Friday, January 12, 2007

Small stock debate

On January 5 the WSJ had an article entitled "In Small Stocks, A Debate Grows--Do Hedge Funds and ETF's Overly Sway Pricing of Shares?" I've been meaning to post something about this for a week, but current events and personal distractions made my markets writing feel trivial for a few days, but I'm back today and need this distraction.

The ideas discussed were basically, first, whether the emerging importance of ETF's(exchange traded funds that are indexed) in small cap land was creating significant new demand that was driving up small company stock prices and, secondly, whether the hedge funds are focusing more on and influencing prices of this market segment.

My thoughts? On ETF's I doubt that this is a big issue. ETF's in the small cap sector are not huge and if they have an effect it would likely just be reasonably short term as the new buying would build liquidity for longer term holders to take gains and move on. Also ETF's that focus on really discreet areas of this market segment like PHO(water investments) and PXN(nanotechnology investments) are small funds with limited volume and therefore would be unlikely to materially affect their sector without a much more significant level of assets. So on ETF's my take is that they are barking up the wrong tree.

Hedge funds, in my view, are an entirely different matter. It's happening, and it's driving up values because they are doing their homework on stocks that are minimally covered by analysts, often covered only by analysts with almost no experience or those who just look at charts or quant screens. I think and hope that I speak from experience.

Over the last year I invested new equity money almost solely in three areas: ETF's; index funds with 10 basis expense ratios like those offered by Fidelity and Vanguard; and buying individual stocks by copying the investments in smaller companies of a few hedge fund managers that I admire. On this last one I tracked the SEC filings of a few value focused hedge fund investors with great track records. These filings must be made when an investor owns 10% of a company. These hedge fund guys that I like buy beaten up, unappreciated stocks that they think deserve a new life, and that's based on their financial analysis and a point of view on the potential growth of the sector they are in. So I look at what their investments are, I read about the companies, and I look at a several year stock price chart to make sure that in acquiring their 10% these guys didn't finish off the punchbowl. And if I like it, I'm a small fry piggybacker on their idea.(Yahoo Finance is a good source for compiling this information)

In brief, here are some recent results. From August to October I made investments in five stocks following this approach. As of today, on average five months later, the aggregate gain on these investments is 33%, with the lowest of the group being 21%. Now it's been a terrific market so the wind has been at our backs, but I like what I see for now. From late November until the end of December I made four more investments with this approach with the returns to date being 12%, 2%, negative 2% and negative 3%. So it doesn't happen overnight and of course it won't happen with all investments at all---so I like to say that if the investment is down 10% I'm out, before I'm down and out.

I don't always follow this good advice for what can be speculative investments. For example in 2002 I piggybacked on a stock at $22 that I really liked, and the hedge fund guy actually pumped it in Barrons. For three years it moved from between $18 and $24. I liked the idea still, the hedge fund guy was still in, so I hung in with some anxiety and in 2005 I increased my investment, again at $22, by 5 times, quintupled it. From that point this pipe and irrigation equipment maker and installer in Nebraska is up 136%. But in March of 2006 I bought another stock using this approach(I liked two of the major holders), but I also was influenced by a CNBC market entertainer. It went down. I added more in June, went down again such that I was down almost 40%. Ouch. It finally revived some in the fall, so I gave up for short term tax loss purposes on that one two weeks ago with a 22% loss. The hedge fund guy is still there so I'll check it again when the 3o day waiting period for recognition of my loss is over. The discipline of a stop loss level is something that I need, but more than that I should certainly know that by the time a CNBC talking head is in on the game, the opportunity is more than likely over.

To the smart people in the market, meaning a select group of hedge fund and private equity types, this small cap investing is not news and I think that it is now a trend. But it is a trend that is focused on finding real value and not speculating on some big growth story or the next ipod or a drug that cures cancer or baldness. It's about companies that have businesses here and now, and if they really fall on their face, the big hedge fund guy and his private equity pals can just buy it, go private and shape it up. It's of course not without risks for small investors like myself but I like the odds.

So hedge funds are absolutely focused on small cap stocks and in my view finding real value. And it's interesting stuff, if one is so inclined. It still feels a little trivial in the broader perspective, but then again it's a distraction.

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