Thoughts While Not Golfing
July 5, 2005
Baltimore, Maryland
*** iPass and Intrado in the Crosshairs
*** Small-Cap Growth Rules
*** Thoughts While Not Golfing
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Irwin Greenstein reports from Baltimore, home of the brand-new Reginald F. Lewis Museum of Maryland African-American History & Culture...
*** James Altucher of the Financial Times wrote a stimulating column today about the latest foray of Shamrock Activist Value Fund co-managers Stanley Gold and Roy Disney. For fellow Sleuthers who have been traveling out of the country for the past 18 months, Gold and Disney take credit for driving out Michael Eisner from the corner office at The Walt Disney Co. To say that Gold and Disney don't suffer fools is certainly an understatement. Now, with that notch in their gun, Gold and Disney have set their sights on two small caps: iPass, Inc. and Intrado, Inc.
Gold and Disney recently took substantial positions in both companies. Their rationale is that return on equity stinks and shareholder activism will extract maximum value.
iPass and Intrado are doing fine in terms of revenues. iPass, which delivers a secure network for roaming employees at large corporations, has been making money. On April 26, iPass announced Q1 revenues of $44.1 million...an 8.4% rise over the $40.7 million of last year's first quarter. Intrado provides value-added wireless services to public safety organizations such as 911, messaging and network optimization. In February, Intrado posted a Q4 loss of 55 cents per share on $36 million -- but saw a 9% revenue increase from $33 million in Q4 2003.
The bone of contention for Gold and Disney is that iPass is sitting on $158 million (no debt), while Intrado has $40 million in the bank with $4 million in debt. The boys at Shamrock think that money could be put to better use. They point to iPass' ROE of 9.43% and an ROE of negative 2.4% at Intrado. Here at Sleuth, we prefer a minimum ROE of 20%, although we'd settle for 15% for an otherwise stellar company.
So keep your eyes on iPass and Intrado -- because our money is on Gold and Disney.
*** And the winner is...small-cap mutual funds.
Lipper, Inc. announced Q2 results for mutual funds, and small-cap growth took the cake, with a return of 3.77%. Runner-up small-cap core yielded 3.3%. Mid-cap core came in third, at 3.24%. As Lipper tells it, the odds-on favorites for the quarter were large-cap growth funds. But surging oil prices triggered massive large-cap sell-offs, putting small caps ahead.
We've been saying for months now that risk is in fashion -- pushing sentiment away from large caps toward small caps. Since the beginning of the year, experts have been predicting that after a six-year run, large caps would finally trounce small caps. And it certainly looked that way -- at least in Q1.
But could there be a reversal of fortune?
Last Friday (http://www.pennysleuth.com/alertholder/07-01-05), we reported on
the reconstitution of the benchmark Russell 2000 small-cap index that took effect today. We said it could hurt the likes of index funds, hedge funds and pack runners. That means you'll have to work harder to ferret out the best investments, rather than relying on funds that place bets on a basket of stocks that track the index.
We still believe that small caps will gain traction later in the year (as they did in 2004) and dominate returns in sectors such as energy, financial services and health care (including biotech). But with the revamped Russell 2000, a 2005 index win is unlikely -- giving groupthink a black eye.
*** That said, there is the possibility that the Russell 2000 could surge ahead on the wings of an economic recovery. If so, it may not matter at all that the index is currently saddled with low-performing tech stocks.
Here's why...
Mark Riepe, a senior vice president at the Schwab Center for Investor Research, wrote a paper in December 2004 in the Journal of Financial Planning that substantiated the market caveat: Small caps lead large caps out of a recession.
Yes, we know that the current economy is not in a full-blown recession...that some folks think of it as stagflation, while others call it a jobless recovery. Regardless, things are pretty weird.
But taking into account the prevailing sentiment toward small caps, one factor could be that Wall Street expects the economy to improve for the second half of the year -- driving up the entire small-cap market as a leading indicator of a full-blown economic resurgence.
In his paper, Riepe cites that in the period from two months prior to a recessionary trough till six months after the trough, the average monthly small-cap premium over the six recessions studied was positive.
"Across the board, we see high reliability, with almost all of the months being positive four or five times out of six," he writes.
To capitalize on his findings, Riepe makes two recommendations: (1) Overweight on small caps just as the economy is emerging from the trough, and (2) Keep historic trends in mind when trying to anticipate when to continue loading up on small caps.
Here are six recessions for his model:
*** Now for the true test of a Sleuther. Would you rather crunch the numbers in Riepe's model or play golf with Chris Mayer...?
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Thoughts While Not Golfing
Years ago, Dean LeBaron, contrarian par excellence and founder of Batterymarch Financial Management, wrote a short investment piece called "Thoughts While Not Shaving," which he supposedly wrote one summer while he was in the Swiss mountains contemplating life and everything, during a period in which he also gave up shaving.
In that spirit, I offer the following "Thoughts While Not Golfing." Since the Washington area was beset with rolling rain and thunderstorms, I was unable to play golf. I did manage to find time to hit a bucket a balls at the local range. Anyway, I was thinking a lot about investing.
First, I've been thinking a lot about this idea of "time arbitrage," an idea I've run across in more places lately. It's a fancy and smart-sounding phrase that simply describes a strategy in which you exploit the fact that most investors (professionals and laypeople alike) have extremely short time horizons. These time horizons are usually inside of one year, meaning you can build an advantage around simply thinking longer term.
Proof of this short time horizon is provided in Michael Panzner's recent book, in which he shows that the average holding period for a NYSE stock has fallen to a matter of months. This is the culmination of a long trend. As recently as 1990, the average holding period exceeded two years; in 1975, it was over four.
Thinking long term today means only thinking out a year or more. Just that, I think, could give you an exploitable edge and allow you to earn superior returns. Louis Lowenstein covered this idea in his paper on successful value investors. Ralph Wanger talked about it in his interview with me.
Bill Miller, the famed manager of Legg Mason's Value Trust (which has beaten the S&P 500 for 14 years running), also talked about it in a recent interview with Value Investor Insight. Miller said, "In an environment with massive short-term data overload and with people concerned about minute-to-minute performance, the inefficiencies are likely to be out beyond, say, 12 months."
That's amazing. Miller says looking 12 months out can find inefficiencies. The investor's short-term orientation has been one of the most profound changes in markets over the last 20 years. With the Internet and with easy access for anyone to tap out trades at a few keystrokes, plus the proliferation of shortcut speculative vehicles like ETFs (basically mutual funds made up of several companies in the same industry, which then trade just like a stock) -- well, add all that together, and you have a very short-term-oriented environment.
Exploiting that is the concept behind "time arbitrage," a term I am growing to like. It's nothing new or highly original; lots of great investors have been preaching the virtues of long-term investing for years now. But in this market, I believe the idea has heightened importance and immediacy.
The second thing I was rolling around in my head as I smacked my drives 300 yards (well, not 300 yards, but they always seem to go farther at the driving range) was the importance of thinking differently to succeed as an investor.
Miller brought this point home for me in his recent interview: "In markets, everyone tends to see the same things, read the same newspapers and get the same data feeds. The only way to arrive at a different answer from everybody else is to organize the data in different ways and to bring things to the analytic process that are not typically there."
I think there is a lot in what Miller is saying. The basic idea is that if you are looking at the same stuff everybody else is, then the only way you are going to find great ideas before the herd does is to adopt a pattern of thought that is not shared by the herd.
This is one of the reasons I shy away from simple value tools such as just looking at price-earnings ratios, growth rates or such tired concepts as businesses with great management -- because everybody and their brother is already looking for those things. Thinking differently can uncover opportunities before they become apparent to the herd. When they are apparent, it is too late.
Does this sound cliche or trite? Maybe so, but it is so important, and as much as I read about investing, I see analysts and writers routinely fall into this trap all the time. They talk about all the great things that everybody already knows and believes.
As an aside, I find Bill Miller a fascinating guy. He's a brilliant value investor who thinks very differently from just about everybody else. He recommended a book called Nature: An Economic History by Geerat Vermeij. Sounds like highbrow stuff. Vermeij is a paleoecologist. That's right, paleoecologist. I didn't know such a thing existed. But what he's done is take the history of evolution and apply it to economics, with interesting results. He draws insights from the natural world, about how things relate, how they compete for resources, how they change and adapt and much more.
Miller talks about how Vermeij's study provided a unique insight into the notion of efficiency. What Vermeij found is that efficiency is not what's important in nature. Something called "aggregation of power" is more important. In nature, and in economics, Vermeij found that small and efficient was often crushed by bigger but less efficient.
So Miller finds that many analysts fret too much over profit margins, which he argues are less important than actual profits themselves. Greater profits with lower margins may be more valuable, because this creates size, and inherent in that size may be certain advantages you couldn't get otherwise.
That's an uncommon insight, and it might prove useful in thinking about businesses, about the importance of profit margins versus marginal profits.
Here's another uncommon insight. This one Miller draws from another highbrow book, by W. Brian Arthur, called Increasing Returns and Path Dependence in the Economy. The basic idea is that market shares in the technology world are remarkably stable for mature applications. Therefore, Miller believes, even though technological industries are by new products and short product cycles, the mature and larger companies often maintain their slices of the overall pie. Using this insight, Miller finds that Wall Street has a tendency to overestimate competitive threats.
Investing, like golf, can be done a lot of different ways. But to succeed in investing you must stray from the herd. In the small cap arena, particularly now, thinking long-term is one of the ways to profit by thinking differently. Bill Miller, while mainly a large-cap investor, is a good model for the power of independent thought. The same principles apply in small-cap investing.
Sincerely,
Chris Mayer
Editor, Fleet Street Letter
PS: As your devoted Penny Sleuth has known for a long time, Chris NEVER stops thinking about this stuff -- and that's why you want him working for you. Don't wait... click here: http://www.agora-inc.com/reports/FST/WFSTF431.
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