Weekly Small Cap Market Review: March 6 – March 10
By Mark Spatt, CFA, Investment Analyst at Cornerstone Investment Partners, sub-advisor of the AdvisorShares Cornerstone Small Cap ETF (NYSE Arca: SCAP)
March Madness (copyright NCAA) is finally here, and although the South is certainly more focused on a much shorter college sports playoff, there are few better days of sports than the first round of the tournament. Perhaps I’m just more excited this year due to my alma mater Princeton’s 19-game win streak and bid to the dance. While the odds of Princeton winning its first round game are low (Vegas has Notre Dame as a 7 point favorite), the Tigers beat UCLA in 1996 and almost did the same to Kentucky six years ago, so I wouldn’t count them out yet. Now, while Princeton does have the most football national championships (and I’m sticking by that), it hasn’t been a big-time sports powerhouse since Dick Kazmaier won the Heisman trophy in 1951. But Pete Carril’s Princeton offense is one of the best-known playbooks in the college game, and the intellectual predecessor to modern NBA small ball best espoused by the dominant Warriors teams of the past few years (For more on this, see the recent WSJ article, “Pete Carril Saw The Future of Basketball”). Put simply, it spreads the ball around the court to encourage high-efficiency shots, such as layups and three pointers. It was developed because it is designed to play to the team’s strengths and avoid its weaknesses – slowing down the game versus teams that were more athletic than their competition (almost all of them), and focusing coaching on highly trainable shots in which others may not see as much value.
As cliché as it is making sports metaphors for investing, there are some valuable lesson for small caps. First, play to your team’s strengths. If you know very little about individual drugs and diseases, don’t try to pick up a microcap with a single phase 2 drug. Second, trainable, high-efficiency shots are more valuable than just chucking it up there. Do your research, pick your spots, and have a plan. Third, slow it down. The market moves instantaneously, but investors do not have to. Time arbitrage is one of the most valuable edges any long-term investor can have, so be disciplined and don’t let the market set the pace.
The small cap market, as defined by the Russell 2000 Index, was down 2.0% overall during the week, and no sectors were in the black. Within the Index, Information Technology (-0.5%) was the strongest performer as semiconductor and software names were relative performers. Health Care (-0.9%) and Consumer Staples (-1.0%) were also up. On the downside, Energy (-7.1%) was down on weak commodity prices, and Real Estate (-4.9%) continues to be weak, responding to the potential for higher rates and supply.
There were a few key issues driving the decline this week. First, Republicans in Congress appear to have gotten the President’s message, and are focused on the repeal and replacement of ACA/Obamacare. The new bill, AHCA (perhaps they wanted to save money on paper), is mostly in line with key messages previously discussed, and although it will likely pass given Republican majorities, will certainly require long discussions. Putting health care to the side (directly, 13% of the Russell 2000 Index), potentially a more pressing issue for small-cap stocks is that focusing on health care means Congress is not focused on tax reform, pushing that potentially until after the summer. Crude oil prices fell significantly, as increased inventory levels in the US and questions around OPEC’s production cuts. Lastly, strong jobs numbers provided what seemed like final confirmation that the Federal Reserve will increase the Federal Funds rate on Wednesday. Although down overall during the week, large cap continues to demonstrate significant relative strength, with the Russell 1000 Index outperforming the Russell 2000 Index by over 150 basis points. Among small caps, Growth again significantly outperformed, with the Russell 2000 Growth Index beating the Russell 2000 Value Index by around 145bps.
Earnings season has basically come to a close, with almost 90% of the Russell 2000 out so far. In general, companies beat quarterly estimates in line with historical periods. However, estimates for next quarter have come down, and 2017 estimates are slightly down as well. Given high valuations, it is important to consider companies’ ability to respond.