Fat Spreads for Active Managers

• Introduction: Never Has So Much Value Been Ascribed to Such Losses
• The Simplicity of Price-to-Sales Tells the Same Story
• Unforgiving Fundamentals
• Conclusions
• Exhibit

Introduction: Never Has So Much Value Been Ascribed to Such Losses

Kailash’s most recent paper “S&P500 vs. R2500: Will the Herding Continue?” detailed the record valuation spreads between the S&P500 and R2500 and the Kailash’s picks within the Small & Mid Cap universe. Kailash suggested the below action items in the conclusion as a means to exploit the anomaly. This paper seeks to emphasize in a simple way why an actively managed product might prove a better option than purchasing a Small & Mid Cap index fund.

1. Buy actively managed Small & Mid Cap Products
2. Buy a Small & Mid Cap Index Fund
3. Buy the Kailash SMID Top 25 Picks
4. Buy All-Cap Index Funds which may benefit from the rise of smaller firms
5. Purchase long/short products in large cap that can short the most overvalued firms since 2000

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Figure 1 below presents the Kailash Small & Mid Cap Short portfolio’s aggregate historical Enterprise Value (EV) and Free Cash Flow (FCF). Negative numbers are a funny item for analysts. If two companies lose $100 but one has an EV of $1,000 and the other an EV of $2,000, the FCF/EV is -10% and -5% respectively. One could suggest that the $2,000 firm is “less” expensive than the $1,000 firm because the market has told us it is worth twice as much and the market is efficient. Or, in your author’s view, the second firm is 100% more expensive – if two firms lose the same amount of money, the one with the higher enterprise value is just pricing in more promises! The data below shows that never in history has such an immense amount of EV rested on such a large amount of losses in our short portfolio. Our SMID short book has essentially pooled a group of companies that, combined, are worth $300bn dollars and lose $10bn.

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Disclaimer

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