Perritt Capital Management commentary for the third quarter ended September 30, 2016; titled, “You Can’t Always Get What You Want.”
- Q3 2016 hedge fund letters
- Q2 2016 hedge fund letters
Low cost passively managed funds have been all the rage for investors in the past few years. According to Morningstar, investors have pumped $437 billion into passively managed funds in the past twelve months while yanking $303 billion from actively managed funds. Given recent rule changes, this interest in passive funds could grow further. The Department of Labor (DOL) earlier this year introduced a new Fiduciary rule, set to take effect in April 2017, which holds individual advisors who work with tax-advantaged retirement accounts to a fiduciary standard, meaning they must work in the best interest of clients. At the top of advisor’s and investor’s minds is cost, which can lead them to passively managed funds. Morningstar also recently said the new Fiduciary Rule by the DOL could attract as much as another $1 trillion into passive funds.
Before you go out and join the others in buying passive funds, we believe it is important to understand history and the details of the indexes used to create these passive funds. The number of publicly traded companies in these indexes has declined dramatically in the past 20 years, which we believe has huge implications for passive investors. As you can see from the chart above, the number of U.S. companies listed on the major exchanges has declined from more than 7,000 to less than 3,600 today. We think it is quite ironic that the Wilshire 5000 Index only has 3,600 U.S. companies in the index.
There are several reasons for the decline in public companies, but many are related to the lack of IPOs and the regular occurrence of mergers and acquisitions. We would argue, that the quality companies are routinely acquired, therefore there are less public companies which reduces the quality of the indexes. In fact, one of the most important factors we use to judge company quality is profitability.
The table below details some interesting history for the Russell 2000 Index and the Russell Microcap Index. As you can see, the number of profitable companies has declined significantly in the past 10 years while the number of unprofitable companies has increased significantly. In fact, the Russell Microcap Index has lost nearly 500 profitable companies during the past 10 years, and the percent of profitable companies in the Index is only a little more than 50%. In addition, nearly 150 of those 500 companies were only recently removed from the Index, and the majority of those were related to buyouts. It is important to note that this is a record high of unprofitable companies for the Russell Microcap Index and a non-recessionary high for the Russell 2000 Index. We believe these statistics increase the attractiveness of active management within the small/micro-cap marketplace.
As I mentioned earlier, investors are flocking to passively managed funds, which include products that mirror the Russell 2000 Index and the Russell Microcap Index. In the past 10 years or so, we have seen assets invested in these vehicles grow from less than $1 billion to tens of billions. For example, iShare offers IWM, which is an ETF tracking the Russell 2000 Index. This passive fund has grown from less than $1 billion in assets a little more than 10 years ago to nearly $30 billion today, and this is only one of several passive funds in the small-cap space.
The bottom line is that we believe investors want a low cost diversified portfolio of high quality stocks, but you can’t always get what you want. We believe if investors are willing to pay a little more for the skill of an active manager, they can get what they need.
Performance And Valuation Update
Perritt Capital Management – Distribution Update
Due to recent gains, both the Perritt MicroCap Opportunities Fund and the Perritt Ultra Fund will pay a distribution on 11/18/16 to shareholders. Based on estimates:
- The Long Term Capital Gain distribution in the Perritt MicroCap Opportunities Fund (PRCGX) will be approximately 9% and roughly 5% in the Perritt Ultra MicroCap Fund (PREOX).
- The Perritt Low Priced Stock Fund (PLOWX) will have no distributions.
- No short-term income or short-term gains will be paid in any of the Funds.
Shareholders of record on 11/17/2016 will receive distributions
Distribution figures and distribution dates are estimates only and are subject to change. Actual distributions may be substantially different (higher or lower) or may not be distributed at all.
Actual distributions on a dollar per share basis will be available on or after 11/18/2016.