Boring Portfolio

Large-Caps Rule?
... while small-caps cool.
by Greg Markus (TMF Boring)

THOMPSONVILLE, Mich. (June 26, 1998) -- Major market averages rose moderately Friday, with the S&P 500 and Nasdaq each gaining about a third of a percent in value. The Boring Portfolio advanced 0.37% in value, thanks in large part to a $2 15/16 gain in shares of Cisco Systems (Nasdaq: CSCO). CSCO closed at $89 7/8, establishing the stock's eighth new high in the past nine sessions.

Morgan Stanley Dean Witter analyst George Kelly upped his 12-month price target on Cisco by $15 to $105 per share Friday, while maintaining his "strong buy" on the stock.

Kelly reportedly cited "recent favorable developments" that he believed were not yet reflected in Cisco's share price. Those developments, which are well-known to Cisco watchers, include the company's role in building out Sprint's (NYSE: FON) next-generation communications network and this week's announced merger of AT&T (NYSE: T) and Tele-Communications Inc. (Nasdaq: TCOMA), which Kelly believes will result in new contracts for The Kid.

An article in the New York Times earlier this week drew attention to the continuing underperformance of mid-cap and small-cap stocks relative to their more heavily capitalized brethren. Year-to-date, the S&P 500 Index has gained 16.7%, and the largest of the large -- those stocks comprising the S&P 100 -- have risen even more, up better than 20%.

As you move down the capitalization ladder, gains shrink considerably. The S&P Midcap 400 Index is up only 7.2% so far this year, the S&P Smallcap 600 has gained only 4.2%, and the Russell 2000 index of smaller stocks has struggled with a mere 3.0% gain.

Those statistics explain a great deal of the Boring Portfolio's modest performance this year (and for the last third of 1997, too). Ever since it debuted in early 1996, the Borefolio has been an experiment in investing that has been oriented primarily toward mid-caps and small-caps.

Only one of our current holdings, the formidable Cisco, is a member of the S&P 100. Andrew Corp. is an S&P 500 stock, but it's among the smallest companies in the entire index.

In the past week, Borders Group (NYSE: BGP) moved up to join the S&P Midcap Index, where our diversified manufacturers Carlisle Companies (NYSE: CSL) and Pentair (NYSE: PNR) also reside. TCBY is an S&P 600 stock.

Atlas Air (NYSE: CGO) and FelCor Suite Hotels (NYSE: FCH) are not currently in any S&P index, both being probably too small and too new to qualify -- although I suspect that they could be added to one of the indexes in the relatively near future if they continue to grow.

So why the marked underperformance of stocks of smaller companies?

As the Times article (and similar features elsewhere) point out, the answer surely isn't a matter of value. On the basis of price to earnings, price to cash flow, or price to pretty much any criterion of value you care to choose, stocks of smaller companies compare very favorably with those of the big guys.

True, stocks of smaller companies tend to be more volatile and riskier. On the other hand, volatility has, if anything, increased more among big-caps than among the beanie babies lately. Also, many small-caps have little or no exposure to weak Asian economies, which should reduce investment risk.

Working against the little guys more than anything else are two factors: liquidity and momentum.

Liquidity -- the ability to move large amounts of money in and out of a stock without rippling its price unduly -- has gotten to be more and more of a concern for mutual fund managers as investors have poured more and more money into stock funds. Small-cap stocks by their nature are less liquid than big-caps, and less liquid yet than the mega-caps.

Liquidity of smaller stocks, many of which reside on the Nasdaq, has been further constrained by recent rules changes that have had the effect of trimming the size of bid/ask "spreads" on Nasdaq stocks... but have also discouraged some market makers from dealing at all in some of the smaller issues. The smaller the number of market makers competing to buy and sell a stock, the more difficult it is to buy or sell a large amount of that stock without moving the price significantly.

The other factor that has probably held back small-caps is the increasing focus of fund managers on price momentum. Since they're paid to match or beat the performance of "the market," many fund managers find themselves under strong pressure to buy whatever happens to be going up. That produces a positive feedback: the more a stock's price goes up, the more it goes up... at least for a while.

Complicating the situation -- there's always a complication -- is the little bit of nonlinear dynamics that George Soros refers to as "reflexivity." A rising share price does more than attract momentum buyers temporarily. It can also lever a company into a competitive advantage of more lasting significance: companies can use their healthily appreciated stock to buy new technology, other companies, the best executives and engineers, whatever they need.

Cisco CEO John Chambers is quite familiar with the benefits of reflexivity, I have no doubt. And Cisco's stock is up 60% year-to-date, by the way.

So shouldn't the Borefolio perhaps forsake its battle against the tide and instead go with the flow and enjoy the ride?

Well, maybe. After all, the object of the game is to make money, not rail against a market that isn't behaving the way one thinks it "should."

On the other hand, over the long term value has repeatedly demonstrated that it matters beyond all else. Ultimately, the price of a stock is determined by the aggregated estimates of buyers and sellers of the future cash flows accruing from that stock. When price and value get too far out of whack, the market eventually... eventually... corrects the stock price accordingly, upwards or downwards. Forget about value and you may find yourself forgetting about long-term investment growth.

I have no neat answer with which to conclude this Friday evening meditation. All I can do is put on the table some of the issues with which individual investors (or at least this one) grapple. The guidelines we use here in the Borefolio will always be provisional, subject to change as we learn from experience, right along with you. The only thing that will not change is the way we engage in that continual learning process right out here in the open.

Do enjoy the weekend, folks.

FoolWatch -- It's what's going on at the Fool today.

06/26/98 Close

Stock  Change    Bid 
 ANDW  -  3/8   18.38 
 CGO   +  3/8   33.38 
 BGP   -  11/16 36.63 
 CSL   +  11/16 43.75 
 CSCO  +2 15/16 89.88 
 FCH   -  5/16  31.19 
 PNR   +  3/16  40.31 
 TBY     ---    8.38 
                   Day   Month    Year  History 
         BORING   +0.37%   1.60%   2.83%  29.39% 
         S&P:     +0.35%   3.89%  16.77%  82.30% 
         NASDAQ:  +0.34%   5.10%  19.05%  79.60% 
     Rec'd   #  Security     In At       Now    Change 
   2/28/96  400 Borders Gr    11.26     36.63   225.38% 
   6/26/96  150 Cisco Syst    35.93     89.88   150.12% 
   8/13/96  200 Carlisle C    26.32     43.75    66.19% 
    3/5/97  150 Atlas Air     23.06     33.38    44.74% 
   4/14/98  100 Pentair       43.74     40.31    -7.84% 
   5/20/98  400 TCBY Enter    10.05      8.38   -16.63% 
   11/6/97  200 FelCor Sui    37.59     31.19   -17.03% 
   1/21/98  200 Andrew Cor    26.09     18.38   -29.57% 
     Rec'd   #  Security     In At     Value    Change 
   2/28/96  400 Borders Gr  4502.49  14650.00 $10147.51 
   6/26/96  150 Cisco Syst  5389.99  13481.25  $8091.26 
   8/13/96  200 Carlisle C  5264.99   8750.00  $3485.01 
    3/5/97  150 Atlas Air   3458.74   5006.25  $1547.51 
   4/14/98  100 Pentair     4374.25   4031.25  -$343.00 
   5/20/98  400 TCBY Enter  4018.00   3350.00  -$668.00 
   11/6/97  200 FelCor Sui  7518.00   6237.50 -$1280.50 
   1/21/98  200 Andrew Cor  5218.00   3675.00 -$1543.00 
                              CASH   $5511.82 
                             TOTAL  $64693.07