Tuesday, July 01, 2008

Flight to Quality

Will small cap stocks be left behind on the tarmac? Conventional wisdom holds that in an economic downturn investors abandon small cap stocks in favor of larger companies with strong balance sheets. All industries have down cycles, but only the strongest contenders survive.

It has been a tough year in the U.S. equity market, with comparisons made to the market crashes of 1933 and 1987 among other debacles. The S&P 500 and Nasdaq are down 13.5% and 13.4% since the beginning of the year, respectively. The ultimate large cap barometer, the Dow Jones Industrial Average, has declined by a whopping 16.9%. If the flight to quality argument is in play, we would expect to see an even steeper drop in the small cap indices. However, the S&P Small Cap 600 has faired relatively well in comparison - down 7.4% for the year. The Russell 2000 and Mini-Russell 2000 have declined 9.5% and 11.5%, respectively. Only the much larger Wilshire 5000 - down 12.3% for the year - has recorded losses as deep as the bell-weather S&P 500.

We agree with the importance of a strong balance sheet regardless of capitalization. A low-debt balance sheet and cash flow from operations sufficient to finance growth are key selection criteria for Crystal Equity Research. Consequently, we have some confidence that companies in our coverage universe can weather a period of slow growth without the need for layoff, restructuring or recapitalization.

In my view, it is important to pay as much attention to balance sheets and cash flow statements as it is to earnings per share. Indeed, investors are far too focused on the EPS figure. Reported earnings can still be growing long after working capital accounts and declining cash flow have begun to disclose a deteriorating operation.

The small cap sector may seem like it is out-of-favor based on the various pundits and talking heads on network news programs. However, the indices tell a different story. The flight to quality has been delayed.

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