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July 7, 2006 5:55 pm

Mark Sellers: Think big and sell the small caps short

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The past seven years have been tough for the highest quality US blue chip stocks. These companies have, on average, increased earnings by about 80 per cent since 1999. Yet their stock prices are roughly flat over the same period. This has lowered their price/earnings ratios by about 80 per cent, from 33 in late 1999 to about 18 today.

At the same time, small-cap shares have soared. The Russell 2000 index of small cap stocks has outperformed the S&P 500 index of large cap shares in each of the past seven years and is on track to do so again this year. The average price/earnings ratio for the stocks in the Russell 2000 is 36.

In a time-honoured pattern of performance chasing, retail investors have thrown buckets of money at small cap funds recently, using money they have removed from large cap funds. There have been outflows from large cap growth and large cap blend mutual funds over the past three years.

At this point, the pendulum has swung so far that there is a low-risk arbitrage play which should be quite profitable over time: buy blue chip large cap stocks and sell short small cap stocks using the Russell 2000 exchange-traded fund.

You don’t have to run a hedge fund to take advantage of this strategy. Using ETFs and a few stocks, anyone can do it.

Here are a few pros and cons.

According to Morningstar there have been net outflows from large cap blend and large cap growth mutual funds since 2004. This is a rare situation; the average investor tends to contribute a set amount to mutual funds every month through a company savings plan and rarely switches mutual funds. Research suggests it is a contrarian signal.

Several researchers have noted that the valuation discount of large caps compared with small caps is at or near an all-time high. Large caps typically sell at a premium to small caps because large companies can weather economic volatility better and are considered less risky. That is not the case today. Among other pieces of evidence, Credit Suisse recently put out a report stating that “large cap stocks have never looked so cheap against small caps”.

Expected earnings growth will soon slow down across the US economy as the effects of tighter monetary policy move through the system. Large cap stocks have already incorporated this into their valuations; small cap stocks almost certainly have not.

And the last of the pros, if we enter a bear market, small caps should go down more than large caps because they are more volatile, and blue chip companies are seen as defensive safe havens.

Meanwhile, there are some cons. It is impossible to predict with accuracy when an arbitrage opportunity such as this will work out. Small caps could outperform for a year or two. This is unlikely. Small caps do better when the economy is on the way up and monetary conditions are loose. With interest rates rising, and volatility up, it would surprise me if risky assets such as junk bonds and small caps continued to outperform.

As of June 26, the Russell 2000 is already 12 per cent off its all-time high, set on May 5. Perhaps there will be a bounce, and it would be better to wait before entering into this trade. But even after the correction the valuation discrepancy remains glaring between the two asset classes. You may miss a good long-term opportunity if you wait.

Based on this analysis, the long/short arbitrage idea carries pretty low risk and significant upside if you don’t mind waiting. Over time, small-cap valuations have to at least come down to parity with large caps; small caps are riskier, and even if they have faster growth over a long period, there is no reason why they should sell at a higher p/e ratio given the increased volatility of their earnings and their low liquidity.

To use this strategy, take long positions in 10 blue chip stocks and sell short an equal dollar amount of the Russell 2000 ETF. Among others, the following blue chips are selling near multi-year low valuation multiples: Wrigley, Home Depot, Medtronic, General Electric, Amgen, Ebay, Wal-Mart, Microsoft, Dell, and McDonald’s.

Mark Sellers, formerly of Morningstar, is a hedge fund manager with Sellers Capital in Chicago.

msellers@sellerscapital.com

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