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Fourth Quarter 2011 Quarterly Newsletter

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The Little Engine That Couldn't

There’s a 100 year-old heartwarming story about a little engine that persevered by repeating “I think I can, I think I can,” until it was finally able to pull a line of railroad cars up a mountain. Small, but mighty. In the investment world, we have our own diminutive hero, known as the Small Cap asset class. You probably remember hearing that this asset class has superior long term performance compared to the behemoth blue chip engine that is the Large Cap benchmark – the S&P 500 Index.

You might also think that the best overall performing stocks within the Small Cap asset class are the tiny, hard working growth companies – the ones that chug along and grow and grow until they finally reach a new, larger size asset class at the top of the Wall Street mountain. But that’s where these two comparisons appear to derail.

We have been a long time proponent of Dimensional Fund Advisors (DFA) asset class mutual funds for our clients’ equity vehicles. Investors looking from the sidelines may think that DFA is simply another manager of index funds. This is because DFA management style is essentially passive and they charge rock bottom internal fees, much like “normal” index fund managers such as Vanguard and others. But DFA is a colossal academic locomotive. They use scholarly research from both internal sources and top graduate business schools to ferret out every advantage possible, and thereby add value to a portfolio.

An example of this occurred in 2010, when they explored the internal performance of various subsectors of the Small Cap asset class. DFA’s research discovered a strange anomaly. They found that the smallest, highest growth companies had consistently inferior performance when compared to most other stocks within the vast Small Cap arena of thousands of equities. That’s right – inferior. It was a real head scratcher. Below are some of the data.

When the Small Caps were broken into five subsectors, and the average monthly return is reviewed, the highest growth quintile had the worst performance in every time period. The differences to the other four Small Cap subsectors were dramatic.

AVERAGE MONTHLY RETURN 1960-2009
AVERAGE MONTHLY RETURN 1975-2009
AVERAGE MONTHLY RETURN 1990-2009
ANNUALIZED RETURNS 1979-2009


There is no single, simple explanation to this phenomenon. However, the culprit appears to be one that deals with the valuation of the stocks that comprise the Small Cap asset class. The highest growth stocks are obviously the ones with the highest earnings growth, and lowest book to market value. The high market valuations given to the top growth companies allow for little additional price growth due to already expanded valuations. Any earnings disappointments from these types of stocks can result in large price drops. Therefore, high growth stocks can only grow from earnings growth, not higher valuations. All the other Small Cap subsectors allow for price appreciation from both earnings growth and some degree of valuation expansion.

The bottom line is that the smallest and highest growth subsector puts a damper on the entire Small Cap asset class’s performance. Unless… you remove that subsector from the asset class. Can you guess what DFA did? That’s right. Starting in 2010, they started removing the smallest high growth subsector from their small cap funds. (See the last table above to see the difference removing this subsector can make.) The bottom line is that the Small Cap strategy without the extreme Small Cap Growth subsector was able to outperform the Russell 2000 by over 2% per year.

Obviously, DFA has several other methodologies relating to asset class construction and trading technology to add even more value to the Small Cap and other asset class funds they manage, but clearly the above information adds meaningful value for our clients. It is one of the many reasons we feel so strongly about including DFA equity asset class funds in our clients’ portfolios. We believe they are simply the best at continuing to use top academic research to uncover ongoing advantages to their fund holders.

So the next time you hear of a Wall Street darling in the form of a high growth Small Cap stock or fund, don’t be blinded by the headlights and loud whistles, and jump on the wrong track. Owning Small Growth companies or funds that use them will most likely lead to an inability to chug, chug, chug your way over the hump toward superior portfolio performance. And no amount of “thinking you can” will change that!

Fourth Quarter 2011 Asset Class Returns

Fourth quarter equity asset class performance differed meaningfully. All asset classes bounced back from the beating they took in the tumultuous third quarter, but US equities faired dramatically better then their foreign counterparts. This was due to the drubbing of foreign currencies, European debt pains and the resulting economic stagnation due to Japan’s earthquake/tsunami earlier in the year.

US equity asset classes all produced low to middle teen returns. Except for Large Caps and Real Estate, the pullbacks experienced earlier in the year by the other asset classes were too deep for positive full year returns. International equity asset classes, on the other hand, had very modest 4th quarter bounces, which left large, double digit negative full year returns.

Interestingly, intermediate and longer term US bonds were still able to gain value as interest rates edged down even further. One has to wonder just how much farther the rubber band can be stretched until higher rates show that bonds can have the same dramatic negative volatility as stocks. Over the last 18 months we have shortened the average maturities of our Income/Hybrid asset classes to protect our clients from higher future rates, and therefore our portfolios have not seen the dramatically positive returns of long term fixed income. Because we build portfolios for long term performance, we still believe it is better to be safer than sorry. When higher interest rates occur, it will be wise to be already prepared, rather than running for the exits with all those who have waited too long.

We still believe equities are undervalued. In a year when most domestic equity asset classes lost value:
 

    1. Current corporate earnings and future estimates have increased in a healthy manner, while their cash positions, share buybacks and dividend increases are at very high levels.

 

    1. Manufacturing and employment have been gently moving in the right direction.

 

    1. Most equity asset classes continue to be undervalued according to several different historical valuation standards.


If anything less than meaningful economic calamity occurs as a result of the European debt situation, there is ample opportunity for a strong upward market reaction. Obviously this is all conjecture, and has nothing to do with positioning our portfolios. We do not attempt to time the ebb and flow of the marketplace, regardless of the good or bad potential news ahead. We will rebalance to keep client portfolios consistent with desired risk and reward parameters, and in so doing will be buying low and selling high. The long term result should allow capitalism to reward those who are long term owners of diversified equity asset classes throughout the world.

This year promises to be exciting in economic, political and even sports arenas (Summer Olympics in London). So bundle up and stay warm, and get ready for the fun!

Happy New Year,


Frederick F. Kramer IV, JD
Chief Investment Officer
Dixon Hughes Goodman Wealth Advisors LLC