Small-caps, UK value, diversification, terrible decisions and the gold price
The best investment research, blogs and podcasts
Hello!
Welcome and thanks to everyone who has signed up to get my emails recently. As a quick introduction/ reminder, these are my regular round-ups of notes on things that I’ve seen or read or listened to recently. My day job means I have to keep up with this stuff, but even if it didn’t, I’d still have a geeky fixation with macro trends and strategy, and stock markets.
My notes are at the top, and links to some of the best writing and podcasts are underneath.
Have a great weekend,
Ben
Small caps ready to bounce?
Small caps have been under pressure for 18 months, and hopes of a rebound this year are yet to really materialise. However, there could be reasons to be cheerful. There have been a couple of notes in recent days looking at the history of small-cap recoveries in the 12 months that follow market sell-offs.
This first from Premier Miton: Upwardly mobile? The beginnings of a small cap trend
Small caps are attractive because:
Generate higher returns over time
Diversify risk in a portfolio
Create alpha opportunities because of a lack of professional research
Offer a valuable market timing signal
Arguably, the best time to buy small caps has been during recessions at market low points
Small caps tend to perform strongly during economic recoveries and usually covering periods of 3-4 years (see chart below)
Small caps have now underperformed for 2 years
Sharp downward step in recent weeks caused by investor risk aversion stemming from the collapse of Silicon Valley Bank
Global small caps could be at or close to a cyclical low and possibly on the cusp of a positive, upwardly mobile trend
Valuations of small caps are now close to 10-year lows. In absolute terms, the forward Price to Earnings ratio (PE) of global small caps is 15.5x, a slight discount to global large caps at 16.2x as at 03.05.2023.
This echoes the views of this note by Janus Henderdon: Look beneath the surface for small- and mid-cap opportunities
Small caps typically lead large caps in losses going into periods of weakness
Small caps reached a 2022 low of -27% in June while large caps bottomed out in October at -25%.
Excesses of the last several years have been shed in the small- and mid-cap universes
Small- and mid-cap companies tend to be more US-centric (this is US-focused research), potentially benefiting from long-term themes of reshoring/deglobalisation, while also being less sensitive to US dollar fluctuations.
Prudent to take an active approach in the small/mid-cap space to focus on higher-quality companies and avoid unprofitable ones
Roughly 25% of stocks in the Russell 2500 Growth Index currently do not earn money
And… if UK value investors really want to get excited, this note from Schroders should do the trick: Six charts that show how cheap UK equities are
Among the takeaways:
UK equities valuations are at exceptionally cheap levels just about every way you look at them - they look particularly undervalued relative to the US and Europe
Almost every UK industry group trades at a valuation discount to the US.
The UK energy sector is valued at 6.7x the next 12-months’ earnings, whereas the US energy sector is on 10.1x.
The UK pharmaceutical & biotechnology sector is on 15.6x forward earnings. The US equivalent is on 21.4x.
Even in a market that is cheap on various measures, UK value stands out as trading at a sharp discount to UK growth (see the chart below)
Why do we sometimes make terrible decisions…?
This podcast episode from Joe Wiggins and Paul Richards picks up on a story about ultramarathon runner Joasia Zakrzewski, who was recently disqualified from a race for using a car.
Behavioural Investment - New Decision Nerds Episode – F&^% Ups
It was a 50 mile event between Manchester and Liverpool in which Zakrzewski ultimately came third. But it later transpired that after feeling unwell and disorientated, she’d travelled for 2.5 miles in a car to the next checkpoint. From there she continued the race for training (rather than competitive) purposes, but still accepted the podium position once she had finished. Unsurprisingly she got vilified for it.
Why do people make these kinds of mistakes? These are some of the points that come out of this discussion:
We have a tendency to make poor emotionally-led “in the moment” decisions that can come with profound long term costs
That translates directly to investing, where poor short-term choices lead to disappointing long term consequences
Mistakes compound. Small choices commit us to a path that can be profoundly poor
Environmental factors. Never make decisions when you’re tired, stressed or anxious. Sometimes decisions have to be made in the moment, and these factors will drag us down the wrong path.
Fundamental attribution error. Onlookers can often attribute things that have gone wrong to a person’s character, rather than situational factors
The context and environment in which a choice is made is as important as the individual making the choice
Analysis paralysis. When we’ve done something wrong we often spend too much time analysing it. If you make a mistake you should put your hand up straight away and get help to manage it.
People often worry about how a mistake will reflect on the perception of themselves by others.
How many shares should you have in your portfolio?
The subject of diversification in a share portfolio (as opposed to diversification across asset classes) has witnessed some mixed signals over the years.
Warren Buffett’s claim that diversification is a hedge for ignorance doesn’t really explain whether he thinks that’s a good or a bad thing (should you simply know more about what you own, or own more because you don’t know enough???)
Academic finance has had a crack at this too, with analysis focusing on how to eradicate market volatility without diversifying so far that you’ll only ever match the market.
For some, that’s resulted in a view that 10 stocks or fewer is enough. For others, it’s 10-25. Some of the best known research - according to this note by Verdad - puts the figure at 15-20, and it’s become accepted wisdom,
Verdad: Diversification or Di-worse-ification?
But Verdad’s re-assessment of the research shows that these sorts of numbers will get you a portfolio that is much more volatile than the market - which doesn’t achieve what diversification is supposed to achieve.
Past research has often used ‘standard deviation’ to measure the effects of diversification (to show how much the portfolio moves around versus the market average). But Verdad’s preference is to use two alternative statistical measures: R squared and tracking error.
Long story short, if you simply want to manage volatility to the point that 90% of a portfolio’s variation could be attributed to the market, you’d need around 75 shares to do it. Way more than past research suggests. If you want to beat the market, 10-20 shares will do it, but you’ll need good stock picking skills and a stomach for the volatility that comes with it.
Opportunities in emerging markets… but cool on China
The big story in emerging markets this year is really about how many are at a stage in the economic cycle that is very different to that in developed markets. Rather than a high inflation, high rate, low growth environment, the opposite is the case. This note from Jupiter takes a whistle-stop tour of these ideas: Notes from the Investment Floor: The stage is set for emerging markets
Among the points:
Unlike the aggressive approach of some of their DM peers, emerging market banks are happy doing good margin on standard banking products like mortgages and retail loans
Confidence restored after the banking wobble in March, EM bank stocks are back at new highs and their growth runway is good
Outlook for EM shares is bullish but that could be derailed if the Fed tips the US into an hard recession - it would stop investment flows into EMs
EM central banks benefit from not having to unwind a decade of loose monetary policy conditions
A couple of previous headwinds – China’s ‘zero Covid’ policy, and the strength of the US dollar – have turned into tailwinds as China opens up again and the dollar weakens
Brazil has interest rates of 13.75% and inflation that is 4.5% and falling - it should be cutting rates soon
India and Taiwan have the strongest growth potential. China has been disappointing amid the post-covid re-opening and strained relations with the US
What’s the story with the gold price?
The gold price has been impressively strong in recent years. As you’d expect, the huge uncertainty (and equity market collapse) that came with the Covid pandemic in early 2020 triggered a surge in the price as investors raced for a safe haven.
But beyond Covid, the gold price has continued to trend higher. But why?
This note from Invesco explores the question: Uncommon truths Why is gold so expensive?
Here are the main points:
Gold has been among the better performing assets this year and continues to hold up well
Obvious candidates for how things may have changed are: inflation, central bank purchases and cryptocurrencies:
Inflation - The correlation between gold and inflation is not always consistent, but it was strong in 2022 (although gold may have been rising in reaction to a weakening dollar)
Central banks - Central banks had an outsized presence in the gold market in 2022, with net purchases of 1136 tonnes, up from 450 tonnes the year before (according to World Gold Council data).
There were 741 tonnes of unreported central bank purchases in 2022, which raises the suspicion that Russia was very active
Cryptocurrencies - Gold may have benefited during 2022 from the collapse of cryptocurrencies, given that both are thought by some to offer mitigation against inflation and financial crises
Twin Petes hits a century
You can’t really beat the Twin Petes Podcast for authentic, at-times chaotic, super genuine investment chat. This was their 100th episode from earlier in May and they invited a few well known followers along.
Twin Petes Investing Podcast - The Special 100th episode recorded live with two guests & a studio audience
It started (and finished) with all the usual updates and lots of Q&As from both Pete and Pete on what they’ve been doing in the market recently. Among the other highlights - and we’re talking nearly two hours here - was:
Jase Needham (@stealthsurf) on how how he goes after growth stocks breaking out of bases
Algy Hall (@AlgyHall) on running screens to track the best trading ideas of the world’s smartest fund managers
Thinking & Strategy
Excess Returns
[Podcast] Bridging Academic Research and Real World Investing with Vanguard's Kevin Khang
Behind the Balance Sheet
[Podcast] #23 The Best Selling Author
Investment Uncut
[Podcast] S4 Ep.19 With style: a factor investing deep dive
The Long View
[Podcast] Aswath Damodaran: A Valuation Expert’s Take on Inflation, Stock Buybacks, ESG, and More
This Week in Intelligent Investing
[Podcast] Takeaways and Lessons from the Berkshire Hathaway Annual Meeting 2023
Monevator
Too good to be true: how to approach investment opinion, commentary, and third-party analysis
The Value Perspective
Transcript of The Value Perspective Podcast episode – with Sean Peche
Macro Ops: Unparalleled Investing Research
Gary Bielfeldt’s Trading Strategy Explained
Novel Investor
Lessons from the 2023 Berkshire Meeting
Morgan Housel
Vicious Traps
Behavioural Investment
Things Professional Investors Should Say but Can’t
Should Investors Trust Their Gut?
Klement on Investing
Stick with what works, fiddle with what doesn’t
Second best is first to lose
Of Dollars And Data
Money Can’t Buy Happiness…Or Can It?
Dividend Growth Investor
The building blocks of an investing process
Institutional Research
Man Institute
The Road Ahead: When the Facts Change
Dimensional Fund Advisors
30 Years Pursuing the Value Premium: Price-to-Book Stands the Test of Time
Alliance Bernstein
Learnings from Earnings: Macro Crosscurrents Make Growth Elusive
Alpha Architect
The Drivers of Booms and Busts in the Value Premium
Reducing the Impact of Momentum Crashes
CFA Institute Enterprising Investor
Regret and Optimal Portfolio Allocations
Securities & Markets
AJ Bell Money & Markets
[Podcast] Japan index at 33-year high, US debt ceiling fears, cracks in the luxury goods market
The Investor Way
[Podcast] E135 - ITV, ASOS, Boohoo, Airtel Africa, Adidas & Disney
MSCI
The World After COVID-19: Exploring the Market’s Digital Makeover
diy investor (uk)
The All-Weather Portfolio for Uncertain Times
Twin Petes Investing Podcast
The Special 100th episode recorded live with two guests & a studio audience
Musings on Markets
Good (Bad) Banks and Good (Bad) Investments: At the right price...
UK Dividend Stocks Blog
Find quality dividend stocks using these profitability ratios
Selling Hikma Pharmaceuticals after a 40% share price gain in 7 months
Quality Small Caps
[Podcast] Macro/markets – Small caps podcast with Paul Scott – Episode 18 (part 2 of 2)
Capital Employed
15 Best Stock Pitches (1st-12th May)
Maynard Paton
[Podcast] James Halstead With Roland Head And Maynard Paton
[SharePad] Small-Cap Spotlight Report: REACH