"The most common cause of low prices is pessimism," according to Berkshire Hathaway chairman Warren Buffett. "We want to do business in such an environment, not because we like pessimism, but because we like the prices it produces."
That's right. Pessimism produces low prices. Just think back a little bit to 1998 and the large level of pessimism in the air then. You don't remember it? That's because you're focusing on large-cap tech stocks: Yahoo! (NASDAQ:YHOO), Cisco (NASDAQ:CSCO), Lucent (NYSE:LU), et al. You're thinking about a portion of the market for which analysts were projecting 20% to 30% earnings growth for the indefinite future.
Pessimism amidst rampant optimism
But there was a corner of the market that was dominated by pessimism in 1998 -- small caps. So little did the market believe in small caps back then that at the beginning of 1999, you could have purchased all 600 of the companies in the S&P SmallCap 600 index for approximately $300 billion -- the market cap of Lucent in 1999. Let's repeat that: For the price of what it would have cost to buy Lucent -- a company that today is worth $12 billion -- you could have owned 600 companies, including Whole Foods (NASDAQ:WFMI) and Toll Brothers (NYSE:TOL) -- the two of which alone are worth more today than Lucent. Then there are 598 companies more.
But we must thank the pessimists that drove the price of small caps down so far at that point, because that is what set up the possibility of 70% returns in small caps (as measured by the Russell 2000 small cap index) over the past seven years. Large caps (as measured by the S&P 500), on the other hand, have returned essentially zero in capital gains.
As a result of small-cap pessimism circa 1998, investing in small caps over the past seven years has been a bit of a cakewalk. If you were investing in them at all, you have probably done very well. If you have not invested in them at all and have been invested solely in large caps, well, there's a rather high probability that your returns have not been in the range of 70%.
Where are the pessimists now?
This leads to the question: How much pessimism is there today? Are small caps still a cakewalk? If we go out onto the streets randomly hugging strangers, is there a good chance that the people we're hugging will be pessimists concerning future small-cap returns? And whether they are or not, aren't they likely to react with suspicion and violence to unsolicited hugs?
Well, to answer those in order, (a) there isn't that much pessimism toward small caps today; (b) individual small caps are never a cakewalk; and (c) random hugs will probably not be greeted warmly (not by people that you want to keep hugging, anyway).
At present, the P/E for small caps as measured by the S&P 600 is 20. While this is not necessarily a terribly high number (Jeremy Siegel has argued with intelligence and logic that a market average P/E of 20 seems likely in the future), it is much higher than it was in 1998, and is higher than what the P/E is for large caps today. The trailing P/E for the large cap S&P 500 currently stands at 18 -- so by comparison, small caps are modestly pricier.
So should those of us working on the Motley Fool Hidden Gems newsletter, a service devoted to picking the best small-cap companies in America, be worried about the level of pessimism?
I don't think so. There's still more than enough pessimism out there to produce the kinds of opportunities in picking individual stocks that we like to see. The small-cap market is not underpriced as a whole the way it was a couple of years ago. But out of the 5,000 companies that qualify as small caps, there are hundreds that legitimately qualify as being weighted down by pessimism.
Benefit from the market's pessimism
Certainly, there's a lot of pessimism about car manufacturers, and with good reason due to their pension problems and the high prices of steel and gas. Carmakers seem to be in a battle to see who can deliver the gloomiest picture of their future operations and present profitability.
And that doom and gloom has extended to virtually all companies with ties to the automotive industry, including the manufacturers of recreational vehicles. The pessimism even extended to companies that had long histories of smooth growth, including one that Tom Gardner identified in the May 2005 issue of Hidden Gems: Drew Industries (NYSE:DW), the leading supplier of many parts used in recreational vehicles and manufactured housing. Since then, while the automotive sector has gotten even grimmer, shares of Drew are up well over 50%. Our readers' thanks (and mine, since I became a shareholder after sitting down for an interview with Drew's very impressive management) go out to the pessimists who depressed the stock's price.
Finding the sectors most heavily scorned
One of Hidden Gems lead analyst Tom Gardner's strategies for finding promising investment ideas is to simply screen stocks in the sectors that are lowest graded in terms of relative strength in publications such as Investor's Business Daily, yet also have superior individual financial performance. Such diamonds in the rough often have very attractive valuations -- and promising futures.
You can click here to take a 30-day free trial of Hidden Gems to see how that and our other methods for finding market-beating small caps are doing. (They're doing very well, up 28% vs. the market's 9% returns over the same period.) And in the meantime, go out, find somebody who's muttering to himself about how the sky is falling, give him a hug, and say, "Hey, thanks, and keep up the good work."
Bill Barker owns shares of Berkshire Hathaway and Drew Industries, but none of the other companies mentioned in this article. Whole Foods is a Motley Fool Stock Advisor recommendation. The Motley Fool has adisclosure policy.
