Small cap stocks are obliterating the rest of the market and we believe this trend will continue. In this week’s issue we note that the most unlikely of investors are buying small caps and we highlight the sectors that should shine the brightest in the near term.

October 13, 2013
Volume 4, Number 23

The Goldman Guide

Small Cap Kings

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Years ago, a sign that the market had reached a top was when a major mainstream magazine such as Time proclaimed that the market was on fire and clearly poised to move higher. While we are not there just yet, it doesn’t take rocket scientist to see that the Russell 2000 Index is blowing away the   other major indices, with a 31% year-to-date return as compared to say, the Dow Jones Industrial Average, which is up 17.5%.

Interestingly, the valuations are high but not frothy and the best is likely yet to come. In fact, we believe that small caps will continue their run through the early part of 2014. What makes the performance so unique is the fact that ETF and index investing remains such a huge part of the retail and even institutional investing world. Despite this backdrop, a very interesting article in the weekend edition of The Wall Street Journal that quoted some of the leading index investors, along with retail guys who admitted that they still get a rise our of small caps and allocate a small percentage to individual stocks, and oftentimes, they tend to be small caps.

While this isn’t necessarily “new” news, as it was always assumed that even the some passive investors did play in the mall cap world, the outsized gains many have earned likely means that the dollars will remain in this category and could even see additional investment dollars flow in this arena.

Now that we have entered the tail end of October, earnings season is in full swing. Investors should not just focus on companies outperforming EPS estimates this quarter, but should closely monitor EPS estimates and revenue forecasts for the balance of the year and next year.  These are the firms that will truly outperform. Much of the EPS growth has been a result of productivity and margin gains of late, but are not usually sustainable without that top-line growth.

Finally, Google (NASDAQ—GOOG) breached $1,000 price per share last week. For those investors that believe the stock can go much higher, it needs to jump $200 for a 20% gain. At current levels, it trades around 19x FY14 EPS versus say Apple (NASDAQ—AAPL) which trades at $500, or 11.8x FY14 EPS. 

Look, we think Google kicks butt and Apple is in a bit more of a questionable position, but aren’t there other plays that could provide better returns than something trading for $1,000 per share? Growth is slowing to 10% year-over-year for Google so that 19x multiple seems like it will reach that price/valuation ceiling very soon, despite the fact that it has $170 per share in cash.   The bottom line is that even with a 31% return on the Russell, there are a boatload of better plays than Google, from the potential valuation/reward perspective. Thus, small caps still are a compelling place to be.

Looking ahead, we believe that tech and energy may be the top two performing sectors. If the fallout of the government shutdown appears to not have a materially negative effect longer term, than the usual year-end consumer stock run-up could occur in earnest for the balance of the year. We will not have sense of this for a couple of weeks yet, however. As a result, we would be cautious in this sector for the near-term.  Sluggish consumer spending may not derail the market’s increase but it could temper the magnitude of the rise.

Sports fans may have caught news of a sports exchange last week. In our view, it is a really cool idea but it remains to be seen how it is perceived by the investing public. Fantax Holdings, Inc. (https://fantex.com/) has developed a new marketplace where individuals can buy ‘shares’ of elite athletes.  The stock issued by the Company is a tracking stock that is linked to the economic performance and overall worth of an individual professional athlete brand where money is earned from contracts, endorsements and appearance fees. The stock is fully registered and filed with the SEC and the first deal has been struck.

Last week the firm issued its first IPO with Houston Texans running back Arian Foster.  The deal is typical of how the structure will work for shareholders and athletes in the future.  Mr. Foster will received $10 million in exchange for 20% of all future income related to his athletic ‘brand’.  This is an important distinction as the Foster stock could generate income long after he retires from endorsements or personal appearances. Shareholders will own a tracking stock and have no direct investment in the business or assets attributed to the brand contract, associated brand or athlete. Rather an investment in a tracking stock will represent an ownership interest in Fantex, Inc. as a whole. Fantex will operate an exchange and the value of the Foster shares will increase or decrease based on the value of his overall athletic brand and earning potential.

This concept is certainly in our wheelhouse. We are huge sports fans as well as market watchers and analysts. Be on the lookout for additional insight in future editions of The Goldman Guide as this concept could get some real play.

Until next week...