Manager Commentary

Manager Commentary, 2nd Quarter 2014

The Greatest Story Never Told

Examining the ‘Stealth Bear Market’ within Small Company Indexes

Small and large company equity performance has continued to diverge in the first half of 2014. Small companies significantly outperformed large-cap equities in 2013. This year we have seen a reversal, as smaller company equities have lagged large-cap stocks through June 30. Recent trends have led to sweeping claims that small-cap valuations have become “stretched.”  Is this true? This quarter we will attempt to show how investors can determine the answer for themselves by digging through the actual companies listed in the indexes.

The stock market is not a market of indexes, it is a market of companies. When you actually examine the individual names that form the small company indexes, what we see is that we have experienced a “stealth bear market” in smaller company stocks: the average stock in the Russell Microcap Index has fallen -23.97% from its 52-week high. Significant declines are broad-based, as 791 companies have fallen 20% or more from their 52-week high. What this means is that while certain small/micro-cap industries or individual companies are indeed expensive (in our view), there are certainly pockets of opportunity to be found.

Small-Universe-Returns-MC-@-850 (2)

Past performance does not guarantee future results.

Small company indexes are at or near all-time highs, yet the majority of individual names have fallen 20% below their 52-week high. How can we explain this condition? Performance analysis shows that Index returns are being driven by a smaller number of high-flying biotech and internet software stocks. As fundamental, value-oriented managers, we believe these investments carry significant risk. names such as Open Table (OPEN), Yelp (YELP), and Zillow (Z) may benefit from consumer recognition and investor excitement, but their current market valuations may not be justified in the future.. We believe that true small company opportunities – names with strong potential earnings power and valuations that aren’t “stretched” but “compressed” – lie elsewhere.

Russell-Micro-Analysis-MC (2)

Past performance does not guarantee future results.

Performance within the small cap universe has also diverged in the first half of 2014, as seen in our table above. Excluding the group of companies with a market capt under $150 million (which includes many penny stocks susceptible to volatile performance swings), the larger the company the greater the return. Investors can sketch a rough chart ranking 2014 performance by asset class and see a linear climb: large-caps performed best, followed by mid-cap, then small-cap, and finally within small-cap where the smaller companies have the least return.*

We hesitate to draw and conclusions about such short term returns signifying a new trend. It is possible that this is the start of a period of large-cap outperformance. Equally likely is that we are seeing a natural reversion following 2013’s significant outperformance by smaller companies, and we are still in a market where smaller companies are in favor. What does appear material to us is the decreasing level of correlation between the large- and small/micro-cap asset classes.

Low correlation is one of the key reasons why we believe so passionately that investors should allocate to micro-cap equity. According to Ibbotson & Associates**, between 1926 and 2013 smaller company returns have had a correlation of 0.80 to larger company returns. Micro-cap returns should provide investors with even lower correlation than small companies, as micro-cap companies are generally far off the radar screens of traditional Wall Street analysts. Following the financial crisis, returns of all asset classes, including micro-cap equity, began moving in sync and correlation increased. As seen below, over the past year and a half this trend has started to reverse. The r-squared of the Perritt Ultra MicroCap Fund, having tracked generally near 0.75 for the past five years, has begun to decline to pre-2008 levels.

The effect of lower correlation on investor portfolios can be significant. As we will outline in an upcoming research paper, Adding Micro-cap to Small-cap, our research shows that complementing your small-cap allocation with an investment in micro-cap has lowered correlation and has helped reduce volatility. Part of the reason that this benefit has proved possible is the lower correlation historically delivered by an investment in micro-cap.

PREOX-36-Month-TimeFrame-MC

Dig through the individual names in an index and you can see widely varying returns and valuation characteristics. Our final chart below compares valuation metrics according to company size within the small company universe. As can be seen, the smaller the company, the lower the valuation. This holds true for P/E, P/B and Total Enterprise Value/Revenue (TEV/Rev).

Perhaps we have been in this business for too long, but the below chart made us reflect on the “good old days” of the 1970’s and 80’s, when growing small companies were rewarded with higher valuation multiples. In the era when our firm was founded, investors paid a premium to own fast-growing, dynamic small companies. Today, it seems normal for large, consumer staple-type companies to be rewarded with lofty multiples, despite internal growth rates of just a few percentage points per year. Conversely, many small companies growing at 15-20% per year are valued at a discounted multiple. Perhaps this is another example of the famous “new normal,” but it seems backwards in our view.

Median-Valuations-MC (2)

Click here for standardized fund performance.

Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the fund may be lower or higher than the performance quoted. Performance data current to the most recent month end may be obtained by calling (800) 331-8936. The funds impose a 2% exchange and redemption fee for shares held 90 days or less. Performance data quoted does not reflect the redemption or exchange fee. If reflected, total return would be reduced.

The information provided herein represents the opinion of Perritt Capital Management and is not intended to be a forecast of future events, a guarantee of future results, nor investment advice.

The Fund’s investment objectives, risks, charges and expenses must be considered carefully before investing.  The statutory and summary prospectus contain this and other important information about the investment company and may be obtained by calling 1-800-331-8936 or by visiting www.perrittcap.com.  Read carefully before investing.

Performance data quoted of the Low Priced Stock Fund for periods on or prior to 2/28/14 represents past performance of the fund’s predecessor, a separately managed account. The fund is the successor to a separately managed account. The investment policies, objectives, guidelines and restrictions of the fund are in all material respects equivalent to those of the predecessor, and the predecessor’s portfolio managers are the current portfolio managers of the fund. However, the predecessor was not a registered investment company. Had the predecessor been registered under the Investment Company Act and been subject to the provisions of the Investment Company Act and the Internal Revenue Code to which the fund is subject, its investment performance may have been adversely affected. The performance information reflects the gross expenses of the predecessor adjusted to reflect the higher fees and expenses of the fund. The performance is shown net of the annual management fee of 1.00% and other expenses. The performance was achieved by the predecessor when assets were relatively small; the same strategies may not be available, and similar performance may not be achieved, when the fund’s assets are larger.

R-Squared is defined as a statistical measure that represents the percentage of a fund or security’s movements that can be explained by movements in a benchmark index.

S&P 500 is defined as an index of 500 stocks chosen for market size, liquidity and industry grouping, among other factors. The S&P 500 is designed to be a leading indicator of U.S. equities and is meant to reflect the risk/return characteristics of the large cap universe.

The Russell Microcap index is a capitalization weighted index of 2,000 small cap and micro-cap stocks that captures the smallest 1,000 companies in the Russell 2000, plus 1,000 smaller U.S.-based listed stocks.  It is not possible to invest directly in an index.

Fund holdings and sector allocations are subject to change at any time and are not recommendations to buy or sell any security. For PRCGX holdings click here. For PREOX holdings click here. For PLOWX holdings click here.  Correlation is a statistical measure of how two securities move in relation to each other. A correlation of 1.00 equals perfect correlation, 0.00 equals no correlation, -1.00 equals perfect negative correlation. Price to Sales ratio is a tool for calculating a stock’s valuation relative to other companies, calculated by dividing a stock’s current price by its revenue per share.  Price to Earnings (P/E) ratio is calculated by dividing current price of the stock by the company’s trailing 12 months’ earnings per share.  Price to Book Value Ratio (P/B) is calculated by dividing the current price of the stock by the company’s book value per share.  Total Enterprise Value is a valuation measurement used to compare companies with varying levels of debt. This is calculated as: TEV = Market Capitalization + Interest Bearing Debt + Preferred Stock – Excess Cash.

*Micro-cap and small capitalization companies typically have relatively lower revenues, limited product lines, lack of management depth, higher risk of insolvency and a smaller share of the market for their products or services than larger capitalization companies. Generally, the share price of stocks of micro-cap and small capitalization companies are more volatile than those of larger capitalization companies. Also, the returns of micro-cap and small capitalization company stocks may vary, sometimes significantly, from the returns of the overall market. In addition, micro-cap and small capitalization company stocks tend to perform poorly during times of economic stress. Relative to large capitalization company stocks, the stocks of micro-cap and small capitalization companies are thinly traded, and purchases and sales may result in higher transactions costs. A mid-cap company may be more vulnerable to adverse business or economic events than stocks of larger companies.

**Source: Ibbotson & Associates Stocks, Bonds, Bills and Inflation Yearbook, 2014. Small company stocks defined as the bottom quintile of securities ranked by market capitalization from 1926-1981. For January 1982 to March 2001, the series is represented by the DFA U.S. 9-10 Small Company Portfolio and the DFA U.S. Micro Cap Portfolio thereafter.

Mutual fund investing involves risk.  Principal loss is possible.  The Funds invest in smaller companies, which involve additional risks such as limited liquidity and greater volatility than larger companies.  The Funds invest in micro-cap companies which tend to perform poorly during times of economic stress.  The Ultra MicroCap Fund and Low Priced Stock Fund may invest in early stage companies which tend to be more volatile and somewhat more speculative than investments in more established companies. Low Priced stocks are generally more volatile than higher priced securities.

The Perritt Funds are distributed by Quasar Distributors, LLC

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