How will the Fed taper affect small cap value? (Part 3 of 7)
Small Caps—no shortage of risk and opportunity
The below graph reflects the performance of Sotheby’s (BID) versus the Russell 2000 and Morningstar small cap growth index. Not only has growth been lagging value over the long run, which is normal, but Sotheby’s in particular has also been lagging in its small cap growth sector. From this perspective it might appear that—in terms of equity returns—Sotheby’s has been in the worst of the worst investment category. This makes the firm vulnerable to activist shareholders who believe that the company is not achieving its full earning potential. This article considers the upside prospects for Sotheby’s in light of both the Fed’s recent dovish announcement and Third Point’s Dan Loeb’s shareholder activism.
For a similar analysis of how the Fed announcement has affected large cap stocks, read Will the Fed take a bite out of Apple? And for mid caps, read The Fed tapers–will mid cap value hold up better then mid cap growth in Q2?
This article considers the upside prospects for Sotheby’s in light of both the Fed’s recent dovish announcement and Third Point’s Dan Loeb’s shareholder activism.
Hedge fund activist target
Unlike their large cap and mid cap counterparts, small cap companies have some unique risk factors. Sotheby’s is no exception. Small cap growth companies, like Sotheby’s (BID) can be vulnerable to activist investors. Hedge fund activist Dan Loeb of Third Point holds a 9.2% stake in Sotheby’s, which as a total market cap of approximately $3.09 billion. In the case of Sotheby’s, perhaps this activism will increase the share price. Given Loeb’s ~$300 million investment in Sotheby’s, it’s no wonder that he has been (so far, unsuccessfully) seeking to install his own Board nominees. However, hedge fund managers who do not like what they see or get, can just as quickly turn on their investments, and short them with equal vigor and conviction.
Sharks eat the sick, weak, old, and slow
As Sotheby’s has declined nearly 17% so far this year, despite a strong 2013 performance, with quarterly earnings growth up 37.30% year over year, one has to wonder what is taking the wind out of this stock. This looks like a textbook activist opportunity, and if Dan Loeb’s instincts are right, Sotheby’s has a long way to go in terms of improved performance. With a forward 2015 of 14.29 (Capital IQ), this is a growth stock that is priced like a value stock. Yet, Morningstar small cap growth index holds Sotheby’s in its top 25 holdings. Given the price earnings ratio, it is hard to see why they consider it a growth stock, but given the activism brewing, it might be priced like a growth stock in due course.
Sotheby’s has a $3.09 billion market cap with EBITDA, of $242 million on $518 million debt, although it holds $721 million in cash. Sotheby’s does not have a high level of debt, and with a profit margin of 15.23% it would seem to be in a position to finance growth. Such a company might be vulnerable to activist shareholders who would like to utilize Sotheby’s cash position and fairly strong earnings stream to borrow more money, add to debt, in order to finance growth. While Sotheby’s management is likely to be cautious on taking on more debt to finance growth, as the ability to service debt could be weak in a soft economic environment, activist investors are often interested in taking the risk that comes with higher levels of debt.
For an overview on the four main risk factors for equity portfolio returns, please see the prior series, The Four Most Important Factors for Your Portfolio.
To see how small cap value stock Apollo Education (APOL) is performing in this environment, read the next part of this series.
Constructive macro view
Despite problems in Ukraine and China, and despite the modest consumption data in the U.S., the U.S. labor market appears to be recovering—with the exception of the long-term unemployment. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still showing a modest recovery, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find a way into a new wave of profitable investment opportunities, and significantly augment the improvement in the current economic recovery. For investors who see a virtuous cycle of employment, consumption, and investment in the works, the recent out performance of value stocks over growth stocks could become the prevailing trend, favoring iShares Russell 1000 Value Index (IWD) over iShares Russell 1000 Growth Index (IWF).
Cautious macro view
Given the China and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY) and Dow Jones SPDRs (DIA), and iShares S&P 500 (IVV). Accordingly, long-term investors may wish to consider shifting equity exposure to more defensive consumer staples-related shares, as reflected in the iShares Russell 1000 Value Index (IWD) including companies like Wallmart (WMT).
Browse this series on Market Realist:
- Part 1 - Why did small cap value suddenly go red hot in the US market?
- Part 2 - Why is Apollo Education like a sub-prime mortgage originator?
- Part 4 - Will the Fed’s tapering eventually crush small cap value?
- Investment & Company Information