U.S. Small Cap Stocks Appear Over Valued

Small Caps appear due for a correction. They have outperformed their Large Cap brethren since the dot-com bust. It is now time for Large Caps to prevail. I have discussed this trend several times in my blog and newsletters. See last quarter's newsletter posted at our website: http://www.altamontwealth.com/newsletters.html

Here is a New York Times article that further bolsters this argument.

The Financial Pragmatist

Libby Mihalka

March 18, 2007

Beyond the Bubble, With Small-Cap Stocks

By MARK HULBERT

SMALL-CAP stocks are significantly overvalued. In fact, they are even pricier, on average, than they were in March 2000, just before the Internet bubble burst. In contrast, the average large-cap stock is moderately undervalued.

This picture of a highly bifurcated stock market is painted by data from Ford Equity Research of San Diego, which tracks around 4,500 publicly traded companies in the United States. Among companies that have been publicly traded for at least seven years, the firm reports that 55 percent have higher price-to-earnings ratios today than they did in March 2000. The bulk of these pricier issues, however, are in the smaller-cap sectors. Among the very largest companies, the average P/E ratio is now just a third of what it was seven years ago.

If investors focused only on the broad stock market averages, however, they might conclude that the entire market is undervalued. According to Standard & Poor’s, for example, the P/E ratio of the S.& P. 500 currently stands at 17, based on trailing 12-month operating earnings. The comparable ratio at the end of March 2000 was 31.1, almost double the current level.
Though the S.& P 500 includes many large-cap stocks, it also contains smaller-cap issues. Why is the index’s P/E ratio nevertheless so much lower than it was seven years ago?

The answer lies in how the index is put together. The S.& P. 500 is a capitalization-weighted index, meaning that each company’s contribution to it is a function of the company’s size. That would not necessarily skew the average P/E ratio for the index itself, if the average valuations of both larger and smaller stocks were similar. But that’s not the situation today, according to Ford Equity Research: the 50 companies in the S.& P. 500 with the smallest market caps have an average P/E ratio that is much higher than it was seven years ago, while the ratio for the 50 largest-cap stocks in the index is significantly lower.

According to Ford Equity Research, the average P/E ratio among the 50 largest-cap companies is now 19, about a third of the average of 60.7 for the biggest 50 in March 2000. The average market cap for the 50 largest companies is now $123 billion, versus $153 billion in March 2000.
Contrast those numbers with those for the 50 smallest companies in the index: their average P/E ratio is now 30.7, versus 20.3 seven years ago. And their average market cap is now $3 billion, versus $1 billion.

In other words, the smallest-cap stocks in the S.& P. 500 are significantly more overvalued today than they were seven years ago. Yet their higher P/E ratios barely affect the ratio for the index as a whole. That’s because the combined market capitalization of the 50 largest stocks account for nearly half the market cap of the entire S.& P. 500, while that of the 50 smallest stocks add up to just 1.2 percent of the total.

“Investors who pay attention to the P/E ratio of cap-weighted indexes such as the S.& P. 500 therefore need to exercise great care when drawing conclusions about stocks’ relative valuations,” Richard Segarra, director of research at Ford Equity Research, said in an interview. “At best, the P/E ratios for such indexes shed light only on their largest-cap stocks; we should avoid drawing any inference from a cap-weighted index’s P/E ratio about the valuations of its smallest-cap members.”

MR. SEGARRA found that the index’s prevailing pattern also holds true across the universe of stocks that his firm tracks. As a result, an investor who emphasizes market sectors according to relative P/E ratios would have a very different portfolio today than in March 2000. Back then, he would have favored small caps over large caps — and been handsomely rewarded for this choice. The trend is seen in the annualized total returns since March 31, 2000, of three Dow Jones Wilshire indexes: 10.1 percent for the U.S. Microcap Index and 7.2 percent for the U.S. Small-Cap Index, but only 0.5 percent for the U.S. Large-Cap index.

Today, however, according to Mr. Segarra, that investor would favor large caps over small caps. Not only is the average P/E ratio of large-cap stocks only a third as high as it was in March 2000, it is nearly 10 percent below its average level of the last five years. There’s no guarantee, of course, that large caps will outperform small caps over the next five years — but there’s a good argument to be made that they will.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of MarketWatch. E-mail: strategy@nytimes.com.

Vanguard Growth

I am a fan of Bob Turner and am always interested to hear his insights. However, I must disclose that I do no however use his fund in my practice. Instead, I prefer to use Harbor Capital Appreciation as my conservative Large Cap Growth mutual fund. Over the last ten years Harbor Capital Appreciation has outperformed Vanguard Growth Equity with less risk (a lower standard deviation). The graph shows the performance of Harbor Capital Appreciation (the red line) versus Vanguard Growth Eauity (the blue line) I believe Turner's investment approach is soundly executed within Vanguard Growth. It's just that others seem to eke out a better return following a similar investment philosophy. Morningstar considers Vanguard Growth Equity to be a three star fund (out of five possible stars). Here is a current research report on the fund written by Litman Gregory.

FUND UPDATE: Vanguard Growth Equity (VGEQX)

Category: Larger-Cap Growth Managers: Bob Turner Date of Interview: 1/10/07

With: Bob Turner

In early January, Bob Turner (founder of Turner Investment Partners, and lead portfolio manager on Vanguard Growth Equity) visited our Orinda offices, where we discussed his view on the market, holdings in the portfolio (as well as holdings he doesn’t own), and a few firm-related issues.

Turner continues to see good earnings growth in the market, although last year, higher earnings growth did not translate into higher stock prices. In fact, he says companies with the highest earnings growth performed the worst. Citing an internal study, Turner says that companies ranked in the top half of the Russell 1000 Growth Index based on long-term earnings-per-share growth forecasts (i.e., the fastest-growing companies) were basically flat in 2006. Meanwhile, the slower-growing half of the universe was up approximately 16% on average. This made for a tough 2006, as Turner’s investment philosophy is that earnings expectations are the primary driver of higher stock prices. Accordingly, Turner looks to buy companies with the highest earnings-growth prospects, while trying to avoid companies with slow (or declining) growth.

Turner remains optimistic that the firm’s high-earnings-growth focus will be rewarded. He suspects that over the next 12 months, the economy should continue to slow, causing the profitability of some companies to decline. Companies that are able to maintain above-average growth, i.e., growth stocks, should do well. In short, he anticipates that investors may be willing to pay a premium for superior earnings growth, resulting in higher stock prices. While he’s not sure when things will turn, he says, “We have a discipline and we’re sticking with it. We don’t deviate because that’s when things turn against you, and that’s when you blow up.”

Turner’s focus on the fastest-growing companies has led him to continue holding Apple Inc., a stock the team has owned for several years. It’s important to remember that Turner manages the portfolio sector-neutral to the Russell 1000 Growth Index (meaning his sector weightings approximate those of the index), so in order to beat the benchmark, making active company bets is necessary. As of year-end, Apple was a 1% position in the benchmark, but over 2% in the fund. Turner remains confident that Apple will continue to grow and beat consensus earnings expectations. When assessing whether a company can exceed expectations, Turner’s process is more of a qualitative mosaic, where the objective is to gather vast amounts of information from the company, competitors, suppliers, third-party research, etc., and triangulate on the probability of a positive earnings surprise. Building complex earnings models and coming up with an exact earnings number is not part of Turner’s investment approach.

Turner says that the mosaic for Apple is a “little tricky,” in that it’s harder to pinpoint future sales numbers, in part because Apple is so secretive about their upcoming products. By contrast, Turner says it’s easier to estimate sales for less-innovative companies, where calls to distributors provide good insight into inventory levels and other supply/demand metrics. But with Apple, Turner says, “You don’t get any of that.” Researching Apple requires more of a big-picture analysis, and “reverse engineering” methodology. For example, Turner says that forecasting sales of Apple’s PC division requires them to determine how much market share Apple has, and then checking on sales at Dell and other PC makers to get a sense for demand.

Turner adds that part of the analysis for Apple is anecdotal, where the success of products is gauged by how long the lines are in the retail stores and how long the turnaround time is for new orders. “What we’re not going to do is just trust Steve Jobs [Apple’s CEO], and say everything he does is great, and just own this stock blindly. We want to make sure everything is on track,” says Turner. While modeling company earnings is not a competitive edge for Turner, the team does work to understand the impact that margin expansion/contraction or promotional deals have on earnings.

As for future growth, Tuner believes Apple’s penetration in the PC market will continue to increase as iPod users are drawn to consider Macs. Apple also continues to rapidly expand its retail stores, which Turner says have the highest sales per square foot of any store in the world. He also expects international sales to provide the next leg of growth. Turner says that while iPods account for 75% of portable music players in the U.S., there are hardly any in the rest of the world. Growth can also come from new product introductions.

Turner says Apple trades at a premium valuation relative to its growth rate “although it’s not outrageous.” Valuation does not play a big role in Turner’s investment process, and Turner says one thing he’s learned over time is to let his winners run. “When you own tech stocks that are generating outsized extra return, often the best practice is to do nothing and simply let them continue to generate extra return. In some cases, we have learned this lesson the hard way. We have held some big tech winners but succumbed to the temptation to take profits in them—only to buy them back later at higher prices. When it comes to our tech winners, inertia strikes us as a sensible investment strategy. We think our ideal holding period for such stocks is forever or until there’s a good earnings-related reason to sell them, whichever comes first,” says Turner.

Microsoft is one of the biggest active bets in the portfolio, in the form of an underweighting. The stock is the largest company in the benchmark (3.7% as of year-end) and Turner has no exposure to this name. In his view, Microsoft is in a disadvantaged position on a secular basis. Turner says the software industry is moving to an on-demand, open-source world, and away from a closed-source proprietary model. He says that sustained leadership is far less common in the tech sector these days. Although Microsoft has lots of cash flow and tries to be innovative, Turner says “they’re just too big, and it’s hard to get that going. When you look at the secular forces, they’re aligned against Microsoft.” Another negative is competitive threats from Google, which is subtly rolling out spreadsheet and word-processing capabilities. “We know Microsoft can go up, we just feel like the stocks we own can go up more,” says Turner. Finding tech companies that are growing fast at any given time is fairly easy, in Turner’s opinion. The hard part is determining how long those companies can keep growing fast. Those that grow fast and for a long time will be the leaders.

Litman/Gregory Opinion

Vanguard Growth Equity was up 6.2% in 2006, underperforming the Russell 1000 Growth Index iShares benchmark, which was up 8.9%. Although the fund’s performance history dates back to March 2002, we start the record in 1997 when Turner changed the portfolio-construction methodology for comparably run institutional accounts, switching from an equal-weighted product—it held around 100 holdings with 1% positions—to allowing individual positions to account for up to twice the stock’s weighting in the Russell 1000 Growth Index. Since changing the portfolio-construction methodology in 1997, the fund’s annualized return is 6% (through 2006), compared to a return of 5.2% for the Russell benchmark. (Note that prior to the iShares’ inception in May 2000, we use the Russell 1000 Growth index adjusted for expenses as the fund’s benchmark.) Looking at risk, the fund has been much more volatile than the benchmark. For example, the fund’s best and worst rolling 12-month returns are 69.8% and -56%, respectively. By comparison, the benchmark’s best and worst rolling 12-month returns are 31.5% and -45.7%, respectively. We expect the fund’s outperformance on the upside to more than make up for any underperformance in declining (or even flat) markets. Looking ahead, if Turner’s belief that growth stocks are primed to lead the market plays out, we would expect the fund to outperform.

We like that Turner uses a combination of fundamental, quantitative, and technical aspects in their investment process. We think the combination of these tools helps minimize the intuitive aspects of investment decision-making. While Turner’s process is disciplined and systematic, it is also flexible enough to adapt to changing market environments. A sector-neutral approach imposes an additional level of discipline in the stock-picking process. There are several other things to like about Turner, including the firm’s incentive/ownership structure, and a very positive corporate culture, which means that the team is likely to stick together. (There have been very few departures from the investment team.) Turner is also very attentive to asset growth and has a history of closing funds are very reasonable levels. Turner is the only firm that we know of that publishes updated asset-capacity studies for its various strategies on an annual basis. Another plus is that expenses on the fund are reasonable at 0.91%, and have declined as assets have grown.

Turner’s investment team has grown considerably since we initiated coverage on the firm in 2000. At that time, Turner had 10 investment professionals working in a portfolio manager/analyst role. The individuals were divided by sector, with each sector team covering stocks across all capitalization ranges, and making investment recommendations on stocks in those sectors. In late 2000, some sectors were covered by only one or two individuals. Over the last two or three years, Turner has grown the team and now has three portfolio managers/analysts covering each of the five key sectors (technology, health care, financials, consumer, and cyclicals). Turner is now hiring a fourth analyst for each sector team in light of the continued growth in assets (in the past three years, the firm has more than doubled its assets to more than $20 billion) and the introduction of international and global growth-stock portfolios, which are only available through separate accounts. The fourth members will be more junior, and will help with modeling, developing surveys to help gauge future earnings, and attending trade shows to gather industry information, etc. Turner says it’s possible that a fifth member will be added to each team in 2008. We should note that as the broader investment team has grown, we’ve spoken with a number of investment-team members, and we believe the process and philosophy is being consistently being applied across the team. We were also impressed with the depth and quality of the team’s research.

Turner has always had a team approach to investing, believing that collaboration leads to better decision making. We think the larger team is a positive for Turner. Having more eyes and ears on individual stocks and on each sector gives Turner a better ability to deal with the short-term “noise” in the market. Looking back a few years, Turner was more inclined to sell a consumer-related stock in the face of higher energy prices and a declining housing market. Today, a broader, more-informed team allows Turner to stick to their guns (sometimes adding to their position), and benefit from short-term misperceptions in the market. Our overall impression is that the team works very well together. A potential risk with a growing team is the increase in opinions, which can slow the decision-making process. We believe the team continues to work well together but will continue to monitor this issue.

We do not have any major concerns at this time and continue to recommend Vanguard Growth Equity for non-taxable accounts. Tax management is not an element of Turner’s investment approach, and as the fund’s high turnover suggests, there’s a potential for large realized short-term gains. We should note that Turner’s approach has been more successful among the firm’s smaller-cap products, such as Turner Mid Cap Growth and Turner Small Cap Growth and Turner Micro Cap Growth, which are closed to new investors.
—Jack Chee

_________________________________________________________________________________Reprinted Copyright© 2007 Litman/Gregory Analytics, LLC.

Large Cap Mutual Fund Report on Brandywine

I have only a few clients with Brandywine funds left. I began pairing back on Brandywine as a core holding in 1993. I have felt for years that there are better offerings in the Large Cap arena. As my clients know, I don't sell a fund unless they no longer wish to hold it hence not everyone has the same holdings. Litman Gregory and Morningstar are fans of Brandywine funds and have recommended them for years.

For my client's that still have Brandywine in your portfolio, here is an update by Litman Gregory Analytics regarding two Brandywine funds:


Brandywine (BRWIX) and Brandywine Blue (BLUEX)
Category: Larger-Cap Growth
Manager: Bill D’Alonzo
Date of Interview: 11/07/06
With: Trey Oglesby, Scott Gates, Fran Okoniewski, James Gowen, and Ward Jones (research analysts)

On a recent trip to the East Coast, we visited Friess Associates (advisor to Brandywine Funds) in their Greenville, Delaware, offices. The objective of our visit was ongoing due diligence, where we continue to test our original thesis for recommending a manager. The majority of our time was spent with members of the firm’s research team where we had in-depth stock discussions in order to assess the consistency with which the team follows its investment discipline. The Friess approach centers on identifying catalysts that will enable companies to deliver stronger earnings than Wall Street expects. Determining which companies will beat consensus estimates is accomplished through numerous conversations with company managements, competitors, customers, and suppliers, which Friess refers to as “trade checks.” Below are some details of these stock discussions.

Dick’s Sporting Goods, a retailer of name-brand sports apparel, footwear, and equipment, was brought to Oglesby’s attention by a sell-side analyst who noticed increasing sales for the company. Oglesby started his research process by obtaining a Wall Street earnings model in order to understand Wall Street’s growth assumptions for the company. Then, he began trade-checking the company to see if there are catalysts that could lead to better-than-expected earnings. Oglesby says one of the most relevant factors behind Dick’s improving revenues is strong sales of Under Armour products, a maker of performance athletic apparel. Providing perspective, Oglesby says Dick’s sales of Under Armour are growing 60%, while camping equipment sales are growing 3%. So in order to understand Dick’s earnings potential, “We had to stay on top of Under Armour,” says Oglesby. Calls to Under Armour’s management, as well as other makers of performance sports apparel, revealed strong demand for these products. Oglesby confirmed this demand through a third-party source who surveyed customers’ interest for these products. Meanwhile, conversations with Dick’s management revealed plans to devote more floor space to this apparel, something Oglesby suspects may not be fully factored into Dick’s sales estimates.

Another potential source of positive earnings surprise is Dick’s integration of Galyan’s Trading Company, which was acquired in 2004. Oglesby explains that up until now, Dick’s hadn’t included these former Galyan’s stores in their store-base count because they needed to be converted into Dick’s store format. Oglesby says this integration has taken a long time and has been a headwind for the stock, but based on his trade checks, the feedback for these new stores is “very, very positive.” He believes the success of these additional stores will lead to better-than-expected year-over-year earnings comparisons. The Galyan’s acquisition aside, Oglesby says Dick’s square-footage growth, a key driver in retail, is going very well as the company continues to effectively expand its store base.

Given Dick’s organic growth, along with stronger-than-anticipated sales of Under Armour products, and the successful integration of Galyan’s, Oglesby is confident that Wall Street’s sales projections are conservative (although he did not provide his actual earnings estimate). As part of assessing whether Dick’s can surprise on the upside, Oglesby ran through a sensitivity analysis to understand how increasing costs of Under Armour products, for example, would impact Dick’s profitability. In the end, Oglesby’s earnings estimates are at least 10 cents higher than the $1.98 consensus earnings for the company’s fiscal year. He also believes there’s room for multiple-expansion. Oglesby says Dick’s P/E multiple is roughly in line with similar retailers but he thinks the company’s higher-than-average growth warrants a slightly higher premium. The main risk Oglesby sees is declining consumer spending. However, he says trade checks throughout the retail industry suggest that consumers are still spending.

Carpenter Technology is a stock we discussed in our last fund update, but has since been sold. The company is a producer of high-quality specialty steels that are used across various industries including aerospace, health care, and industrial machinery. A big part of Okoniewski’s investment thesis was the company’s decision to refocus its business on higher-margin specialty metals (particularly to the aerospace industry), and de-emphasizing lower-margin products. Okoniewski says management is executing, and revenues from the aerospace division—which were growing at approximately 20% when Friess purchased the stock—are now growing at almost 40%, while aerospace operating profits as a percentage of total profits have gone from 35% to almost 80%. Meanwhile, Carpenter reported one of its most-profitable quarters, beating Wall Street consensus earnings estimates by $0.50. Looking ahead, Okoniewski expects continuing demand for Carpenter’s specialty metals as the airline industry is increasingly focused on making lighter, more fuel-efficient aircraft.

Although Okoniewski believes Carpenter’s operations remain solid, and demand remains strong, he had to sell. He says that after Carpenter’s strong quarterly results, Wall Street expectations became very aggressive as analysts seemed to extrapolate recent results into future quarters. Wall Street estimates exceeded Friess’ estimates by 15% to 20%. Friess only owns stocks where it sees the potential for upside earnings surprise, and as such the stock was sold.

Fischer Scientific, a distributor of scientific equipment, chemicals, and supplies, is a long-time holding. The company is in the process of merging with Thermo Electron, a maker of high-end analytical instruments and laboratory equipment. Gates believes there are a number of reasons to be excited about this combined company. Generally speaking, Gates believes managements are often conservative when it comes to estimating post-merger cost savings. “Most managers just lop 10% off overhead because of merger synergies,” says Gates, but in this case he believes this is extremely conservative. “When I work through the model with both managements, and look at prior acquisitions [there have been probably 30 in the last five years], not one acquisition have they realized less than 10%,” adds Gates. A potential downside is integration risk, as this is the biggest merger for both companies, but Gates isn’t giving it much weight. His confidence is based on the historically acquisitive nature of both companies and his long history with both companies.

Trade checks have revealed that customers are excited by the merger. Gates met with companies that are planning to begin distributing their instrumentation through Fischer, because of the worldwide distribution they gain through the merger. “These contacts go a long way in giving you confidence in what you think management can do,” says Gates. Gates believes Wall Street will eventually see past the “danger zone” and give the company full credit for the power of this merger. “It’s just a matter of proving they can bring the two companies together,” says Gates. As for existing customers, Gates spoke to heads of buying for Astra Zeneca, Bristol-Myers, Lilly, and Pfizer, all of which like that they’ll be able to do one-stop shopping once the companies merge.

Gates is conservatively estimating earnings of $2.50 for 2007, compared to the company’s guidance of between $2.27 and $2.38. On top of higher-than-expected cost savings from the merger, Gates says, “I expect management to make more accretive acquisitions, which could further boost earnings.” When picking a multiple to put on earnings, Gates says the company is growing 30% but he’s applying a 20x multiple, which results in a $60 price target. At the time of our interview, the stock traded at $48. “I think there’s upside in the multiple, and as management executes, Wall Street will give it a better multiple. It will come and I don’t need to raise my multiple now,” says Gates.

Litman/Gregory Opinion
Both Brandywine and Brandywine Blue are having good years. Investors should note that when evaluating Brandywine Fund’s performance, we find it is useful to look at several benchmarks in light of the fund’s all-cap flexibility. We think the best long-term benchmark is the Russell 3000 Growth iShares, but since it is not a perfect fit we also look at the Russell 1000 Growth iShares (a large-cap index), the Russell Midcap Growth iShares, and the Russell 2500 Growth (a mid/large-cap index), to help us get a good overall gauge of performance. Brandywine (up 10.7% so far in 2006) is handily beating the Russell 3000 Growth and Russell 1000 Growth iShares, which are up 8.9% and 8.5%, respectively. Brandywine Blue (up 10.9%) is well ahead of the Russell 1000 Growth iShares.

Looking at longer-term performance on a calendar-year basis going back to the mid-1980s the team has an excellent record except 2002, and 1997 to 1998, which we discussed at length in our June 2001 due diligence report. As we have said before, the Brandywine Fund was one of the few growth funds to capture a lot of the upswing in 1999 and still have a positive return in 2000. The fund’s risk (as measured by standard deviation) is higher than the benchmark’s, but we think the fund’s greater exposure to smaller-cap stocks explains most of the added volatility.
Based on our recent discussions with the analysts, it remains clear that the team is obsessive and thorough when it comes to conducting industry trade checks. They talk to companies up and down the food chain, and across sectors and industries to help them uncover good ideas and gain an information edge over the competition. We view the team’s emphasis on this practice as the most important aspect of its success. On top of this there are several other positives. There is a clear consistency of philosophy across the team. All of the analysts we’ve spoken to seem to completely buy into the approach and are consistent in their understanding and application of the process. Additionally, there is a major emphasis on productivity, where the goal is to keep the research team focused only on stock picking and maximizing productivity. Another positive is stability. Senior team members have long-term employment contracts and have laid out succession plans. Friess has continued to dole out equity to the investment team members as well as non-investment team members, fostering continuity and reducing the chances of personnel turnover.

We do not have any major concerns at this time and both funds remain on our Recommended list of larger-cap growth funds. We have a minor concern related to the future growth of the firm’s asset base and how it will potentially impact the team’s ability to successfully execute their process. For now, asset levels (total firm assets are about $9 billion) are reasonable and we are confident the funds can continue to beat their benchmarks going forward.
Although Brandywine Fund is more difficult to pin down from an asset-allocation standpoint, we think it is still a suitable larger-cap option. Investors who are seeking more dedicated large-cap (but not mega-cap) exposure should consider Brandywine Blue.

—Jack Chee

__________________________________________________________________________Reprinted from AdvisorIntelligence. Copyright© 2007 Litman/Gregory Analytics, LLC.