, leaving the rest of the market in the dust, and it seems as though it will go on forever.

Well, I have a news flash for you: It will not go on forever. It may go on for the balance of this year, or next year, or even five years, but it will not go on forever. And in the interim, you can hang out in bombed-out small-cap value stocks, waiting for the poison to take effect.

When the trade works, the outperformance will be large. The last time this happened, in the early 2000s, the outperformance of small-cap value was in the thousands of basis points. 

Remember, we like to buy cheap stuff with dividends, and the thinking among value investors is that if you buy cheap stuff with dividends for long enough, it will eventually start to work, as the stocks rise to fair value. Value investors have been discredited over the years, as cheap stocks have stayed cheap, but if there is one thing I can tell you about markets, it is that nothing, absolutely nothing, lasts forever. And I would be willing to bet that at 21 years, we are closer to the end of this trend than the beginning.

The End of the Trend

Value is a factor—a group of stocks with the same characteristics. Growth is also a factor. There are other factors, like momentum and quality. Quant traders are very concerned with factors and will trade one against another. I would guess that the growth factor is very crowded after all these years of outperformance, and if you have a trade with a very high Sharpe ratio, it is probably going to attract a lot of sponsorship. Being long tech is like free money, right? It just goes up forever. 

You probably saw that Nvidia is making new highs and is now a $4 trillion market cap, even after the meltdown in April. It is, as Peter Atwater would say, “unstoppable,” which is a very important word—whenever you hear people say it on TV or in articles, you know that we are getting close to the end of the trend.

But like I said, being long small-cap value doesn’t cost anything. I mean, if it goes sideways, it ties up your capital, and there is an opportunity cost. And while it is possible that the bear market continues, and you sustain losses in small-cap value, I find that to be highly unlikely. Also, the small-cap indexes are not as smart as the large-cap ones, and they tend to be easier to beat with good stock selection. The Russell 2000 Value Index has a lot of busted biotech names in it that don’t do anything and just trade for cash.

What about the fundamentals? Well, if you believe that we are entering a deregulatory environment, that would probably be good for small caps, as regulation benefits scale players. A steepening yield curve would also benefit small-cap value, as there are a lot of small regional banks in the index. There are a number of ways to win.

I’m interested. Are you? We will be discussing this more in the coming weeks.

Jared Dillian, MFA