Boring Portfolio

Small Cap vs. Large Cap
And a Short Observation

By Dale Wettlaufer (TMF Ralegh)

ALEXANDRIA, VA (August 13, 1999) -- Short and sweet today. Berkshire Hathaway released second quarter results this evening: Click here for the interim shareholder report.

One question that did come up was per-share results. I see the following: Assuming a 35% tax rate in both periods, $580.5 million in net earnings before goodwill amortization and realized investment gain for Q299, or $382 per "A" share, versus $639.4 million (pro-forma, reflecting Berkshire + GenRe) last year, or $420.8 per "A" share.

I'll leave the intensive analysis until Monday, as this came in pretty late. I do have one other small observation that I wrote for today, though.

On Market Capitalizations

Rummaging through the Yahoo! news today, looking for something while waiting for Berkshire's Q2 report, I ran into a CBS Marketwatch story on small-cap stocks. One analyst quoted in the story says this:

"The second quarter was the first time in seven or eight quarters that we saw a broadening of the market... It looks as though people are getting a lot more confidence in the small-cap universe...There was such disparity between the valuations of large- and small-cap stocks... Gains in the market had been so narrow. There was a huge gap between the market leaders. Small-caps were really undervalued compared to large-caps."

Yikes. When you look at what's driving the S&P 500, you're talking about a relatively small number of companies that dominate that portfolio's economics. Let's compare those characteristics versus the typical smaller publicly traded company:

1. High cash-on-cash returns vs. low returns

The less cash you have to put in to get the same amount of growth, the more a company will be worth, in general. Companies beating their cost of capital generally have much more financial flexibility, with the ability to fund out of internal cash their expansion plans instead of issuing new capital. There are numerous reasons why higher returns on capital make a company worth more, and this is pretty much the financial profile of the top 10% of companies within the S&P 500.

2. Lower cost of capital vs. less flexibility

Companies exhibiting higher returns on capital can usually get better borrowing terms. Fortune 500 companies can also tap a number of different sources of capital, including the money markets, the publicly traded debt markets, and the equity markets. Smaller companies are more limited; with less access to equity markets, they rely more on commercial banks.

The net result of higher cash-on-cash returns, before financing costs, and lower costs of capital is an even wider disparity between static valuation measures such as P/E, price/book value, etc.

3. Dominant businesses vs. less powerful companies

General Electric, Intel, Coca-Cola, Cisco vs. your average Russell 2000 company: hardly a comparison. R&D and advertising budgets at Intel and Coca-Cola dwarf the budgets at competitors such as Advanced Micro Devices and Triarc Companies. Whether you're talking about a brand-name lockdown or a technology lockdown, the valuation disparities are not just linear, because the benefits of those lockdowns result in geometric differences in future shareholder returns. On a present value basis, then, the valuation differences are going to be large.

You could go on with this list, and I encourage investors who believe in this "small caps are going to rise" school of thought to review further differences between the average market-dominating company and the average small company. I personally think, given the reheating of the global economy, that recent action in the Russell 2000 is perfectly logical. I think discussions of investors gravitating to these companies, simply because they're small caps and simply because they're "cheaper," are of little value.

Have a good weekend.

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08/13/99 Close
Stock Change   Bid
APCC  +1 1/2   20.38
BRKb  -29      2104.00
CSL   +  1/8   40.19
GTW   -  3/4   81.75

                  Day     Month   Year  History
        BORING   +0.42%  -1.43%   2.79%  38.02%
        S&P:     +2.27%  -0.08%   8.59% 121.45%
        NASDAQ:  +3.46%  -0.03%  20.30% 153.40%

    Rec'd   #  Security     In At       Now    Change
  8/13/96  200 Carlisle C    26.32     40.19    52.66%
  4/20/99  460 American P    14.48     20.38    40.74%
   2/9/99  100 Gateway 20    72.38     81.75    12.95%
 12/31/98   12 Berkshire   2276.17   2104.00    -7.56%

    Rec'd   #  Security     In At     Value    Change
  8/13/96  200 Carlisle C  5264.99   8037.50  $2772.51
  4/20/99  460 American P  6659.25   9372.50  $2713.25
   2/9/99  100 Gateway 20  7237.50   8175.00   $937.50
 12/31/98   12 Berkshire  27314.00  25248.00 -$2066.00

                             CASH  $18177.16
                            TOTAL  $69010.16