Can the Might of Mean Reversion Send Small Caps Higher?

Our research team published a very simple Chart for The Curious earlier this month comparing the relative size of small cap vs large-cap stocks. While naïve, the implication was striking. Based on history, the difference between large and small cap stocks indicates that recent gains by small caps vs. large caps may have much further to run.

As documented in our research, we believe that asset bloat in index funds and speculative ETFs that focus on large cap, loss-making firms, has caused this anomaly. In this paper we intend to:

  1. Extend on The Low Cost of High Quality which showed there is a speculative cohort of small caps that are as financially weak today and more expensive than they were at the peak of the internet bubble!
  2. Show how a reversion to the long term averages of “large cap vs. small cap” could generate large gains for small cap investors[1]
  3. Offer investors a portfolio from our Small Cap Model that we believe may represent a generational opportunity to pay historically low prices for some of the highest quality Small Caps – a painfully obvious alternative to “speculation investing” in our view

History suggests that the market bubble today is so dangerous and the opportunity to buy high-quality stocks at lower prices so obvious that keeping things simple is in the best interests of our readers. We would rather be roughly correct than precisely wrong to borrow from one of Buffett’s quips.

The chart below shows the market cap of Small Cap divided by the market cap of Large Cap Firms.

  1. Small Cap stocks need to rise 27% to get back to their average weight vs. large cap stocks[2]
  1. Small Cap stocks need to rise 47% to get back to where they went post the dot.com crash!2

YOU ARE NOW READING BASIC MEMBER LEVEL CONTENT

Are Large Caps Losing Touch with Reality?

Our research team has written about Buffett’s valuation metric, which scales Market Cap to GDP, repeatedly over the years. Most recently, we published a Chart For The Curious showing that markets were at frightening valuations. We have documented that, while useless for timing markets, this metric has a potent history of predicting future returns over a long time horizon.

We are currently bringing you FAQs related to some of the more complex terms and ideas as written above…

  1. As a reminder for our Financial Advisors: our models are available on a continuous basis, and most have been in production for over a decade.  If you are looking for simple, concentrated, low turnover, and tax efficient model portfolios we would like to talk with you.  KCR also offers a wide range of easy-to-use but sophisticated tools.  Our toolkits can help identify mispriced stocks with the best and worst risk/reward characteristics, estimate a stock’s duration and warn you when a company is engaging in low-quality accounting. Over the last 12 years, KCR has built and offers time-tested and class-leading products built by experienced and proven money managers for fixed to low prices.
  2. Kailash Capital’s sister company, L2 Asset Management, runs market neutral, long/short, large-cap, and mid-cap long-only portfolios with a value and quality bias.  L2 employs a highly disciplined investment process characterized by moderate concentration, low turnover, high tax efficiency, and low fees. While nobody can predict the future, we believe the recent resurgence in risk-adjusted returns seen across all products is the beginning of what may be a long period where speculation is punished, and prudence and patience rewarded.
The topics discussed in this article are aimed at seasoned professionals, as such, we have included some extra reading for anyone seeking out more information related to the topics above.

[1] Relative gains, that is to say, small caps could rise a great deal vs. large caps or large caps could decline sharply and small caps could decline by less

[2] Assuming Large Cap Stocks don’t move; Large Caps could collapse and Small Caps don’t change….but you’d still want to own some Small Caps!!

[3] XLF up 6.7% vs. SPY up 0.5%

Disclaimer

The information, data, analyses, and opinions presented herein (a) do not constitute investment advice, (b) are provided solely for informational purposes and therefore are not, individually or collectively, an offer to buy or sell a security, (c) are not warranted to be correct, complete or accurate, and (d) are subject to change without notice. Kailash Capital, LLC and its affiliates (collectively, “Kailash Capital”) shall not be responsible for any trading decisions, damages or other losses resulting from, or related to, the information, data, analyses or opinions or their use. The information herein may not be reproduced or retransmitted in any manner without the prior written consent of Kailash Capital. In preparing the information, data, analyses, and opinions presented herein, Kailash Capital has obtained data, statistics, and information from sources it believes to be reliable. Kailash Capital, however, does not perform an audit or seeks independent verification of any of the data, statistics, and information it receives. Kailash Capital and its affiliates do not provide tax, legal, or accounting advice. This material has been prepared for informational purposes only and is not intended to provide, and should not be relied on for tax, legal, or accounting advice. You should consult your tax, legal, and accounting advisors before engaging in any transaction. © 2021 Kailash Capital, LLC – All rights reserved.

Nothing herein shall limit or restrict the right of affiliates of Kailash Capital, LLC to perform investment management or advisory services for any other persons or entities. Furthermore, nothing herein shall limit or restrict affiliates of Kailash Capital, LLC from buying, selling or trading securities or other investments for their own accounts or for the accounts of their clients. Affiliates of Kailash Capital, LLC may at any time have, acquire, increase, decrease or dispose of the securities or other investments referenced in this publication. Kailash Capital, LLC shall have no obligation to recommend securities or investments in this publication as result of its affiliates’ investment activities for their own accounts or for the accounts of their clients.

May 26, 2021 |

Categories: White Papers

May 26, 2021

Categories: White Papers

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