Investing in Outliers

Outliers and the Plight of the Little Guy
By Aaron Gentzler
September 10, 2007

Nice guys get “I like you as a friend” speeches and invites to sit at the “free radicals” table at weddings. Meanwhile, those sporty loudmouth dudes who get all the girls zip about town in tricked out BMWs and never help old ladies cross the street. Likewise, the Dow Jones Industrial Average (DJIA) is a Hall of Fame of gains, while the Russell 2000 burns investment dollars faster than your friend who wanted to start a chinchilla farm.

Gross generalizations like these are not only uncouth and often wrong, they’re bait for another kind of free radicals. I’m talking about statistical outliers. And while staking the farm on outlier philosophy is akin to jumping from an airplane without a parachute, there are lessons ahead for all small-cap investors.

Two examples of outliers — one from the Old Testament, the other from University of Michigan football coach Lloyd Carr’s personal and rapidly manifesting hell: David beat Goliath once. Appalachian State beat Michigan once.

Give David 10 shots at Goliath, you say, and Goliath probably gets the better of David at least seven times. Likewise, if Appalachian State (solid team though they may be) had to play Michigan 10 times, the smart money says the Wolverines win many more games than they lose.

But alas, Goliath and Michigan both ended up dead on the turf. Long live the outliers.

Gross generalizations in sports (and investing) tend to come about via a simple two-step process. In step one, groupthink and/or “conventional wisdom” get the best of those who should know better. Then in step two, the first ailment is exacerbated by a strong dose of outright laziness. People eat what they are fed and fail to do their own work.

Next thing you know, Appalachian State doesn’t have a chance, David is as good as dog meat, nice guys never get the girl and the Russell 2000 is a wasteland compared to the DJIA. I don’t know about you, but I just can’t imagine living in that world.

If you listen to the tout freaks and the balloon-headed commentators, you might think this is the world we live in. So in the hope of cooler heads prevailing both in college football and in the markets, here are some Everyone Stay Calm statistics:

The Russell 2000, which is a small-cap index of the 2,000 smallest stocks in the Russell 3000, is up 12.12% over the past year. The median market cap of Russell-tracked firms is $639 million and the average Earnings Per Share (EPS) growth for the last five years throughout the index is 16.36%.

These numbers fully take into account the fact that the Russell 2000 was off 6.8% in July and is down 0.83% thus far in calendar year 2007. As of September 5, 2007, the index was trading in the mid-790s, but had traded as high as 856 for the year. Today, the Russell is about 7% off its year high.

Overall, that’s not too shabby. But financial media coverage tends to skew incredibly toward small-cap ignorance and large-cap dominance. The fact is, the Russell 2000 compared to the DJIA is not the shocking story you may expect...

Despite the fact that the Dow Jones has been lolling back and forth between 13,525 and right around 13,000 for the past several weeks, the DJIA is still up 6.7% for the year.

A year ago this week, the DJIA closed at 11,392. Despite losing 143 points on September 5, it is still also up 16.75% from a year ago, and is just a shade over 6% off its all-time high of 14,121 achieved on July 19 of this year, the day that it closed at the tenuous 14,000.41 mark.

Shake out the ongoing sub-prime mortgage hurt. Shake out a tricky dollar. Shake out fuel worries. Toy recalls…housing sales slumps…uncertainty concerning Iran — take it all into account. Have an upset stomach? Throw that in the mix too.

Truth is, the Russell 2000 might not be shooting sparks at this very moment, but it is generally keeping pace with the year over year progress of the much bandied-about Dow Jones Industrial Average.

My point is this: Anyone you encounter who exclusively pushes the large-caps doesn’t truly have your best interest in mind.

There are tons of strong deals out there in the small-cap world. Those who hype the large caps to the detriment of all other classes are the groupthink-ers and “conventional wisdom” followers who say Goliath could never lose and that nice guys always finish last.

Dare to be an outlier.

Regards,
Aaron Gentzler

P.S.: Fellow Editor Greg “Gunner” Guenthner has the inside scoop on the small-cap world at Penny Stock Fortunes. His current issue features a semiconductor company poised for strong growth and a supplement maker that is about to change the way we all think about diabetes. Check out what he has to say before you miss out on these opportunities. Read on here…