Small Cap Value stocks outperform Large Cap Growth stocks

Small Cap Value stocks comprise one of the best (if not the best) performing types of stocks for the long haul. As you probably remember, between 1995 and 1999, Large Cap Growth stocks were all the rage and Small Cap Value stocks were shunned like an ugly step-sister. However, since 2000, Small Cap Value stocks have outperformed their Large Cap Growth peers by over 100%.

I performed a little bit of Internet research and discovered that between 1926 and 2004, Large cap Growth stocks had an average annual return of about 9.26%. Accordingly, $10,000 invested in Large Cap Growth stocks in 1926 would have grown to about $10 million by 2004. That's not too shabby. However, it pales in comparison to the astonishing 15.9% annual return of Small Cap Growth stocks over the same time period. $10,000 invested in Small Cap Value stocks in 1926 would have grown to about $1 billion by 2004!

Here's an illustration of these returns that was in the New York Times last year:



For those interested in investing in Small Cap Value stocks, I recommend the Vanguard Small Cap Value index fund (symbol: VISVX) or the corresponding Vanguard ETF (symbol: VBR).

"Periodic Table" of equity style investment returns from 1985-2004

I recently found a "Periodic Table" of equity style investment returns from 1985-2004. The Periodic Table lists the annual returns for various types and styles of equity investments during the 1985-2004 time frame, as shown below. Specifically, annual returns are included for the following types and styles of equity investments: (a) S&P 500; (b) S&P/Barra 500 Growth; (c) S&P/Barra 500 Value; (d) Russell 2000; (e) Russell 2000 Value; (f) Russell 2000 Growth; (g) MSCI EAFE; and (h) the Lehman Brothers Aggegrate Bond index. (Click on the image below to see a larger version of the Periodic Table.)



*** I have written a new post with results from 1989-2008.

Pfizer raised its quarterly dividend by 26% this week!

Early this week, Pfizer announced that it was raising its quarterly dividend by 26%, from 19 cents per share to 24 cents per share. With Pfizer currently trading at about $22.70 per share, its annual dividend payouts will be 96 cents, giving it a dividend yield of just over 4.2%! Even though Pfizer's stock (symbol: PFE) is trading around where it was in 1997, its forward PE is a mere 11, about than 1/5 of what it was in 1998.

Even if Pfizer's earnings don't accelerate in the next couple of years, it is still the 800-lb gorilla of the drug industry, generating billions of dollars in free cash flow and spending upwards of $7 billion on R&D annually. If nothing else, its dividend makes Pfizer look extremely attractive to me. Also, Pfizer has a long history of raising its divdends each year, so the annual dividend payouts should keep rising every year.

I think Pfizer's a steal at just $22.70 per share.

The Templeton Russia & East European Fund

A couple weeks ago I wrote a post about how closed end funds are the best way for small investors to invest in certain foreign markets such as Russia and India, countries for which no country-specific ETF currently exist. Anyway, I decided to look at some statistics for the Templeton Russia & East European Fund today at ETF Connect, when I noted that the fund's average annualized 5-year return through the end of Nov. 2005 is 44.15%! That works out to an ubelievable total gain of about 522% over the past 5 years. I find that to be absolutely astounding. At the end of October I purchased shares of this fund for my Rollover IRA. Too bad I didn't purchase shares way back in 2000...

The MSCI EAFE index is the "S&P 500" of foreign stocks

ETFs and mutual funds investing in foreign stocks have become increasing popular over the past 3 years or so. For example, the iShares Morgan Stanley Capital International, Inc. ("MSCI") Europe, Australasia Far East ("EAFE") index ETF (symbol: EFA) has attracted some $20 billion+ in assets in just a few years, while the MSCI Emerging Markets index ETF (symbol: EEM) has attracted around $7 billion in assets since its inception in April 2003.

The MSCI EAFE index is the less volatile of the two. The MSCI EAFE index tracks the stocks of foreign developed markets. Accordingly, these stocks should be less succeptible than emerging markets stocks to currency devauations, lawlessness, etc.

Its assets are divided between a number of European, Asian, and Australian stocks. As of the end of June 2005, close to 25% of its assets were invested in UK stocks, 21% were invested in Japanese stocks, 9% were in French stocks, close to 7% were in German stocks, another 7% were in Swiss stocks, and close to 6% were in Australian stocks.

The MSCI EAFE index has slightly outperformed the S&P 500 over the past 10 years, returning about 1% more annually over the past 10 years. We've been hearing much about the inevitable decline of the U.S. dollar relative to foreign currencies lately. In the event that does eventually happen, there's a strong likelihood that foreign stocks will outperform domestic ones. Accoridngly, an ETF or mutual fund tracking the MSCI EAFE index is a good addition to an investor's portfolio.

For those who enjoy dollar-cost-averaging, ETFs may not be the best investment vehicle, seeing as how commissions must be paid to acquire the shares on a stock market exchange. Luckily, however, Vanguard offers a low-cost index fund, the Vanguard Developed Markets Index fund, that tracks this index. The Vanguard fund has a low expense ratio of about .29%.

Closed-end funds are the best way for the common man to invest in Russia and India

There's been a lot of talk over the past few years about the benefits of investing in Exchange Traded Funds ("ETFs"). Financial writers and advisors tout their tax efficiency, low cost, and instant diversification as several reasons to buy.

Unfortunately, there are a number of market segments for which no good ETFs currently exist. Those include some emerging foreign markets such as Russia and India. Both Russia and India are supposed to be two of the fastest growing economies over the next several decades. It would be nice if there was an ETF that would invest in stocks in each of these countries. Unfortunately, acording to ETFconnect, there is no such ETF right now. However, there are a couple closed-end funds investing in each of these markets.

The best Russian stock market closed-end fund that I've found is the Templeton Russia and East European Fund (ticker symbol: TRF). This fund has been around since 1995 and returned an annualized 20.10% for the 10-year period ending on 10/31/05. However, this fund is not for the faint of heart - although it has had huge gains, such as in 1999 when it gained 133.57%, it has also had huge losses, such as in 1998 when it lost 74.65% when Russia had a currency crisis.

The best Indian stock market closed-end fund that I've found is the Morgan Stanley India Investment Fund (ticker symbol: IIF). This fund has been around since 1994 and returned an annualized 19.09% for the 10-year period ending on 10/31/05. However, this fund is also very volatile - it returned 144% in 1999 after losing 11% and 14% in 1997 and 1998, respectively.

As with all closed-end funds, these do charge higher fees than most ETFs - usually over 1% of assests. Moreover, closed-end fund can also trade at a discount to their underlying net asset values.

***Update - August 7, 2007***
Since I wrote this article back in 2005, a low cost Russia stock market ETF and an India stock market ETN have been introduced. I discussed both the Russia stock market ETF and the India stock market ETN in 2007 posts.

Powershares has a wide assortment of interesting ETFs

I first heard about the Powershares brand of Exchange Traded Funds (ETFs) about a year ago. Powershares is an investment company that provides a wide assortment of ETFs that track various segments of the stock market and attempt to beat their peer ETFs and mutual funds.

Most of their ETFs track various "Intellidex" indicies. Intellidex indicies track market segments such as Small Cap Value, OTC stocks, and the market as a whole. Powershares doesn't divulge the intellidex parameters, but it does publish a list of the stocks in each of their ETFs on the Powershares website.

My personal favorites are the SmallCap Value, OTC, and Dynamic Market ETFs. Accordingly to Powershares, the SmallCap Value Intellidex has returned 19.49% annually over the past 10 years and 24.18% annually over the past 5 years. The website indicates that the intellidex for the Dynamic Market ETF (which is designed to beat the S&P 500) has returned 15.26% annually over the past 10 years and 9.04% annually over the past 5 years. The website further indicates that intellidex for the Dynamic OTC ETF (which attempts to beat the Nasdaq composite) has returned 16.45% annually over the past 10 years and 1% annually over the past 5 years.

The U.S. Dollar has to eventually weaken

The U.S. Dollar has appreciated (i.e., strengthened) relative to foreign currencies so far this year. However, in the long term, the U.S. dollar has to weaken. There's absolutely no doubt that this will happen. When it does happen, foreign-denominated assets such as foreign stocks should outperform U.S. stocks for some period of time.

The U.S. has been running trade deficits since the 1970s. However, the trade deficits have been accelerating in recent years. This year alone, the U.S. trade deficit is projected to exceed $700 billion. This means that the U.S.'s imports exceed its exports by $700 billion.

With U.S. dollars in hand, the foreigners can either exchange the dollars for another foreign currency or invest the money back in the U.S. by purchasing U.S. assets. For example, much of the dollars are invested in U.S. treasuries or in the stock market. This is probably because interest rates are higher in the U.S. than they are in other parts of the world. Accordingly, foreign investors are currently getting a good return on their invested dollars.

However, at some point this will have to end. In the nightmare scenario, the dollar begins depreciating (i.e., weakening) until froeign invesotrs decide that enough is enough and start quickly selling off their U.S. assests, accelerating the dollar's depreciation. As the dollar depreciates, the cost of imports will likely rise, resulting in strong inflation in the U.S. and causing either a recession or possibly even a depression.

To hedge one's bets, one can purchase foreign stocks and hope for the best. However, if a depression does occur, foreign stocks and foreign economies would likely also suffer, as the U.S. is a big source of revenue for foreign economies. So a good alternative investment may be gold, the universal money.

Maximize your money market interest income

Anyone who has at least a couple thousands dollars laying around should consider opening an online money market account to maximize their interest income. Emigrant Direct currently pays 4% on its money-market account and requires no minimum balance. ING Direct offers 3.5% interest on its money-market account and also fails to require a minimum balance. Another good thing about these accounts is that both are FDIC-insured up to $100,000. The only real catch is that you have to electronically make deposits/withdrawals to/from the account. For example, you can electronically transfer money between your banking institution and your online account. This is no problem and is similar to the direct deposits that many people make with their paychecks into their bank account.

"Value Investors Flock to Microsoft"

There is an interesting article today in the Wall Street Journal about how Microsoft is now viewed as a good value play.

The "FED Model" theory of equity valuation

The "FED model" is a popular yardstick for judging whether the stock market is fairly valued. This term was coined by Prudential Securities strategist Ed Yardeni after a Fed report to Congress in July 1997 suggested the bank was following it.

The FED model compares the yield of the 10-yr govt bond to the "earnings yield" of the S&P 500. The "earnings yield" is defined as the inverse of the forward P/E ratio of the S&P 500. As of the market close today the S&P 500 is trading at 1230.96 and the projected earnings for 2006 of the components of the index are $78.30. The forward P/E ratio for the S&P 500 is therefore about 15.72 (1230.96/$78.30). The inverse of the forward P/E ratio is E/P, known as the earnings yield. In this case, (1/15.72) is .0636, or 6.36%. As of market close today, the yield on the 10-yr govt. bond was 4.564%.

In theory, the yield on the 10-yr bond is equivalent to the different between the earnings yield and the risk premium (i.e., because stocks are riskier than bonds the earnings yield should ordinarily be less than the yield on the 10-yr bond). In this case, 4.564% = 6.36% - Rp (risk premium). In this case, Rp is 1.796%. Between 1994 and 2003, the average risk premium was 0.11%. Therefore, the current Rp of 1.796% is a very bullish sign and signals that it's probably a good time to buy.

During the stock market bubble, the risk premium was around -2% or worse - i.e., investors bid up stocks to great highs because stocks were actually viewed as being less risky than bonds. Today, on the other hand, investors are completely shunning stocks and invest their money in bonds instead.

CAVEATS

Although the FED model is useful, it does have its flaws. For example, the earnings yield is based on projected earnings, and it's always possible that the economy could go south and those projections will not be met. Moreover, this model only addresses the relative (not absolute) valuations of stocks and bonds. Stocks do not necessarily have to rise for Rp to decrease; instead, stocks could stagnate while bonds decrease in value.

The S&P 500 index is undervalued

The P/E ratio of the S&P 500 is near a 10-year low. According to Standard & Poor's, the total reported earnings through 9/30/05 for the sum of the components of the S&P 500 was about $67/share. As of today, the S&P 500 index trades at about 1220. Accordingly, the trailing P/E ratio of the S&P 500 index is about 18.21 (1220/$67). The last time the trailing P/E ratio was this low was 10 years ago, at the end of 1995 when it was about 18.14 at the end of the Dec. 1995 quarter.

While the trailing P/E is attractive right now, the forward P/E looks even better. Standard & Poor's projects the earnings on the index for 2006 to be about $78.30, giving a forward P/E ratio of about 15.58 (1220/$78.30).

Is this a "buy" signal? I sure think so. Stocks have recently been weighed down by high energy prices and a FED that has been steadily raising short-term interest rates. However, consumer price inflation is still relatively low by historical standards. Moreover, relative to bonds, stocks look extremely attractive. The yield on the 10-yr US bond has recently risen sharply to 4.67%. In other words, despite the recent rise in bond yields, they are still priced as though there is no heavy inflation on the horizon.

Accordingly, I am led to the conclusion that stocks are due for a strong rally. Although corporate profits have been strong for several years now, stocks haven't done much since their strong surge in 2003. So I think that a rally is long overdue. It would not surprise me to see a 30% year-over-year rally in the S&P 500.

Selling stocks short

I first became interested in investing when I attended college during the mid-1990s. I read such seminal classics as One Up On Wall Street and Beating the Street by legendary Fidelity mutual fund manager Peter Lynch. During the course of my recreational reading on the subject I learned all about long and short positions. A long position in a stock is one in which the investor owns the shares themselves. A short position, on the other hand, is one in which the investor borrows the shares from another investor and then sells them, making money if the shares drop in value.

Although the concept is not difficult to understand, I had to do some sleuthing on my own before I really figured out what takes place during a short sale, as I discuss below.

(1) The investor must initially instruct his brokerage house to sell short shares of a stock.

The investor can only sell stock short if the investor has a "margin" account. A margin account is one in which the investor can borrow against his current holdings to purchase addition shares of various securities and sell short. A "cash" account, on the other hand, does not permit such borrowing or selling short.

(2) The brokerage house borrows the shares from another investor's account.

This is the part that isn't straightforward. That is, why can a brokerage house borrow shares from another investor's account? The brokerage house can only borrow shares from another investor's account that are held in "street name," i.e., in the name of the brokerage house. Most stock purchased nowadays is held in street name. This makes it much easier to sell the shares. If the stock were held in the investor's name instead of in street name, the invesotr would have to physically deliver the corresponding stock certificates to the brokerage house before selling such shares. However, if held in street name, the shares are already at the brokerage house's disposal.

The reason why the actual borrowing takes place is because a settlement must occur three days after a trade is made. This is known as the "T+3" rule. That is, three business days after a trade is made, the seller must deliver the shares being sold and the buyer must deliver the corresponding money for the shares.

The investor from whom the shares are borrowed can still sell his shares, and the investor's will reacquire the shares and the short selling investor's brokerage house will borrow the shares from a different investor.

(3) The investor buys back the short shares to "cover" the position.

After selling shares short, the investor has to eventually repurchase the shares to close his position in that stock. An investor with a long position makes money by first buying shares at a low price and then sell the shares at a higher price. A short seller makes money, on the other hand, by first selling the shares and then buying back the shares at a lower price at a later date.

CAVEATS

There are some caveats to short selling. First, if the price of the shares sold short keeps rising the investor can quickly lose a lot of money. Second, the investor's short position may be closed at any time such as, e.g., if the investor loses too much on the position relative to the investor's other holdings in the account. The short position may also be closed if the investor from whom the shares were borrowed decides to sell and the shorting selling investor's broker cannot find another investor from whom to borrow the shares.

Anyone considering selling a stock short also needs to be aware that the investor is responsible for paying dividends to the investor from whom the shares were borrowed. For example, assume that investor A borrows 100 shares of MSFT from investor B, and then sells the 100 shares to investor C. In the event that MSFT declares a dividend, investor C will receive the dividend directly from MSFT. However, investor A will have to pay investor B an amount of money equal to the value of the declared dividend.

Hello

Welcome to my blog. This blog is directed to finance and investment-related topics. Feel free to leave comments and I will respond accordingly.

- Jim