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The Emerging Era of MicroCaps (Part 3)

By Marc Robins For those of you suffered through [Part 1] and [Part 2], congratulations! Only two more parts remain. Three times I’ve started this article, trying to wrap-up the series on the New Era of Micro-caps. Given the verbal constipation, one would think I might be having difficulty

By Marc Robins

For those of you suffered through [Part 1] and [Part 2], congratulations! Only two more parts remain. Three times I’ve started this article, trying to wrap-up the series on the New Era of Micro-caps. Given the verbal constipation, one would think I might be having difficulty expressing a concluding thesis. Nyet! My troubles have to do with holiday cheer (or too much of it!), technology breakdowns (“Thumb-drives” {especially the free ones handed out at various conferences that look like they’re ‘info-vaults’} are not to be depended upon. They rank right up there with technological abortions like MS Software, the Hindenburg, 8-track stereo, the Yugo, and cold-fusion.)  Twice, I had made really good progress on Part 3 and TWICE, the “dumb-drives” I was using for storage experienced malfunctions. In other words, the documents were “Lost in Space”.

The benefit the delay to this last installment is that it has delivered us the prima facie evidence before our very eyes. (That’s kind of a repetitive statement; but I do like how it kind of sounds: At Forbes, they would have edited it out but they pay by the word.) Now micro-caps are blossoming anew.  We are seeing stocks like CalAmp[1] (CAMP-$10; No, excuse me $11) act like they are finally being “DISCOVERED” by the market. (We’ve fondly referred to the shares as “CRAMP” for years, since most managers wouldn’t be bothered to hear of the story yet the chart has been one, straight, positive progression.  Now, it’s as if they have discovered a cure for cancer.)  Greystone Logistics[2] (GLGI-$0.55) has been discovered and the masses now believe in the magic of recycled, plastic warehouse pallets.  My most favorite story, least favorite stock, SingleTouch Interactive[3] (SITO-$0.73) has even garnered a following.  One day last fall, the shares were priced at $0.20; very recently, they popped above $0.95 (See, it only took me several years and a couple of recommendations to be right.). Again, it’s like the many unemployed, day-traders have either awakened from their five-year nap or they’re reading our mail (or at least a couple of these articles).

Ok. In the past commentaries, we’ve discussed the couple-decade-long demise of the micro-cap end of the equity capital markets. Since the early 1980’s, there really hasn’t been a genuine small- and micro-cap rally of any real, long-running significance. We also covered why appreciation performance of small-fry equities has not only been ‘stinko’ for the last several years but why normal, retail investors haven’t had much interest in investing in this brand of “up-and-comer” stories….the kind of high-risk/high-reward long-shots that are basically responsible for the past two centuries of America’s incredible technological and economic growth…is perplexing.

To explain these trends (or the virtual absence thereof), we described how the striking rise of professionally managed, RIA portfolios; legislated laws (SarBox, in particular); administrative rulings and regulations to supposedly protect investors from unscrupulous, Wall Street types; the huge flood of retirement savings flowing to equities back in the 1980’s (and the juxtaposition of account liquidity requirements matching that onslaught of cash); the neutering of American CEO grit as well as the fallout from the last economic decline. All of these factors have worked to compress microcap valuations, pushing risk-tolerant investors away and dampening the overall growth of the economy. Undeniably, the “British-ification” of the markets conjoined with the advancing reign of regulators has ultimately resulted in the spaying of the country’s entrepreneurial spirit.

Think about what I just stated: the government, brokerage industry and even the markets (by this, we can use as an example DTCs own administrative ability to “chill” small companies, for fairly spurious reasons, right into oblivion) have been working to squeeze risk out of the investment equation. Yet, one does not have to be a religious zealot to comprehend, and accept, that the over-reaching “invisible hand” of the markets is poised, better yet clenched and hovering, to come down on what’s been accepted as the “new”, safety-first norm thus (?)shattering what is now held as conventional beliefs.  For those of us, died-in-the-wool contrarians and long-term market observers, the market-altering changes we’re awaiting should demonstrate a marked shift away from the path of greatest expectation and normality: This new course will be of far greater extent than most expect.  It’s like buying real estate in 2008, or selling oil shares in 1988, being bullish in 1987 or buying gold in 1980….Just because everybody is “doing it,” that’s exactly the reason to move aside or change direction.  I am wholly and truly worried that because the government has been working so hard to stave off risk and save us from our detrimental investment ways, that the concussive response will be exactly opposite what they want and most desire and in tsunamic proportions.

Indeed, due to my procrastination, we are already experiencing this shift.  Or to use a more pithy expression, micro-caps “ARE ALIVE!” he says with surprise greater than Dr. Frankenstein!

To explain my optimism, let’s go back and think about the several “truths” we know, and have come to depend upon, about the stock market. We know the stock market….

  • Predicts the future…..  (That is what we used to believe and I personally believe it stands true today.  I use the most recent presidential election as evidence that this first postulate still stands.)
  • Has a natural orientation reflecting, or portraying, a positive risk-reward relationship….  (In other words, one has to accept more risk in an investment {or portfolio} to realize higher rewards.)
  • Is a proficient mechanism of portraying appropriate pricing from an efficient distribution of news….. (This is particularly true of large-cap stock, but in my estimation the reverse has never been more evident in the small- and micro-cap arena.  The void of valuable intelligence {knowledge and comprehension of events, not “smarts”} is shocking.).
  • And, it reflects (and this is particularly evident in individual stocks) the level of interest rates and the perception of forward earnings…..

Based on the fact that the market is never wrong (for long), the “Risk/Reward” curve starts at the “zero-risk” T-bill rate and slopes upward and to the right where higher amounts of return rise with incremental increases of risk.  Then I submit to heartily recall four things:

  1. Oldsters/pensioners (as well as plenty of younger investors) can’t live on the meager, ½% passbook savings dolled-out by banks and the relatively meager absolute returns retirement asset portfolios have been earning of late. Their financial requirements for living are quickly out-stripping investment returns…meaning folks have been drawing down their corpus and they are realizing the dire need to either shift consumption habits (which is being exacerbated by increasing fee and tax burdens), understand they are leaving less to their heirs, or creep-out on the risk/reward curve to “up” returns.
  2. The “2 and 20” crowd (professional Hedge Fund Managers) are being challenged on several fronts: Their 2008-on shift to more mundane, large-cap names for the sake of transactional liquidity is hurting portfolio returns, increased scrutiny by the regulators (and more acutely the negative onus placed on “hedgies” because of the news  articles heightening awareness on the successfully prosecuted “insider trading” charges) and the far smaller in-flow of new funds are all helping to “let the air out” of this market hotspot. Again, many of these managers have tried every security strategy except investing and it’s really showing the inherent weaknesses of mechanical “scams.” (In this instance I don’t mean unscrupulous dealings but rather “conjured” strategies or derived investment algorithms.)[4].
  3. The consultants’ massive push to orient portfolios to incorporate a greater fixed income emphasis is about to unwind. There’s been a recent market shudder that should have warned most everybody that the secular downtrend in rates is either over or going to get a severe case of indigestion. One would think asset trustees would have learned this is not a very good overall position given the recent “back-up” in ten year rates that virtually wiped-out three years of bond returns. That said, we have learned of some consultants beginning to shift their emphasis away from fixed income instruments and to riskier holdings….In some cases, small- and micro-cap equities.
  4. The increasing volatility of market favorites (Apple, Google, BofA, Facebook, etc.) is taking-out the “assuredness” of making trading profits and is signaling a potential rotational change to the next cultural nifty fifty.  Interestingly, one of my favorite micro-cap managers mentioned that he was getting calls from the news media because “they were just really tired of talking about the same old, favorite names.” Even the media wants to reach out and expand their investment horizons.

So, we’ve mentioned a number of factors that tend to provide reasons to rotate out of the current fad investment classes.  But it still leaves us with two questions: 1) What’s going to really push us over the edge to experience a full-fledged rally in small- and micro-cap stocks?  2) What will help convert this recent flurry into a full-fledged, long-legged, secular up-draft?

The market, economic climate and cultural shifts remind me so much of the period between late 1966 and September, 1974 that the coincidences are remarkable.  Surely, it’s not a perfect fit. (“History doesn’t really repeat itself, but it rhymes,” to quote Twain.) But, the parallels are sufficiently close that I think we can expect a repeat of the markets from 1974-to-1983.

Back then, we had had years of Johnson’s “New Society” programs gushing an unbridled flow of money into both “guns and butter”. There was a litany of new, alphabet-titled regulatory and ‘do-gooder’ agencies, or the revitalization of existing administrative entities, that worked every which-way to diminish productivity. Although we have yet to see it in its blooming glory (it has been hidden either by fancy logic, increasing productivity, weaker oil prices or luck) but inflation is prevalent and is just beginning to re-appear[5]. From a market perspective, the DOW and “Nifty-Fifty” were creamed in the late 1960’s and early 1970’s after years of nearly unbridled expansion. (Place this in the context of the market run from the bounce after 9/11 through almost late 2007 and then the devastating correction of 2008 and some of 2009.)  Then, as inflation, gasoline supply disruptions, a mighty “blue funk” about Viet Nam, higher taxes, government expansion, a slower economy and incredible angst by our parents about the up-and-coming, boisterous and opinionated, “rock ‘n roll” generation became the focus of the 1970s, the performance of the major averages went sideways. While the Dow Industrials bounced between 600 and 1000, the fired-up performance generated by the “up-and-coming” little stocks attracted significant investor capital, leading to outsized gains that lasted for almost a decade.

In 1988, I moved from the “sell-side” as an analyst/institutional salesmen to the “buy-side” co-managing a small-cap/micro-cap portfolio with really very good returns for five years. Part of our small-cap pitch at the time was how, during this eleven-year period from the early 1970’s to the early 1980s, small-caps out-performed the large caps better than 2-to-1. Now the numbers I remember using to depict this feat was somewhere close to 34% per year for small-cap returns versus 15% for the S&P. The era was a remarkable time and many made small fortunes by betting on stocks found off in the scrub. This is the same environment that Peter Lynch of Magellan Fund fame really blossomed: if you read his books, one understands that his returns were really due a rotational play away from the staid major names that managers, trust departments and most funds depended on and into those higher-risk, unsafe secondary equities that are practically outlawed today.

Some additional facets that I remember from that period as observed by a budding analyst were the dearth of major new innovations and avant garde consumer brands, the major shift of women becoming a “new” component of the workforce and the ridiculousness of tax policies that pushed so much of the economy underground (We’ve forgotten, but part of the major reason the Reagan tax policies made so much sense and were so heartily welcomed back in the early 1980s was that people spent incredible resources either finding tax dodge schemes or moving substantial personal entrepreneurial cash operations and transactions below the detection horizon of the “Revenooers.” If business couldn’t be detected or cash transactions were hidden where they couldn’t be taxed, you’d experience underperforming reported GDP growth and crimped tax revenues to support government activities. Such was the case in the 1970’s. On the other hand, do you think it’s more than a mere coincidence that Discovery, History and Animal Planet have programs highlighting moonshiners, junk traders, pawnshops, gold miners and backwoods families? I think not. I’m sorry; but I have to laugh. Every time the moderator mentions the moonshiners and their ill-gotten gains, it always includes the phrase, “…and they’re generating $30,000 tax free!” I submit we’d be better served by congress and the President if they’d believe less about their world in a goldfish bowl and watched more TV.)

I don’t want this financial commentary to degrade into another political rant, but, besides the financial reasons for the shift toward small- and micro-cap stocks, we seem to have moved into a “Jimmy Carter” era of political, social and economic exasperations. The current environment is so similar to that earlier era. I truly believe that we -as an investing nation and as a nation of many other scientific, consumer products, medical contributions – are again on the bubble as it concerns investment perspectives by both individuals and professionals: Want better total investment returns? Go to the small-cap end of the market. Want to save more on those realized gains? Try to garner long-term capital gains for a tax policy preferred savings on those returns. Want to benefit from, or defend against, new, silly-ass social programs? Turn to smaller companies that can out-maneuver restrictions or can invent new products or programs to circumvent dictates (ie. Smith & Wesson Holdings)[6].

Stay tuned for station identification……

I promised you that this was the concluding portion of the “Era” discussion, but Ian thought it should be divided into two because of its length.  OK, my verbosity got the better of me.

That said, we are going to really put a ribbon around the work to date.  We discuss how this bounce will turn into a powerful rally and with long “shelf life.”

[1] I do own shares in CAMP: Recommended the shares as a “Buy”, July, 2009 at $1.56.

[2] Thanks to Sean Marconi and Ian for this great idea. I own these shares upon their recommendation.

[3] I do own SITO and it is the reason I’ve turned so grey: Recommended shares June 10th, 2010 for Catalyst at $1.30.  I also recommended the shares as a “Buy” for AMI on April 18, 2011 at $0.65.

[4] One of my partners here on the desk exclaims to his clients and prospects that “87% of managers are under-performing the averages!”  Given the poignancy of this statement (which I really can’t be held accountable for or speak to its true validity, but it is a great statement.) points to the problem described in #1 and #2, above.  From an actual return standpoint, if relative performance is that poor versus the averages and can be described by the path of a “Slinky” during the last 5 years, actual performance—the return numbers that families and pensioners actually live on—have to be abysmal.  Given these returns juxtaposed to the egregious fees and ‘share’ overrides levied on accounts,  managers have to be under incredible pressure to show more vibrant returns to keep accounts.  This means one thing; managers can’t hide any longer behind market capital size or algorithms but have to creep out the risk/return curve.

More to this point:  Not too long ago, these professional and retail investors tried “Red Chip” stocks (Oh, excuse me;   Chinese stocks.) and that proved to be a charade, wrapped in a secret, shrouded in fraud.  They’ve tried nearly every complex derivative exercise imaginative and that’s not worked out so well either.  Hedging has been around forever and it’s not really caught-on as the “be all.”  What investors, both professional and amateur, have yet to embrace is “investing!”  Buying companies that have 15% or higher revenue or earnings growth, equally high or strong returns on assets, high insider management ownership and low institutional ownership and holding these undiscovered gems longer than a quarter or two.  One would be hard pressed to find a big cap name with these kinds of attributes.  That means one would have to turn to micro-caps or the small end of the small-cap universe.  Would you believe me if I said ‘maybe it’s time has come?!”

[5] Want to argue? Just ask your wife about how much more it costs to buy a week’s worth of groceries than it did a year, or four years ago? Then try to convince her that ‘food and energy’ shouldn’t be a part of “consumer package” when gauging inflation. Over the weekend, it was announced how major retailers were “right-sizing packaging” (Read: Shrinking the overall package size of goods and food so as to mask the reality of inflation and not ‘clobber’ consumers with the new reality of prices. This is exactly what was done in the early 1970s when corporate America didn’t want to admit to the shrinking value of the dollar. Indeed, I have an “All” barrel in my basement that was used to sell laundry detergent in the 1960s. Yes, laundry detergent was bought first by the 40 pound barrel; now detergent and cereal boxes vie for the most shelf space.) For the more financially erudite, the yield curve has a positive slope. We can argue as to whether the Fed is rightfully or wrongfully pegging the short-end way to low or not, but the curve is sloped upward indicating an inflationary environment or one that about to be.

[6] I’d like to make one more observation that is tangential to the theme of this paper.  There is an overwhelming cry about how advances in science, consumer technology and medical accomplishments are waning.  (A feature article was published last month about ‘how technology isn’t going to save our bacon as it concerns “global warming”, energy shortages, diminishing food supplies, any number of things.)  If one looks around and truly observes the environment we live in, it seems that America has stalled-out creating new technologies.  Readers would most likely announce, “Well, what about the iPhone?”  Replace iPhone with SmartPhones, Tablet technology, WiFi, Alternative Energy cars, iTunes, Netflix, Facebook, Touchscreens, headsets {I actually challenged a younger colleague in the office to help me with the list so it wasn’t entirely tainted by the thoughts of an old, curmudgeon.} I would tell you that almost every one of those advances or products (except for Facebook and media sharing…everything} I’ve listed were first produced over the course of the last two decades, not in the last several years.  Many have been developing technology during the last 25 to 30 years.  What has occurred is the popularization of these devices and services because they have gotten simpler to operate, or the connectivity is faster and ubiquitous (less a function of “new” science versus improved availability.)  I am hard pressed (and I try to scan the press when it comes to new inventions and innovations) to point to any major, new or great product developed by major companies.  Conversely, I am witnessing a number of exciting new technologies and services developed by many tiny firms.  Such is the ebb and flow of our economy…It also points out why building bigger government, more regulatory overhead and larger corporate structures flies in the face of progress.

About Marc Robins: Mr. Marc Robins is a Managing Partner and Founder of Catalyst Financial Resources, LLC. He is also employed as a Preisdent and Director of Research at The Robins Group, LLC. Prior to these positions, Mr. Robins was the Founder, Editor-in-Chief at the RedChip Companies, Inc.. Mr. Robins resigned from this other post as of November 22, 2002 and has since moved to full-time positions at Catalyst Financial Resources, Crown Capital, LLC, The Robins Group, LLC and Crown Point Group, Ltd. Prior to founding the RedChip Companies, he was co-manager of the WestCap Small-Cap Portfolio for Capital Consultants, Inc. in Portland Oregon. Mr. Robins has previously held positions of portfolio manager, and directors of research at several Portland, Oregon-based investment firms. Mr. Robins was the President of the Portland Society of Financial Analysts. He served as a Director of Inc. since August 2000.

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