Small Caps Lead the Way
While the S&P 500 has posted a respectable gain of more than 7 percent so far this year, the small-cap Russell 2000 Index has gained almost 11 percent. With the American economy continuing to show signs of improvement and progress being made on the European sovereign-debt crisis, investors have discovered a newfound sense of optimism that is driving gains in risk assets.
I recently spoke with Ken Salmon, co-manager of BMO Small-Cap Growth (MRSCX, 800-236-3683), who explained his investment process and shared his market outlook. While he focuses on individual stock selection, his outlook and sector themes should be helpful for exchange-traded fund (ETF) investors since there are a number of ETFs–such as PowerShares S&P SmallCap Health Care (NSDQ: PSCH) and PowerShares S&P SmallCap IT (NSDQ: PSCT)–that dovetail with his favored sectors in 2012.
Ken, please describe your investment process.
As a small-cap growth fund, we focus on companies with market capitalizations ranging from $200 million to $3.5 billion. However, we don’t have many holdings with market caps below $500 million because their stocks usually don’t offer sufficient liquidity.
We define a growth stock quite liberally, so we don’t limit ourselves to certain thresholds for earnings or revenue growth.
We take a fundamental approach to security selection. Anything can happen to equities in the short term. But long-term stock performance is closely correlated to changes in the fundamentals of the underlying business. Once we understand a company’s fundamentals, we have a better sense of where its stock is headed over the long term.
Additionally, the market systematically underestimates both the duration and magnitude of changing fundamentals. When a business has deteriorating fundamentals, for example, that change is likely to be both worse than anticipated and last longer than anticipated. And that means the company’s stock will drop further than investors expect.
We look for three things when examining possible additions to our portfolio: Fundamentals have to be improving; we have to be able to explain why those fundamentals are improving; and we have to be able to reasonably project that the improvement will be sustainable over several quarters.
We avoid or sell companies with deteriorating fundamentals.
What type of catalysts for improvement do you look for in a stock?
The most common catalyst is a new product or new product cycle. That’s especially apparent in the technology and health care sectors, whether the product is a new drug or medical device or new semiconductors or software. The main difference between the two sectors is that product cycles can be quite short in technology and quite long in health care. Our investment rationale for many of our portfolio holdings in those two sectors is tied to a new product cycle.
In other sectors, catalysts such as a change in the management team come into play. New management teams often pursue cost-cutting measures that liberate excess cash flow. That allows management to return capital to shareholders or invest in the company to further improve growth rates.
Acquisitions are another positive catalyst, whether it’s transformative for a company or involves industry consolidation.
There can also be cyclical or structural developments within an industry that can change the number of competitors, the pricing structure of products and services, or even demand.
What would cause you to sell a stock?
The easiest trigger is if our thesis is wrong. If the fundamentals deteriorate or if they don’t improve as we anticipated and there’s some kind of negative surprise, we’re very like to sell the stock. We take that approach because, as I mentioned earlier, a negative situation tends to persist longer than most investors expect. We prefer not to have our capital tied up in such a company when numerous other opportunities abound in the small-cap universe.
We also have a valuation discipline. We rarely liquidate entire positions based solely on valuation, but we will incrementally adjust the size of our positions based on our valuation analysis.
How did small caps perform in 2011 and what is your expectation for 2012?
We actually don’t pay that much attention to what the market’s doing; we’re not market forecasters, so we don’t know how the market will perform in the future.
Small caps suffered downside volatility during the third quarter. But they recovered during the fourth quarter, with the Russell 2000 Growth Index finishing the year down about 3 percent.
Our fund lost about 4 percent for the year, which was a little bit worse than our peer group and our benchmark for that period.
The numerous macroeconomic headwinds–ranging from the European sovereign-debt crisis to the slowdown in China–have had a huge impact on volatility. It’s been a frustrating market.
But it sounds like you can still find opportunities if you focus on fundamentally strong companies.
Small caps are a stock pickers market. Whatever happens to the broad market tends to be magnified in the small-cap area. When stocks rise, small caps typically enjoy greater gains than their larger-cap peers. Conversely, when stock prices decline, small-cap stocks tend to suffer even greater drops in value than the broad market.
We construct a diversified portfolio of liquid stocks whose underlying businesses aren’t dependent on the macroeconomic environment. That approach helps our portfolio outperform the market in most economic scenarios.
Unfortunately, there’s not much small-cap investors can do to weather a financial crisis, such as the one that unfolded in 2008. But an improving economy offers the best opportunity for stock picking among small caps.
In what sectors are you seeing the best opportunities for investors?
Because of our fundamental approach, we don’t target a specific sector allocation versus our benchmark or peer group. Instead, we select individual companies that offer compelling growth.
For that reason, we’re currently overweight in energy. We largely focus on exploration and production (E&P) companies that can grow their production consistently and rapidly and do so with efficient use of capital. We prefer companies that don’t have to keep tapping the market for funds to grow production.
We tend to avoid the financial, consumer discretionary and consumer staples sectors. The materials sector is also difficult to navigate in the small-cap space. The mining and metals companies in this sector are volatile and capital-intensive businesses. By contrast, health care, industrials and information technology offer better opportunities for growth stock selection among small caps.
Please tell us about two of your favorite names.
Energy XXI (NSDQ: EXXI) performs shallow water oil and gas drilling in the Gulf of Mexico. It’s grown production for eight consecutive quarters at a strong rate and we think that growth is sustainable. Its E&P program has generated organic production growth of about 20 percent to 25 percent. The company funds that growth internally with its cash flow.
Even if the price of oil suddenly drops and the company’s stock takes a hit, we’d still add to our position because Energy XXI is growing production rapidly—that’s what ultimately determines the value of the company. We also like its ability to replace and grow reserves.
The company’s stock declined following the BP (NYSE: BP) oil spill simply because Energy XXI happened to operate in the Gulf of Mexico. But Energy XXI is a shallow water driller, so the US government’s moratorium on deepwater drilling didn’t affect its operations. This is a prime example of how the energy sector is periodically roiled by commodity price volatility or negative news flow. If we’re still comfortable with the long-term growth rate of a company’s production, we’ll use that temporary weakness as a buying opportunity.
Zoll Medical (NSDQ: ZOLL) is best known for the portable defibrillators used to treat sudden cardiac arrest that are seen in hospitals and office buildings. Although that product is an important component of Zoll Medical’s business, the company boasts a diverse product line that is changing the trajectory of its earnings and revenue growth.
Zoll Medical’s business slowed in 2009 because budget cuts in the public sector reduced demand for defibrillators from non-profit hospitals and municipalities’ emergency services. But the company caught our attention when its business started to recover. During our research process, we discovered new products, such as the LifeVest, that were starting to drive growth.
The LifeVest is an external defibrillator that a patient wears. When a patient with a heart condition requires a pacemaker, there’s usually a lag between when that determination is made and when the device is actually implanted in the patient’s body. This interim period is extremely risky for patients, and consequently the LifeVest can be prescribed to them until they receive their pacemaker.
The LifeVest has an excellent safety and efficacy record. This product has helped accelerate the company’s growth and improve its margins.
But in mid-2011, the Centers for Medicaid & Medicare Services (CMS) decided to revisit its reimbursement policies for the product, as well as the indications for which it was being reimbursed. With some degree of precision, investors can determine how much revenue a company will lose if CMS eliminates reimbursement for an indication of one of its products. In this case, such an outcome would have weighed heavily on Zoll Medical’s earnings, so that action roughly halved the price of the stock in a span of just a few weeks.
But the LifeVest is such a well-regarded product that doctors, hospitals and medical associations, including the American Heart Association, advocated for the product with CMS.
In mid-December, CMS decided to maintain its existing reimbursement policies. Since then, the stock has largely recovered and its prospects for growth remain strong. Last year, Zoll Medical’s earnings per share (EPS) grew 60 percent and we believe that 35 percent to 40 percent EPS growth is reasonable for this fiscal year, with high potential for it to continue into next year as well.
What is your best advice for investors?
Stick with domestic stocks. The emerging markets have disappointed and there’s still a great deal of uncertainty facing foreign stocks because of the European sovereign-debt crisis. By contrast, the US economy and stock market should continue to improve.
What’s New
VelocityShares launched eight double- or triple-leveraged long and inverse commodity exchange-traded notes (ETN) backed by Credit Suisse last week. The new ETNs are:
Even for leveraged funds, these ETNs are extraordinarily expensive. The first six ETNs listed above charge a 1.35 percent annual expense ratio, while the natural gas ETNs each charge a 1.65 percent annual expense ratio. All eight of the funds track indexes provided by S&P GSCI and reset their portfolios on a daily basis.
Last week, Global X Management launched Global X Permanent ETF (NYSE: PERM), which employs an investment strategy championed by Harry Browne in his 1998 book “Fail-Safe Investing.” Built on the notion that the economy is always in one of four environments–rising growth, falling growth, increasing inflation or falling inflation–a permanent portfolio is designed to hold up regardless of economic conditions. So the fund’s target allocations–which are achieved by holding individual stocks and bonds or other ETFs–are 25 percent to equity, short-term bonds and long-term bonds, 20 percent to gold and 5 percent to silver.
The permanent portfolio strategy has been quite attractive to investors, a fact best evidenced by the popularity of the mutual fund Permanent Portfolio (PRPFX), which has accumulated $16.8 billion in assets over the past two decades. In fact, the ETF sponsor hopes to use this ETF to steal market share from the mutual fund. And with the ETF’s annual expense ratio of 0.48 percent versus 0.77 percent for the mutual fund, the ETF might have some success luring investors away despite some subtle differences between the two funds.
Finally, ProShares Advisors rolled out two new triple-leveraged inflation plays.
Rather than simply tracking a basket of Treasury Inflation-Protected Securities (TIPS), Proshares UltraPro 10-Year TIPS/TSY Spread (NYSE: UINF) and ProShares UltraPro Short 10-Year TIPS/TSY Spread (NYSE: SINF) track the spread between TIPS and 10-year Treasuries, also known as the breakeven inflation rate. The long fund essentially has a long position in 10-year TIPS and a short position on 10-year Treasuries, while the short fund does the opposite. The long fund should outperform during periods when the market underestimates inflation, while the short fund will outperform during periods of heightened inflation expectations.
The 10-year breakeven inflation spread is a widely watched indicator among investors. Unfortunately, these funds take a short-term perspective of a long-term phenomenon by virtue of their portfolios’ daily resets. As a result, the two funds aren’t going to accurately reflect long-term shifts in inflationary outlooks. Each fund charges a 0.75 percent annual expense ratio.
Portfolio Update
After a disappointing 33 percent loss last year, Market Vectors Nuclear Energy (NYSE: NLR) has gained more than 12 percent so far this year. While the meltdown at Japan’s Fukushima Daiichi nuclear power plant following last year’s earthquake continues to cast a pall on nuclear energy’s prospects, the US Nuclear Regulatory Commission approved licenses for the construction of two new nuclear reactors in Georgia last Thursday. The US Department of Energy also recently reaffirmed its decision to fund small modular nuclear reactors, which are about one-third of the size of current nuclear reactors.
Continue buying Market Vectors Nuclear Energy under 30.
I recently spoke with Ken Salmon, co-manager of BMO Small-Cap Growth (MRSCX, 800-236-3683), who explained his investment process and shared his market outlook. While he focuses on individual stock selection, his outlook and sector themes should be helpful for exchange-traded fund (ETF) investors since there are a number of ETFs–such as PowerShares S&P SmallCap Health Care (NSDQ: PSCH) and PowerShares S&P SmallCap IT (NSDQ: PSCT)–that dovetail with his favored sectors in 2012.
Ken, please describe your investment process.
As a small-cap growth fund, we focus on companies with market capitalizations ranging from $200 million to $3.5 billion. However, we don’t have many holdings with market caps below $500 million because their stocks usually don’t offer sufficient liquidity.
We define a growth stock quite liberally, so we don’t limit ourselves to certain thresholds for earnings or revenue growth.
We take a fundamental approach to security selection. Anything can happen to equities in the short term. But long-term stock performance is closely correlated to changes in the fundamentals of the underlying business. Once we understand a company’s fundamentals, we have a better sense of where its stock is headed over the long term.
Additionally, the market systematically underestimates both the duration and magnitude of changing fundamentals. When a business has deteriorating fundamentals, for example, that change is likely to be both worse than anticipated and last longer than anticipated. And that means the company’s stock will drop further than investors expect.
We look for three things when examining possible additions to our portfolio: Fundamentals have to be improving; we have to be able to explain why those fundamentals are improving; and we have to be able to reasonably project that the improvement will be sustainable over several quarters.
We avoid or sell companies with deteriorating fundamentals.
What type of catalysts for improvement do you look for in a stock?
The most common catalyst is a new product or new product cycle. That’s especially apparent in the technology and health care sectors, whether the product is a new drug or medical device or new semiconductors or software. The main difference between the two sectors is that product cycles can be quite short in technology and quite long in health care. Our investment rationale for many of our portfolio holdings in those two sectors is tied to a new product cycle.
In other sectors, catalysts such as a change in the management team come into play. New management teams often pursue cost-cutting measures that liberate excess cash flow. That allows management to return capital to shareholders or invest in the company to further improve growth rates.
Acquisitions are another positive catalyst, whether it’s transformative for a company or involves industry consolidation.
There can also be cyclical or structural developments within an industry that can change the number of competitors, the pricing structure of products and services, or even demand.
What would cause you to sell a stock?
The easiest trigger is if our thesis is wrong. If the fundamentals deteriorate or if they don’t improve as we anticipated and there’s some kind of negative surprise, we’re very like to sell the stock. We take that approach because, as I mentioned earlier, a negative situation tends to persist longer than most investors expect. We prefer not to have our capital tied up in such a company when numerous other opportunities abound in the small-cap universe.
We also have a valuation discipline. We rarely liquidate entire positions based solely on valuation, but we will incrementally adjust the size of our positions based on our valuation analysis.
How did small caps perform in 2011 and what is your expectation for 2012?
We actually don’t pay that much attention to what the market’s doing; we’re not market forecasters, so we don’t know how the market will perform in the future.
Small caps suffered downside volatility during the third quarter. But they recovered during the fourth quarter, with the Russell 2000 Growth Index finishing the year down about 3 percent.
Our fund lost about 4 percent for the year, which was a little bit worse than our peer group and our benchmark for that period.
The numerous macroeconomic headwinds–ranging from the European sovereign-debt crisis to the slowdown in China–have had a huge impact on volatility. It’s been a frustrating market.
But it sounds like you can still find opportunities if you focus on fundamentally strong companies.
Small caps are a stock pickers market. Whatever happens to the broad market tends to be magnified in the small-cap area. When stocks rise, small caps typically enjoy greater gains than their larger-cap peers. Conversely, when stock prices decline, small-cap stocks tend to suffer even greater drops in value than the broad market.
We construct a diversified portfolio of liquid stocks whose underlying businesses aren’t dependent on the macroeconomic environment. That approach helps our portfolio outperform the market in most economic scenarios.
Unfortunately, there’s not much small-cap investors can do to weather a financial crisis, such as the one that unfolded in 2008. But an improving economy offers the best opportunity for stock picking among small caps.
In what sectors are you seeing the best opportunities for investors?
Because of our fundamental approach, we don’t target a specific sector allocation versus our benchmark or peer group. Instead, we select individual companies that offer compelling growth.
For that reason, we’re currently overweight in energy. We largely focus on exploration and production (E&P) companies that can grow their production consistently and rapidly and do so with efficient use of capital. We prefer companies that don’t have to keep tapping the market for funds to grow production.
We tend to avoid the financial, consumer discretionary and consumer staples sectors. The materials sector is also difficult to navigate in the small-cap space. The mining and metals companies in this sector are volatile and capital-intensive businesses. By contrast, health care, industrials and information technology offer better opportunities for growth stock selection among small caps.
Please tell us about two of your favorite names.
Energy XXI (NSDQ: EXXI) performs shallow water oil and gas drilling in the Gulf of Mexico. It’s grown production for eight consecutive quarters at a strong rate and we think that growth is sustainable. Its E&P program has generated organic production growth of about 20 percent to 25 percent. The company funds that growth internally with its cash flow.
Even if the price of oil suddenly drops and the company’s stock takes a hit, we’d still add to our position because Energy XXI is growing production rapidly—that’s what ultimately determines the value of the company. We also like its ability to replace and grow reserves.
The company’s stock declined following the BP (NYSE: BP) oil spill simply because Energy XXI happened to operate in the Gulf of Mexico. But Energy XXI is a shallow water driller, so the US government’s moratorium on deepwater drilling didn’t affect its operations. This is a prime example of how the energy sector is periodically roiled by commodity price volatility or negative news flow. If we’re still comfortable with the long-term growth rate of a company’s production, we’ll use that temporary weakness as a buying opportunity.
Zoll Medical (NSDQ: ZOLL) is best known for the portable defibrillators used to treat sudden cardiac arrest that are seen in hospitals and office buildings. Although that product is an important component of Zoll Medical’s business, the company boasts a diverse product line that is changing the trajectory of its earnings and revenue growth.
Zoll Medical’s business slowed in 2009 because budget cuts in the public sector reduced demand for defibrillators from non-profit hospitals and municipalities’ emergency services. But the company caught our attention when its business started to recover. During our research process, we discovered new products, such as the LifeVest, that were starting to drive growth.
The LifeVest is an external defibrillator that a patient wears. When a patient with a heart condition requires a pacemaker, there’s usually a lag between when that determination is made and when the device is actually implanted in the patient’s body. This interim period is extremely risky for patients, and consequently the LifeVest can be prescribed to them until they receive their pacemaker.
The LifeVest has an excellent safety and efficacy record. This product has helped accelerate the company’s growth and improve its margins.
But in mid-2011, the Centers for Medicaid & Medicare Services (CMS) decided to revisit its reimbursement policies for the product, as well as the indications for which it was being reimbursed. With some degree of precision, investors can determine how much revenue a company will lose if CMS eliminates reimbursement for an indication of one of its products. In this case, such an outcome would have weighed heavily on Zoll Medical’s earnings, so that action roughly halved the price of the stock in a span of just a few weeks.
But the LifeVest is such a well-regarded product that doctors, hospitals and medical associations, including the American Heart Association, advocated for the product with CMS.
In mid-December, CMS decided to maintain its existing reimbursement policies. Since then, the stock has largely recovered and its prospects for growth remain strong. Last year, Zoll Medical’s earnings per share (EPS) grew 60 percent and we believe that 35 percent to 40 percent EPS growth is reasonable for this fiscal year, with high potential for it to continue into next year as well.
What is your best advice for investors?
Stick with domestic stocks. The emerging markets have disappointed and there’s still a great deal of uncertainty facing foreign stocks because of the European sovereign-debt crisis. By contrast, the US economy and stock market should continue to improve.
What’s New
VelocityShares launched eight double- or triple-leveraged long and inverse commodity exchange-traded notes (ETN) backed by Credit Suisse last week. The new ETNs are:
- VelocityShares 3X Inverse Crude ETN (NYSE: DWTI)
- VelocityShares 3X Long Crude ETN (NYSE: UWTI)
- VelocityShares Long Copper ETN (NYSE: LCPR)
- VelocityShares 2X Inverse Copper ETN (NYSE: SCPR)
- VelocityShares 3X Long Brent Crude ETN (NYSE: UOIL)
- VelocityShares 3X Inverse Brent Crude ETN (NYSE: DOIL)
- Velocity Shares 3X Long Natural Gas ETN (NYSE: UGAZ)
- VelocityShares 3X Inverse Natural Gas ETN (NYSE: DGAZ)
Even for leveraged funds, these ETNs are extraordinarily expensive. The first six ETNs listed above charge a 1.35 percent annual expense ratio, while the natural gas ETNs each charge a 1.65 percent annual expense ratio. All eight of the funds track indexes provided by S&P GSCI and reset their portfolios on a daily basis.
Last week, Global X Management launched Global X Permanent ETF (NYSE: PERM), which employs an investment strategy championed by Harry Browne in his 1998 book “Fail-Safe Investing.” Built on the notion that the economy is always in one of four environments–rising growth, falling growth, increasing inflation or falling inflation–a permanent portfolio is designed to hold up regardless of economic conditions. So the fund’s target allocations–which are achieved by holding individual stocks and bonds or other ETFs–are 25 percent to equity, short-term bonds and long-term bonds, 20 percent to gold and 5 percent to silver.
The permanent portfolio strategy has been quite attractive to investors, a fact best evidenced by the popularity of the mutual fund Permanent Portfolio (PRPFX), which has accumulated $16.8 billion in assets over the past two decades. In fact, the ETF sponsor hopes to use this ETF to steal market share from the mutual fund. And with the ETF’s annual expense ratio of 0.48 percent versus 0.77 percent for the mutual fund, the ETF might have some success luring investors away despite some subtle differences between the two funds.
Finally, ProShares Advisors rolled out two new triple-leveraged inflation plays.
Rather than simply tracking a basket of Treasury Inflation-Protected Securities (TIPS), Proshares UltraPro 10-Year TIPS/TSY Spread (NYSE: UINF) and ProShares UltraPro Short 10-Year TIPS/TSY Spread (NYSE: SINF) track the spread between TIPS and 10-year Treasuries, also known as the breakeven inflation rate. The long fund essentially has a long position in 10-year TIPS and a short position on 10-year Treasuries, while the short fund does the opposite. The long fund should outperform during periods when the market underestimates inflation, while the short fund will outperform during periods of heightened inflation expectations.
The 10-year breakeven inflation spread is a widely watched indicator among investors. Unfortunately, these funds take a short-term perspective of a long-term phenomenon by virtue of their portfolios’ daily resets. As a result, the two funds aren’t going to accurately reflect long-term shifts in inflationary outlooks. Each fund charges a 0.75 percent annual expense ratio.
Portfolio Update
After a disappointing 33 percent loss last year, Market Vectors Nuclear Energy (NYSE: NLR) has gained more than 12 percent so far this year. While the meltdown at Japan’s Fukushima Daiichi nuclear power plant following last year’s earthquake continues to cast a pall on nuclear energy’s prospects, the US Nuclear Regulatory Commission approved licenses for the construction of two new nuclear reactors in Georgia last Thursday. The US Department of Energy also recently reaffirmed its decision to fund small modular nuclear reactors, which are about one-third of the size of current nuclear reactors.
Continue buying Market Vectors Nuclear Energy under 30.
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