Over the coming months you’re going to see a lot more original content coming from Sylva. We receive tremendous feedback on our work product, so Ross and I decided to do more of it; our goal is to generate so much compelling content that Sylvacap.com becomes part of your daily habit. You can also create a free account with us by clicking here, and we’ll notify you every time something new gets posted.

Speaking of original content, Ross has been absolutely crushing it with his options picks. Hopefully you’ve jumped on the Ross Silver Money Train and profited from his ideas.

This month I wanted to try and drill down a little bit on why microcap stocks don’t seem to be doing well as a whole. For the last 5 years the Russell 2000 (which is an index comprised of 2,000 small cap stocks) has underperformed the Dow and the S&P by almost 10%. The obvious question investors are asking is, why? Since 2009, the market has been on one of the greatest bull runs in the last century, and yet the smallest companies have somehow been left behind.

There’s an old financial axiom that a rising tide will lift all ships, yet somehow this particular tide seems to have left the smaller members of our fleet in the lock. Clearly there’s a disconnect between the economy, the stock market as a whole, and microcap stocks.

The reasons why are a head-scratcher for some but we’ve got a theory, to which there are two components.

First and foremost is the flow of funds to money managers, which refers to the movement or flow of money between actively managed funds and passively managed funds (which for the purposes of this article will include both mutual funds and exchange traded funds that seek to mimic the performance of a benchmark index).

Passive funds now hold a whopping $3.6 trillion of investor funds which equates to 42% of stock fund assets, and approximately 25% of the overall value of the stock market. That amount is nearly double what it was just 7 years ago. Active funds are institutions that try to pick individual stocks in an effort to out perform the market. For this service, investors are charged a fee, often referred to as a “load”. Loads vary from fund to fund and can sometimes be quite expensive. In theory, the expense is justified by the fund’s superior performance to the broader market.

The problem is, the market has been performing so well over the past 8 years, that investors haven’t received much benefit (if any) from paying professionals to manage their money.

There are of course a few outliers. Peter Bortel runs the Tiburon Opportunity Fund which has been doing quite well, and Ross interviewed him about 8 months ago. Peter mentioned ticker HIIQ which was trading around $4 at the time, and today it trades at almost $31. Unfortunately, Peter is the exception to the rule.

According to the LA Times, only 37% of actively managed small cap funds outperformed their relevant index over the last 15 years. (The index wasn’t named in the article, but presumably it’s the Russell.)

In turn, investors have yanked their dollars away active money managers, and invested that money in passive funds. Passive funds simply invest in the market, rather than trying to beat it. So, for instance, a passive fund may invest in all of the DOW or S&P 500 components. The load for investing in a passive fund is typically very minimal, and some don’t have any fees at all.

The current direction of the flow of funds is having a fairly significant impact on small, and particularly microcap stocks, because there aren’t really any passive funds (ETF’s) that invest in microcap stocks. Now that fund managers have fewer dollars at their discretion with which to invest, the amount of institutional money available to purchase small and microcap stocks has diminished. This attenuation is, in no small part, responsible for lackluster performance of small and microcap stocks.

For whatever it’s worth, we believe the current flow of funds just seems unstoppable, but it’s really not.  I’m not sure I’d go as far as to call it a bubble, but it’s clearly a very strong trend. Like all other fads, this too will normalize over time; if for no other reason that it’s in our human nature to voraciously seek alpha (a measure of an investment’s return in relation to a market index). It’s called greed. And to quote the venerable Gordon Gecko, “Greed is good.”

For this reason, I would actually consider investor satisfaction with market-like returns to be an anomaly. It cuts against the very fiber of the capitalist society, and sooner or later greed will get the better of us. It always does.

In addition to the small & microcap headwinds created by the flow of funds, small cap stocks (though not the companies themselves) are being hurt by a weak dollar.

Here’s how this works: in order to pull the U.S. out of the great recession of 2008, the government enacted the American Recovery and Reinvestment Act of 2009, otherwise known as “stimulus”, in conjunction with quantitative easing. We all remember that, right?

Quantitative easing (explained so brilliantly in this video) flooded the market with U.S. dollars. As a result, borrowing became incredibly cheap, which encouraged companies and individuals to borrow, and U.S. treasuries became very expensive to buy, meaning investors were incentivized to put their money to work by buying stocks instead of bonds.  I’m oversimplifying things a bit, but that’s the general idea.

I would be remiss if I didn’t footnote that in 2010, Ross actually wrote that, “anyone purchasing fixed income products from 2009 through the next decade are total morons, because ‘risk free’ yields will not come remotely close to equity yields given the game is rigged for equities to outperform.”  Nice call, Ross.

Anyway, with a glut of greenbacks circulating throughout the world, the law of supply and demand necessitates the value of those dollars becoming worth less in international markets. When the dollar is worth less (if CNBC picks up this piece, please make sure to get this point right – “worth less” is two words, not one), it means those who hold foreign currency can buy items denominated in U.S. dollars more cheaply. This includes commodities like gold and oil, as well as stocks, bonds, and consumer goods.

The upshot is that companies that do business internationally received a windfall, because holders of foreign currency can purchase their wares less expensively. Since a lot of small companies in this country conduct most, if not all, of their business domestically, they didn’t receive any economic benefit from the soft dollar. This may also partially explain why the earnings of small and microcap companies have been ho-hum in comparison to their larger counterparts.

While small businesses haven’t benefited from the weak dollar, it’s worth noting that they haven’t been directly injured either. The only tangible effect is that small and microcap stock prices have languished, in part because investors have played the currency arbitrage by betting on companies that are in the best position to benefit, namely mid and large caps.

So will there be redemption for microcaps?

Yes. We absolutely believe there will be or Ross and I would be out right now searching for some other way to make a living. Small businesses are the lifeblood of this country and they’re not going away. They just so happen to be out of favor right now.

Small & microcap stocks could also benefit from President Trump’s, “America First” policies, should they ever get enacted. Historically, protectionism benefits companies that are heavily reliant upon domestic commerce for their growth and prosperity. Additionally, protectionism could strengthen the U.S. dollar, which should also benefit smaller companies. I’m certainly not trying to make a case in favor of protectionism. I actually think it would be quite disastrous for our country as a whole. But broader implications aside, America First would likely have some very favorable side effects for small businesses.

But even without a protectionist agenda, there’s a tremendous amount of innovation occurring in the U.S., and a lot of it is being forged by small businesses. Some of the companies we cover are doing the most incredible things with science and technology that could very easily pave the way for the future of America’s economic growth.

The fact that investors currently eschew these tiny pistons of our economy should not discourage anyone from taking a more holistic and long-term view of the microcap market.  And just as we believe the flow of funds will normalize at some point, so too will the currency trade, especially if President Trump is able to deliver on his campaign promise of putting America first.

Musings From Dealing with Airlines & the Stupid “Fight”

Greg, well done on your piece and I agree whole heartedly with your assessment. This is the non-equites/economics section so I will instead fire off some of my dealings with people that make me crazy and this moronic “fight” between McGregor & Mayweather.

First up, people that make me crazy. Are there any companies on this planet that offer worse customer service than airlines? I mean sweet mother of ____(fill in the blank). So that I may not incur the wrath of United Airline’s (UAL) counsel, I will not name the airline I am speaking of. First and foremost, why does it cost $150 to change a ticket that has been purchased? I also don’t understand why checked bags cost a fee and finally, and most irritating, why are there no consequences for airlines when they are late or cancel your flight without 24 hour notice? Those of you lobbying on behalf of the airlines are winning, yet your victory comes at the cost of the consumer, not sure how you sleep well at night.

I almost forgot to mention airline “customer dis-service” representatives. For the love of _____(again fill in the blank) why is it that I have to spend 15 minutes navigating the stupid customer dis-service phone maze to get to hold for 30 mins and then speak to someone? When I speak to someone, they are based 18 hours ahead of me and English is definitely not their strong suit nor is it spoken well. For those of you seeking a good laugh, just imagine me and my three young children, and mega pregnant wife, inside a crowed airport while I am speaking to a customer dis-service agent. While I am being transferred to the next available agent in 22 minutes, which also could be any minute per past dealings, you know where you put these people on speaker thinking you really have 22 minutes and they pick up a minute later. I digress, my two barbarian sons are trying to see how far they can make a cup full of water and ice slide down a railing without spilling and have assured me spilling has a zero probability. I am barking at them to stop and sit in their seats and airport patrons are doing their best to give the aforementioned barbarians adequate room to maneuver in order avoid the inevitable spill and “sorry Dad” that is to come. Suddenly, I kid you not, agent named Judo picks up and asks how my day is going in broken English and how he/she may help me (it was unclear whether Judo was a man or woman). Of course Judo has no idea how to resolve my situation and his/her computer is running slow so back to hold and to another agent who can assist me. Airlines, you should be ashamed of yourselves and there is nothing more I enjoy than shorting your stocks, that time is coming soon I believe buddy ole pal.

Sticking with my vitriol theme, what in the world is this McGregor vs Mayweather “fight”? Is anyone stupid enough to attend this thing or buy it on pay per view? I sincerely hope not. This is the equivalent of me saying I could beat Michael Jordan in a game of one on one. Not only would it not be close but it would be laughable. I did win the Pepsi Hot Shot contest in my city when I was twelve, so therefore I know how to shoot, but does that make it even remotely fathomable that I could have even the slightest chance to take down Jordan? The answer is emphatically…maybe. Ok, ok I will extinguish my ego, the answer is I would have no chance against Jordan. This is what this donkey show of an event Mayweather versus McGregor is. One of the greatest boxers of all time is going to fight some dude who won a few amateur boxing fights.

Greg actually bet on McGregor to win when we were in Vegas and based on the intel I am getting from my friends in Vegas 95% of the bets casinos are taking are for McGregor. I wish I could book this fight, I would happily give anyone who wants to bet on McGregor 100-1 odds instead of 5-1 that the casinos have it at. I spoke with a friend of mine who knows things and he said the casinos are in shock that they will actually get to make a killing on Mayweather barring some whales coming in and dropping $10M+ on Mayweather. Just as I put up every dollar I had on Earth on Lennox Lewis in his rematch with Hasim Rahman, where Lennox dismantled Rahman. I will be putting every dollar I have on Earth on Mayweather because this will be the easiest 20% return on my money I have ever made in my life barring some freak occurrence. Mayweather is currently -500 which means if I put up $5M, I win $1M.  See you at the window friends! Until next time…