Small-Cap and Mid-Cap Volatility Creates Opportunities in the Long Run

This year was a rough year to be invested in small and mid-cap stocks, which make up the backbone of our portfolio. As I write, small-caps have underperformed the S&P 500 by more than 10 percentage points, returning a negative return for 2014, and mid-caps have performed about the same. Liberty Hill Investing portfolios have done better than the small-cap average, but they have been pulled down by this broader trend. According to research by Morgan Stanley, this year saw one of the largest divergences between small-cap and large-cap stocks in the past 15 years. This is a good time to remember that small-cap investors need volatility, with years like 2014, in order to create the market inefficiencies that offer value and outsized returns in the long run.

Given the volatility and the gap between large-caps and small and mid-caps this year, I thought now might be a good time to revisit one of my previous articles on value stock volatility. Whether the investor is finding value in small and mid-cap stocks, turn-around stories, or dysfunctional businesses that are under-priced, the processes and responses to volatility are essentially the same. This article is a great look at the emotions and the thought process of one of the great value investors as he works through the cycle of owning value stocks.

I recently ran across a couple graphs created by deep-value investor Seth Klarman. He specializes in buying companies that have major problems, but are under-priced, even accounting for the issues facing the company. Many investors feel uncomfortable buying and holding companies that face business problems, have poor future growth prospects, or demonstrate downward price trends. In nearly all of these sort of deep-value investments, these companies have just had a cataclysmic drop in price and there is no formula to decipher when the price will stop dropping.

The key to value investing generally is the ability able to make cool rational decisions. Most of the value investors I research have a learned even temperament that is necessary for beating the market over the long-term. Yet, even for those skilled investors, buying value stocks can be unsettling, and holding a value stock to maturity can be a roller-coaster of emotions. To illustrate this, I would like to share Klarman’s graphs.

The graphs show his thoughts throughout his ownership of the same stock on two separate occasions. The first buy was in 2011:

graph one

These deep-value stocks tend to move without much news or information to justify big price swings.
In the above case, when Klarman saw the stock price slowly erode for 7 months from his initial purchase he questioned the company’s suitability as a value investment. Without much negative news, however, the firm’s promise as an investment hadn’t actually changed. If nothing has changed in the story, and the company still fits your original well thought-out checklist, then buying additional positions can be rewarding (but scary). Klarman closed out his position when it reached fair value.

Here are Klarman’s thoughts on his second trip owning the same stock in 2013:

graph two

With value stocks, especially the type that Klarman frequents, the price of the company is so depressed by the market, and there is so much negative sentiment built into the stock price, that any change in the negative perception of investors can send the stock surging. Price corrections, however, don’t happen overnight. In the two periods in which he held this deep-value stock it took just over a year for the market price to rise to reflect his assessed fair value. And these are just two examples, it can often take several years for the market to move a particular stock to fair value.

The takeaway from Klarman’s graphs is that even great investors will doubt their investment thesis when a company’s price moves south on them. The difference between the investors that beat the market over the long-term and those that do not is a matter of discipline and a focus on the fundamentals.

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