Sent November 2022
The part of our proclivity as human beings is to cheer for the underdog. We like stories of the small guy beating the big, the weak overcoming the strong, the disadvantaged defying the odds, etc. etc. This month we’ll address two of those “overcoming” stories in the economic realm and the lessons they teach us.
Small Capitalization Companies
First, we’ll address the small capitalization companies in the United States publicly traded markets. These “Small Caps” are commonly defined by their size in terms of the firm’s market value. The total shares outstanding for any company is multiplied times the current price per share of the stock and that result is that company’s market capitalization. Small cap companies have a market value up to $1.5 billion, which though pretty significant, is dwarfed by large cap companies having capitalizations in excess of $10 billion (for instance, Apple’s market cap is $2.4[i] trillion and 3M Corporation is $68 billion).
Notwithstanding this “size” advantage, small cap companies are down 12-14%[ii] this year, whereas the large cap companies are down 18-20%. The fundamental reason they are holding up so well is because these entities are making good profits, in spite of the current challenges with inflation. Over the past couple of years their greatest challenge has been not being able to find good employees due to a hot labor market, but that pressure is beginning to ease.
Why Small Companies Do Well
The reason small companies do well historically is because they must fight harder and can never be complacent. Speaking in terms of higher finance, they have to deliver greater returns or the investor in them would not be “compensated” for the risk shareholders naturally bear. The future earnings of these companies are “discounted” more severely accordingly.
Our clients thus hold more of these small cap companies in their portfolios because on average, they make shareholders a greater return. They are “riskier” companies because they are only $1 billion in site, but we diversify that risk away by owning not 5-10 of these companies, but literally thousands of these companies. I find it disingenuous that Wall Street is touting in the press that it’s now time to own small companies[iii] when that train certainly has left the station, but then again Wall Street is known for being late to almost every party.
U.S. vs China and India
The other small versus large is the United States versus China and India. The population of the USA is 340 million people (GNP $20.49 trillion[iv]), whereas China has 1.6 billion people and India 1.1 billion[v]. We therefore see countries with 300% to 500% more people battling on a global scale, yet total gross national products of China ($13.4 trillion) and India ($2.72 trillion) are 2/3rds and 1/8th the size. The total market value of all listed United States companies is $53 trillion, compared to $3.1 trillion and $1.6 trillion for China and India, respectively.
Some Reasons for These Disparities
Ease of Doing Business
Competition in free markets is always hard, but companies need a steady set of rules and independent courts to operate within accounts. Political favoritism and corruption are natural impediments to independent courts and rule of law. On the international ranking scale of ease of doing business[vi], the USA ranks 6th. The Russian Federation itself is 29th on the list, which is I think a low bar itself, but China ranks 32nd and India 62nd. Regarding wanting to open a business in those countries, as my late brother Paul used to say: “I’d rather stick needles in my eye.”
Government Involvement
Ideologically, companies that serve shareholders cannot serve the State.
Over the last 2 years, the Chinese market has seen the Communist Party single-handedly defeat a number of promising upstarts. Most notably, it took down Ant Group, arguably a web-based payment merchant company that would have seriously challenged PayPal and Amazon’s dominance. The IPO of the Ant Group (and for its founder/leader Jack Ma) would have been the largest in the world and yet it literally went “poof”! In a great surprise to all, it was pulled last minute from the market. But behind the scenes it disappeared from its Hong Kong listing because Mr. Ma did not demonstrate sufficient fealty to Premier Xi Jinping (who last week was appointed to an unprecedented 3rd 5-year term).
In India, prices of wheat and gas are still controlled by their central government[vii] and private enterprise cannot operate freely – which is a foundation to free markets. These constraints bring “externalities” to the market and squeeze private enterprise out, stifling innovation, and the poor suffer miserably for it. As Margaret Thatcher said: “The problem with socialism is that you eventually run out of other people’s money.”
The Odds Favor the Brave
The nimbleness of small companies allows them to adapt and the fear of failure forces that adaptation. If you look at the very slim likelihood of success the United States faced upon its start in 1776 through its War of 1812 with England, you’d see that gutsiness in action. It is a reality that our country’s business genetics continue that heritage. The world is a scary place right now but when it’s deep in your bones to scrap and fight your way forward, the odds favor the brave – and bravery is economically rewarded.
It remains my deep and distinct honor to serve you.
Patrick Zumbusch
Founder and CEO
Wellspring Financial Partners
[i] Yahoo.Finance.com (October 26, 2022)
[ii] Fund Center (Dimensional Fund Advisors, October 25, 2022)
[iii] “Small-Cap Stocks Are Starting to Stage Their Comeback” (Pia Singh, Wall Street Journal, July 8, 2022)
[iv] “Matrix Book 2022: Historical Returns Data” (Dimensional Fund Advisors)
[v] -ditto-
[vi] “Ease Of Doing Business Ranking” (World Bank, 2019 Ranking)
[vii] “Government Control Over Price and Distribution” (Civil Service India, October 26, 2022)
