Behind the small-cap junk rally
Behind the 4.6% rise in the S&P 500 Index and a 9.7% gain in the Russell 2000 Growth index in the last quarter of 2014 was what I’d call a “junk rally” in small cap stocks.
Low-quality companies with little or no operating earnings and low stock prices outperformed their higher quality peers.
The surprising winners in the fourth quarter were unprofitable companies in my opinion.
Laggards Win
That is to say that non-earners generated a 17.4% average return, while companies with positive earnings returned 8.7%.
Further confirmation of the low quality nature of the quarter was that companies generating the highest return on invested capital (ROIC) and the highest net margins were not rewarded by investors.
Stocks in the top quintile of the Russell 2000 Growth as measured by ROIC underperformed the bottom quintile stocks by 510 basis points.
Similarly, the top quintile of stocks as measured by net margins underperformed the bottom quintile stocks by 1,250 basis points.
Biotech
This flight to low quality dynamic was best depicted by the performance of small-cap biotechnology stocks, which as a group gained 21.5% in the fourth quarter.
The biotechnology sector outperformance is evidenced by its proportionate weight in the Russell 2000 Growth Index growing in excess of 200 basis points to 9.11% during 2014.
Many of these stocks spiked on the euphoria of early stage clinical trial news reports despite the typical five to six years needed for drug development.
IPOs
Equally noteworthy is that there were more than 70 biotechnology initial public offerings (IPOs) in 2014, which is significantly more than the cumulative number of new listings during the prior five years.
Now the number of biotechnology stocks in the index is 132, an increase of 30 new companies.
The current environment is reminiscent of the year 2000 when biotechnology stocks experienced a similar period of irrational exuberance and following that period, these more speculative stocks underperformed the broad market for a multi-year period.
Staying focused
At Redwood, we adhere to our disciplined process of buying stocks of attractively valued companies that will generate better than expected profits with strong return on capital because we expect stocks with these characteristics will be rewarded.
Our investment team is excited because we believe this junk rally created a way to add opportunistically to positions of companies exhibiting strong fundamentals.
In our opinion, stocks that retreated on either no news, negative momentum, or the change in investors’ appetite for lower quality companies are poised to generate strong returns for our clients.
2015 Outlook
We continue to be optimistic about the outlook for US stocks. The US economy is in the midst of a slow but well established expansion and interest rates and inflation have remained at historic lows.
Recent energy price declines provide more disposable income for the American public. Historically, a Republican- controlled Congress combined with a Democratic President is positive for the equity market.
In a similar vein, the third year of presidential cycles tends to be historically strong, with the S&P 500 averaging 17.1% annual returns over the last 17 presidential cycles, compared with a 6.4% average in years 1, 2, and 4.
Against this positive intermediate backdrop, the investment team is cautious about the near-term environment based on several data-points.
Risk Factors
Too Bullish: In December, individual investors’ equity allocations rose to 68.5%, the highest level since 2007 while cash allocations fell to their lowest level since 2000.
China: Growth is expected to continue to decelerate. After having maintained GDP growth in excess of 9% from 2008 to 2011, China’s growth rate has decelerated to 7.4% and 2015 is expected to be another year of slowing growth.
Europe: While improving from a low base, Europe is recovering in fits and starts. Its economies are being pressured by continued high structural unemployment, large national debts, a depressed euro relative to the US dollar and the challenges of coordinating a unified monetary and fiscal policy.
Monetary Policy: We anticipate equity market volatility as the US Federal Reserve implements its quantitative easing exit strategy.
US Dollar: The strength in the US dollar against both the euro and the yen will make US exports less competitive globally, and the earnings from overseas operations will be translated back into fewer dollars.
Geopolitical Risk: The weakness in oil prices will exacerbate tensions in the Middle East, Russia, and other oil dependent regions. Additionally, political allegiances may shift causing instability and potential conflagrations.
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