Geoff Gannon January 19, 2006

On Small Cap Value and Large Cap Growth

Yesterday, there was an interesting post entitled “Finding Value in Growth” over at Value Discipline. About midway through the post Rick writes:

“As someone who generally has espoused small cap value picks, I have to admit how difficult it is to find value in this part of the universe. A few exceptions naturally do apply, but overall, the pickings are slim.”

I couldn’t agree more. The wheel has turned.

Immediately following the bursting of the speculative internet stock bubble, growth stocks were still overvalued. I found occasional exceptions, but these were short – lived. For instance, I briefly owned Cisco Systems (gasp!). However, I purchased the shares at what happened to be just about the lowest point they’ve traded at in eight years. I sold the stock within a matter of months. This is unusual behavior for me, but I bought the stock when it was undervalued and sold it when it approached fair value – the fact that this happened within a matter of months is the market’s fault, not mine.

What’s really remarkable here is that this undervaluing of Cisco (CSCO) only lasted for a matter of months. Ever since, Cisco hasn’t even approached levels I’d consider buying at. What (still extant) stock is more closely linked in investors’ minds with the internet induced insanity of the late 90s than Cisco? I can’t think of any.

So, one would have assumed Cisco would become one of the most reviled stocks of the earlier 00s. But, that didn’t really happen. Cisco was certainly less appreciated. But, it was only very briefly underappreciated. As I watched the bubble burst, my mouth was watering for the bargains that never came. I was sure great companies like Intel (INTC), Microsoft (MSFT), Cisco (CSCO), and Dell (DELL) would finally be offered at bargain basement prices. But, it didn’t happen.

This once again demonstrates my complete inability to predict stock price movements, future market levels, investor psychology, etc. I’m only good at one thing – finding businesses that are selling for less than they’re worth. Fortunately, this is the only skill an investor needs. Still, the whole experience does serve as a good reminder to ignore anything I have to say about the broader markets or short – term price movements. If I am ever foolish enough (and I’m sure I will be) to write about those things on this blog, please ignore me. That’s the best advice I’ll ever give.

Returning to the Value Discipline post, you’re probably wondering what this little story about Cisco has to do with “Finding Value in Growth”. Well, the wheel has turned. After all these years, “growth” is cheap and “value” is expensive. As I’ve said before, as far as you are concerned there are no such things as growth stocks and value stocks; there are just stocks. Don’t decide on growth or value and then pick a stock that fits into one of those boxes. Just go out and find a business that’s selling for less than it’s worth. If you keep that advice in mind, there’s no harm in noting that, generally speaking, those stocks that are usually most loved by self proclaimed growth investors are looking cheap; while those stocks that are usually most loved by self proclaimed value investors are looking pricey. All this is because the wheel has turned.

What do I mean when I say the wheel has turned? No, I’m not trying to be cryptic. I’m trying to be illustrative. Keep that picture of the turning wheel in your mind’s eye, but make room for a few more pictures. I don’t normally pay attention to stock charts. However, these particular charts paint such a clear picture, I couldn’t resist.

About three years ago, a member of my family approached me looking for some free stock advice. I don’t normally give advice – at least not the kind of advice most people want. Most people are looking for advice along the lines of: “buy stock X, stock Y, and stock Z. I’ll call you when it’s time to sell stocks X, Y, and Z.” There are very good reasons for not giving this type of advice to anyone – especially anyone you know. The number one reason is that most people who ask such questions are not equipped to handle the answers. Usually, they neither think for themselves, nor trust others to think for them. They tend to make decisions first and ask questions later. Those questions are always asked of the advice giver and never of themselves. They are the kind of people who buy and sell the same stock about twenty times in twelve months. These are not the kind of people you want to give advice to.

This person was not one of them. He can think for himself and, if he takes your advice, he will stick to it. So, he is the kind of person you can give advice to.

He came to me with two questions. Actually, he came to me with one question and one statement, but the statement was really just a question masquerading as a statement. It went like this: “I bought some Wal – Mart”.

Now, when someone says, “I bought some Wal – Mart” to me, that’s not what they mean. When they say “I bought some Wal – Mart” to their accountant or their spouse, that’s exactly what they mean. They’re letting them in on a fact. But, when they say it to me, they’re asking a question. The question goes something like this: “Am I an idiot?”. When this particular person said “I bought some Wal – Mart”, I must have made the kind of face that responded, “Yes, in fact, you are an idiot”, because he immediately became interested in exploring alternative purchases.

I suggested he buy Village Supermarket (VLGEA). If he was wedded to the idea of buying a discount superstore, I proposed BJ’s Wholesale Club (BJ) as a better alternative. I told him I didn’t believe Village and BJ’s were better companies than Wal – Mart, but I did believe they were better investments given the difference in price.

He was clearly thinking large cap growth while I was thinking small cap value. Here are the charts for those three companies:

Wal – Mart (WMT) vs. Village (VLGEA) and BJ’s (BJ).

There is no bias here. These were the only retailers we discussed, and the discussion happened almost exactly three years ago. The charts basically show you exactly what those stocks have done since the conversation. Can you see the wheel turning?

At the same time, this individual was also considering buying stock in a big pharmaceutical company. The boomers were aging and he wanted to cash in on the trend. He mentioned two stocks: Pfizer (PFE) and Merck (MRK).

I said I didn’t understand pharmaceutical companies very well. Their revenues were hard to predict, and were dependent upon government rulings. Despite my misgivings, I said I would look into health stocks for him, but I wasn’t going to limit my search to big pharma.

I came back to him with two names: Bio – Reference Labs (BRLI) and U.S. Physical Therapy (USPH). Both were real small stocks. I told him I’d rather own USPH than Pfizer or Merck, but that I couldn’t actually recommend the stock given its price (the margin of safety was insufficient). I told him BRLI was selling for less than it was worth and he should definitely buy it. He wanted to know if there were any other interesting health stocks. I told him there weren’t. All he was getting out of me were two “interesting” labels and one buy recommendation – nothing more.

Again, there is no bias here. Three years ago we discussed these four stocks and only these four stocks. Check out the charts:

Pfizer (PFE) and Merck (MRK) vs. Bio – Reference Labs (BRLI) and U.S. Physical Therapy (USPH)

Can you see the wheel turning?

As you probably already know, Warren Buffett’s Berkshire Hathaway has bought shares in Anheuser Busch (BUD), Home Depot (HD), and Wal – Mart (WMT). Now, I am not as enthusiastic about these stocks as Mr. Buffet is. Obviously, your best bet is to trust him, not me. Even though these stocks aren’t at the top of my pile of good ideas right now, I’d rather own a basket made up of BUD, HD, and WMT than the S&P.; Wouldn’t you?

The wheel has turned. A new inefficiency has appeared. In a market that’s mostly efficient, this kind of thing isn’t supposed to happen. The question I asked about owning a basket of three large, well – known companies or owning the best – known index should be a really tough question to answer. It isn’t. The BUD, HD, WMT basket is a much better buy than the S&P.; The wheel has turned. The market is still inefficient; but, now, there’s a new way to exploit its inefficiency.

The growth/value imbalance isn’t limited to the biggest companies. Look at PacSun (PSUN) and Timberland (TBL). Two small stocks, but pretty well known names that were once well liked by the growth crowd. Today, they could use a little love. Maybe you should be the one to give it to them. Are they selling at the kind of discount I suggested Overstock was selling at (67%)? No. But, they both look like they’re selling for less than they’re worth. I’d rather own a 50/50 PacSun – Timberland basket than the S&P.; Wouldn’t you?

I’m sure a lot of people will start looking at Intel, Microsoft, and Dell. I’m not looking there – yet. But even I have to admit those stocks do look more attractive than they have in some time.

The wheel has turned. We may be principled when it comes to buying a business for less than it’s worth. But, that doesn’t mean we have to be dogmatic or close – minded.

So, don’t forget to think growth and think big.

Read the refreshingly short post that prompted this verbose sermon.