Government debt grows while political leaders feud. Record-low interest rates persist as yields shrink. Investors remain nervous and pull their money from stock mutual funds for five years running.
It’s the most challenging time to invest that Bill Nasgovitz has seen in a career spanning more than 40 years. It’s particularly difficult in his area of expertise, picking stocks of small companies.
Overall, it’s been a good ride for Nasgovitz and investors in the mutual fund he runs with two comanagers. Since he launched the fund in 1984, Heartland Value has returned an average 12.4 percent a year, beating the 9.4 percent average for the Russell 2000 index of small-cap stocks.
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When picking stocks, Nasgovitz looks for a low price relative to the company’s earnings and to the strength of its balance sheet. Yet these factors offered little protection in 2011. The European debt crisis worried investors, who preferred the relative safety of dividend-paying large-cap stocks. The Standard & Poor’s 500 index returned 2 percent including dividends, while the Russell 2000 lost 4.2 percent.
But that doesn’t tell the whole story. Split that Russell 2000 index into five groups - from the biggest among the small-caps to the tiniest - and the largest group actually climbed, finishing up an average 11 percent. The smallest group took a huge hit, plunging 49 percent.
Volatility is the norm for the smallest stocks, but the vast size of that gap, 60 percentage points, frustrates Nasgovitz. The wide disparity is reflected in his fund’s performance. Heartland Value lost nearly 7 percent last year.
Things are looking better. Less than a month into this year, the fund is up 6.7 percent and small-caps are outperforming large.
Yet Nasgovitz still believes investors have become so afraid of risk that they’re unwilling to take a chance on the smallest companies. It’s a huge concern because nearly two-thirds of his fund’s portfolio was recently invested in micro-caps, defined as companies with a market value of less than $300 million.
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Here are excerpts from a recent interview:
Q. Why did small-caps have such a rough 2011?
A. We’ve got these big headwinds, like the nation’s debt problem, that have damaged the appetite for long-term investing. It has especially hurt the high-risk, high-reward segments of the market, including small- and micro-caps. The smallest of the small were punished by fear and a flight to safety.
Q. Can a small stock whose business is fundamentally sound manage to attract attention from investors in this environment?
A. Fundamentals don’t count anymore. A lot of the small companies we like have no debt. But people were still selling these stocks indiscriminately last year, putting money into bond funds and Treasurys because that is a place to hide. Perhaps it will change. But investors just don’t have confidence.
We’ve had five years in a row when investor withdrawals from stock funds have exceeded deposits. People don’t understand how huge this has been. This has put pressure on mutual funds and professional investors to sell securities to meet redemptions. So this aggravated last year’s bear market for small stocks.
Q. Why are investors so worried?
A. The nation’s debt problem has scared people so much that they’re afraid to invest for the long-term. The government owes roughly as much as the nation’s economy produces in a year. Yet 10-year Treasurys are yielding 2 percent, suggesting risks are low. We’ve never seen this before.
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If our cost of borrowing goes to 5 percent, where Italy is today, we’ll reach the point where we can’t pay interest and principal. Back in the early 1980s, long-term Treasurys were yielding 14 percent. But the government could handle those high rates, because the debt-to-gross domestic product ratio was less than half what it is now.
At some point, what’s happening in Europe is likely to happen here if we continue on this path. It’s a question of when, not if, unless we do something. Our elected officials love to spend more than we take in and at some point we hit the wall. And we’re relying on foreign creditors to support our low borrowing costs. It’s not like Japan, where domestic investors have financed the government’s debt.
Q. Small-cap stocks have been doing better this year, though it’s early on. Do you think smaller stocks could be regaining favor?
A. Small-caps are a good place to allocate a meaningful part of one’s portfolio, because most investors are looking elsewhere for opportunity now. The herd is going into bonds, or putting cash under the mattress, or something else.
I don’t know if this will be the year for small-caps. But I think it’s a buyers’ market now.