Value Investing

Smead Capital on Warning Signs from the Callan Periodic Table

by Smead Capital Management

Smead Capital  August letter:

Our first look at this comes from Callan’s long-term style box chart. The purpose in looking here is to get a feel for the over-capitalization of asset classes:

Smead Capital

Source: Callan Associates Inc.

Three to five years of first and second place finishes is a warning sign for asset classes. Four years near the bottom of the chart indicates pretty good fishing for the discerning long-term asset allocator. There appears very little to worry about in the US small-cap realm from any overt popularity. For example, US large was on fire from 1996-2000 and heading for the deep, long-term doghouse. More recently, MSCI Emerging Markets have had an unusually long streak of first place finishes and appear to be an area which should be avoided at all costs. Nothing we see on this chart indicates the kind of popularity which would make five years of purgatory likely for small cap US stocks.

With the chart as a backdrop, we’ll take a stroll down IPO memory lane. Small caps were mega-popular by 1983 in the aftermath of IPOs like Apple (AAPL) and Genentech (GENE) in 1980. The US small cap equity market peaked on June 24th, 1983 at 126.99 as measured by the Russell 2000 index. By the Oct. 19th, 1987 low in the US stock market, the Russell 2000 bottomed was at 133.71. The year 1983 was a good time to back off on small caps, but was a poor time to reduce ownership of large cap stocks. From June 24th, 1983 to October 19th, 1987, the Dow gained 8.1% per year versus a gain of 1.18% in the Russell 2000.

Small caps got popular in 1996 with Netscape’s IPO in 1995 leading the way to another “white hot” IPO market. This era is marked by Federal Reserve Board Chairman Alan Greenspan calling the frothiness in stocks “irrational exuberance” in December of 1996. The great irony of 1996 was that the froth got handed off like a relay race at a track meet from small caps to large caps. This handoff came from the massive upward movement in capitalization of all the tech, telecom, and internet stocks. I remember the extremities which existed back then. A company called Etoys went public in 1999 and immediately grew to a $10 billion market cap with less than $100 million of sales, while bleeding red ink all over their quarterly earnings reports. Toys-R-Us had $10 billion in sales and a $300 million after-tax profit and had a market cap of $3 billion.