MICRO CAPS IN THE PORTFOLIO ASSET ALLOCATION

The notion of asset allocation has increased in complexity and scope over the past decade. In the beginning it was stocks versus bonds and how much of each was appropriate for a given investor. Over time, many other asset classes were introduced. Oftentimes these other asset classes were recognized because they started out in the portfolios of a narrow group of institutional investors. As the diversification benefit of these asset classes became more widely known, they moved into a larger number of investors’ portfolios. Over time, indexes were created to track the performance of these new asset classes, and the investments became available to an ever larger number of smaller investors.
Real estate is a good example of this asset class evolution. When originally introduced to institutional investors, only the largest and most progressive used real estate in their portfolios. As real estate’s low correlation to stocks and bonds became better known, the asset class found its way into a larger number of institutional portfolios. Over time, no self-respecting fiduciary would have a diversified portfolio if it did not include real estate. The emergence of the real estate investment trust (REIT) asset class over the past 20 years has made it possible for smaller investors to enjoy the benefits of owning an interest in a diversified portfolio of real estate. Now even the smallest retail investors can include a REIT mutual fund among their holdings and have the positive diversification of real estate. In many ways, the emergence of the micro cap asset class will allow smaller investors to benefit from the diversification of venture capital through the inclusion of micro cap investments in their portfolios just as the emergence of REITs as an asset class has allowed a similar diversification into real estate. The largest and most sophisticated institutional investors have allocated a portion of their portfolios to venture capital. A study done by Uniplan Consulting found that as of December 31, 2003, pension plans in the $1 billion to $10 billion range had allocated on average 7 percent of their assets to venture capital. This was down from 11 percent as of December 31, 1999, which was likely the peak of venture capital investing among these institutions, and that peak largely coincided with the peak in technology and Internet investing.

Finance Basics, part 8

It is difficult to see how a company with nothing, promising to do nothing, could be worth $22.9 million. In Spring 2000 it was a tough job explaining market efficiency, let alone rationality. This leads to point number eight. The equity market may be broadly efficient, but that does not mean equity prices are accurate signals of the fundamentals in the economy. This is what is meant by allocational and productive efficiency.

Ideally, high profits in any sector of the economy indicate high consumer demand and the need for firms to produce more. This is the heart of a free-enterprise, competitive economy with the equity market at the heart of this process. High profits end up being capitalized into equity prices, with prices increasing above book value, so that high market-to-book ratios indicate that new investment and production are needed. But what of the Internet bubble? The signals given in the late 1990s were that Internet companies, like E-Toys were really valuable; consequently, broadband communication companies, like WorldCom, were valuable and so, too, the equipment makers, such as Cisco and Lucent. The extremely high valuation on these technology stocks provided the signal to the real economy to expand production in those areas.

Unfortunately, those valuations were not the result of high profits: Consumers had not indicated they were demanding or willing to pay large amounts of money for broadband connections and Internet services. The stock market valuations were not based on financial projections, but a “new age of investing,” and it turns out that those signals were hopelessly wrong. We now have a glut of production in most technology areas and large numbers of bankruptcies. In terms of the signal that the equity market gives to managers, we have to remember that it is a very noisy signal. Unlike the fixed income market, it doesn’t always pay to listen to the equity market.

Point number nine is another corollary of potential equity market deviations from fundamentals, which is that executive stock options are not the panacea that finance people have been claiming in terms of executive compensation. The basic assumption justifying executive stock option grants is that they motivate managers to act like stockholders, and further that managers can, by their actions, influence the value of the firm.

In the late 1990s, during the bubble in Internet and technology stocks, it was quite clear that it wasn’t the actions of the managers that were influencing stock prices. The economic fundamentals of these sectors were overwhelmed by the stock market bubble in prices. As a result, managers at many of the Internet and technology companies were actively exaggerating and fermenting the bubble in their stock prices. For many Internet startups, the first senior appointment was not in finance or marketing, but in public relations, to keep a stream of information coming to the market to hype the stock price.

Clearly, there has to be a realignment of the value of executive stock options as a compensation tool. We can’t just allow firms to award executive stock options and not include their cost in the financial statements. For many firms this practice vastly understates the true cost of their operations and distorts both the labor market and the stock market. Further, the practice of lowering the exercise price when the stock price goes down, so that the executive is guaranteed to exercise sooner or later, removes any coincidence of interests with stockholders, who have no such opportunities.

Finally, point number ten is that corporate financial policy isn’t as important as corporate investment policy. Whatever the firm is doing in terms of its financing – in terms of its debt-equity ratio and of its dividend policy – is of relatively minor importance compared to the fundamentals of actually producing profitable products. This is the classic proposition that earned Professors Franco Modigliani and Merton Miller the Nobel Prize. I would guess that the performance of Enron and the use of special-purpose vehicles has brought home to people that financial chicanery can transfer value, sometimes huge amounts of value, from one group to another, but it does not create value.

Finance Basics, part 7

Point number seven is that even though the equity markets are efficient, that doesn’t mean they’re also rational. We have to understand that there is an enormous amount of noise in the equity market, and share prices are affected by many more factors than bond prices. It is very difficult to pick stocks consistently to beat the market, but that doesn’t mean that those equity prices are set rationally. It is a conundrum that although it is well known that in an efficient market, asset prices fluctuate randomly, this can also happen in an inefficient market: Randomness per se or, alternatively, the difficulty of beating the market, doesn’t in and of itself prove market efficiency.

The basic problem is that sometimes we get bubbles in the stock market. Some academics will go though amazing contortions, rather than face the obvious truth that security prices are set by individuals operating in capital markets and that individuals both individually and collectively sometimes make mistakes, huge mistakes. The central problem is that it is incredibly difficult to form a correct valuation of the equity market. Unlike the bond market, where prices always revert to the bond’s principal value at maturity, there is no “anchor” for equity market values. As a result, equity values can drift off from fundamentals for a long period of time without any certainty of a short-term reversion to their “true” values. So even though the prices are still set in an “efficient” market, and it is difficult to make money, it is not necessarily true that the prices reflect the underlying fundamentals.

To some extent the foregoing remarks are time-dependent and reflect the run-up in the Internet and technology stocks in the late 1990s and their subsequent collapse. With hindsight it is clear that prices were considerably in excess of fundamentals and that the equity market wasn’t rational. However, it was still extremely difficult to take advantage of these opportunities in terms of making money by speculating against the market. Why this is the case has been one of the most controversial topics in finance for the last hundred plus years. This is partly because we have had bubbles in stock markets going back to the Amsterdam tulip mania and the South Seas Company bubble in England in 1720, where famously Sir Isaac Newton lost his fortune and declared, “I can calculate the motions of the heavenly bodies, but not the madness of people.”

Classically trained economists tend to believe that speculation offsets bubbles, so that they can’t exist. If prices get above the fundamentals, then shrewd speculators step in and sell to reap huge profits when prices revert to their fundamental values. If this were true, we would have expected to see professionals selling at the top of the stock market bubble. However, it turns out that this was not the case. Those who should know the most about the value of their companies, the companies themselves, repurchased a record amount of stock in 2000 right at the top of the market!

In 1936 John Maynard Keynes pointed out that professional investors do not speculate in the manner described in classical economics. As he argued:

They [professional investors] are concerned, not with what an investment is really worth to a man who buys it “for keeps,” but with what the market will value it at, under the influence of mass psychology, three months or a year hence.

Keynes himself was a very successful speculator, as well as the most brilliant economist of the 20th century, and was under no illusions as to how financial markets worked. However, even he would have wondered at some of the implications of the Internet bubble. Michael Lewis, the author of Liar’s Poker, pointed out that an Internet company, NetJ.com, had filed statements with the Securities and Exchange Commission with the confession, “The company is not currently engaged in any substantial activity and has no plans to engage in any such activity in the foreseeable future.” The company had $127,631 in accumulated losses and so little money on hand that the directors would have had to chip in themselves to pay any filing costs to raise capital. The only snag was NetJ.com had a market capitalization of $22.9 million!