Small cap value versus growth: Apollo Education versus Sotheby’s
Growth still dominating
The below graph reflects the small out performance of small cap growth shares versus small cap value shares since 2002. Plus, it’s apparent that small cap value stocks held up a little better than small value growth stocks during the financial crisis, and outperformed growth shares during the recovery into 2010. However, with the exception of mid cap stocks as noted earlier, both small cap growth shares and large cap growth shares have continued to outpace their value peers the past two years. This article considers the outlook for value versus growth shares and the prospects for value versus growth in a potentially weakening consumption environment.
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For a detailed analysis of the U.S. macroeconomic environment supporting this series, please see Must-know 2014 US macro outlook: The crack in the debt ceiling.
Small caps: No shortage of risk and activists
Unlike their large-cap and mid-cap counterparts, small-cap companies have some unique risk factors. Apollo Education and Sotheby’s are two companies that are no exception. Small cap growth companies, like Sotheby’s (BID) can be vulnerable to activist investors. Hedge Fund activist Dan Loeb of Third Point holds a 9.2% stake in Sotheby’s, with a total market cap of $3.09 billion. In the case of Sotheby’s, perhaps this activism will increase the share price. Given Loeb’s approximate $300 million investment in Sotheby’s, it’s no wonder that he’s been (so far unsuccessfully) seeking to install his own board nominees. However, hedge fund managers who don’t like what they see or get can just as quickly turn on their investments and short them with equal vigor and conviction. As Sotheby’s has declined nearly 20% so far this year, despite a strong 2013 performance with quarterly earnings growth up 37.30% year-over-year, you have to wonder what’s taking the wind out of this growth stock. Perhaps a disgruntled activist investor—or simply speculators who follow the activist drama with exceptional insights or information.
University of Phoenix: Political football
Similarly, Apollo Group’s acquisition of the University of Phoenix in 2011 appeared to be a great investment in a value stock with great growth potential. Since 2012, Apollo Education (APOL) had fallen from $55 per share to $16 per share, though it has recovered to over $30 per share. Not only has enrollment in the University of Phoenix declined since 2011, but the very issue of using federal student loan monies for tuition purposes has become a political football. Truth in advertising surrounding the value of an online education is an important political issue that became politicized during the financial crisis, when the Federal budget deficit reached record proportions. However, now that the Federal budget deficit is improving in conjunction with the labor markets, perhaps the hard data on the University of Phoenix university degree has become an issue lobbyists have been able to smooth over. On the other hand, for profit institutions like APOL could continue to see regulatory pressures to disclose the economic value of their degrees, and the availability of Federal student loan revenues could become an issue in the future.
Morningstar small cap value holds Apollo Education (APOL) as number 15 in its index, at 0.71% of holdings. Apollo Education has a market cap of $3.63 billion, a 2015 forward price-earnings ratio of 17.24, a 19.21% return on equity, and total debt of $6.26 billion on $719 million in earnings before interest, taxes, and depreciation, or EBITDA, reflecting some leverage—though nothing like Caesar’s Entertainment (CZR) which has an EBITDA of $1.64 billion on over $21 billion in debt.
Sotheby’s (BID) has a $3.09 billion market cap, with EBITDA of $242 million on $518 million debt, though it holds $721 million in cash. Sotheby’s doesn’t have a high level of debt, and with a profit margin of $15.23%, it would seem to be in a position to finance growth. This type of company might be vulnerable to activist shareholders who would like to utilize Sotheby’s cash position and fairly strong earnings stream to borrow more money and add to debt in order to finance growth. While Sotheby’s management is likely to be cautious on taking on more debt to finance growth, as the ability to service debt could be weak in a soft economic environment, activist investors are often interested in taking the risk that comes with higher levels of debt.
While consumption may remain soft, as reflected in the University of Phoenix enrollment level of 173,000 in the last fiscal year, versus the 2010 peak of 371,000, it’s important to note that small cap stocks—both value and growth—can be influenced by many factors other than simple economic growth numbers. Regulators and activist investors can impact stock prices much more quickly than simply a little soft economic data. Plus, activist investors that may seek to add to a company’s debt level may also have a tendency to add risk or return to a stock, though if they add to a company’s debt level, they can lower the credit quality of the company’s existing bonds. This dynamic can pit risk embracing-equity holders who want growth against the interests of risk-averse bond holders who seek earnings stability. This is simply the age-old tug-of-war between equity and fixed income investors.
To see how overall economic growth numbers are driving equity prices, please see the next article in this series.
Equity outlook: Cautious on China’s rate collapse and Russia
Tensions in Ukraine have led to a 20% sudden drop in the Russian stock market. China’s Shanghai composite index is also down 20% from its 12-month peak. The VIX volatility index in the USA has risen from its 15% lows earlier in the year to near 17.0% currently. This is still a fairly low level of volatility in the U.S. markets, as VIX volatility is quite normally within the 12%-to-20% annual volatility range. However, it should be clear that the volatility in the U.S. markets is driven by the tensions in Ukraine and evidence of some deterioration and oversupply in China.
In China, recent announcements of the bankruptcies of Chaori Solar and a trust investment portfolio loan of $500 million to Shanxi Energy raised concerns that China’s shadow banking system is coming under increased pressure. With China’s ICBC bank letting Trust product investors take the losses on this 10.% coal company loan, it might appear the speculatively inclined Chinese investor on the mainland is getting a lesson in credit risk—just as Chinese investors in Hong Kong did in 2008, when they invested in Lehman Brothers–structured investment products. This should keep the speculative investment climate a bit cooler in China.
China’s short-term interest rates plummet
While the allowed defaults in China should cool speculative investing, the China Central Bank has also been careful with interest rates in order to rein in speculative lending. The summer of last year saw the seven-day benchmark lending rate spike over 10.0%, with a run to near 9.0% at the end of 2013. Currently, the seven-day repo rate is at 2.50%. With the specter of shadow banking default looming in China, the Central Bank, since the beginning of 2014, has ensured ultra-low interest rates. Cautious investors could see this as a somewhat extreme level of credit market facilitation on behalf of the China Central Bank, suggesting that the Central Bank may be quite nervous about potential credit market contagion.
Given China- and Russia-related uncertainties, investors may wish to consider limiting excessive exposure to broad equity markets, as reflected in the iShares Russell 2000 Index (IWM), State Street Global Advisors S&P 500 SPDR (SPY), Dow Jones SPDR (DIA), and iShares S&P 500 (IVV). Accordingly, investors may wish to consider shifting equity exposure to more defensive consumer staples–related shares, as reflected in the iShares Russell 1000 Value Index (IWD).
Equity outlook: Constructive
Despite problems in Ukraine and China, and despite modest consumption data in the USA, U.S. labor markets appear to be well into recovery—with the exception of the long-term unemployed. From this perspective, it would appear that the U.S. is probably the most attractive major investment market at the moment. While the fixed investment environment of the U.S. is still quite poor, corporate profits and household net worth have hit record levels. Hopefully, all of this wealth and liquidity can find their way into a new wave of profitable investment opportunities and significantly augment improvement in the current economic recovery.
For investors who see a virtuous cycle of employment, consumption, and investment in the works, the continued outperformance of growth stocks over value stocks could remain the prevailing trend, favoring the iShares Russell 1000 Growth Index (IWF) and growth-oriented companies such as Google (GOOG) or Apple (AAPL).