Small-Cap Fund Manager Showing Them How It’s Done

Small Cap Funds

We don’t even consider beating 99% of your peers with a fund even meaningful, if your peers are weaklings. Eddie Brown’s small cap fund takes them all on though.

At first glance, seeing remarks like a fund beating a high percentage of its “peers” has us grimacing a little, feeling bad for all those investors who fall prey to this commonly-used tactic designed not to inform, but to use a very thinly-disguised attempt at foolery.

A lot of people fall for these things, even though we would think that the first thing people would want to ask is how this fund who is puffing out its chest so much measures up overall. Maybe it beats 99% of the certain fund category that they are in, but the category itself may be riddled with poorly performing funds where your fund can perform poorly and still measure up well, perhaps even beating every single one of these so-called peers but still stinking.

This goes for comparing against indexes as well, and while we may think that it may not be fair to measure a small-cap fund against bigger opponents, we should want to be in the best performing funds and if a small-cap fund cannot beat large cap funds or large cap indexes, we need to ask ourselves while we would ever pick a fund that compares poorly.

There are reasons why investors are attracted to smaller cap funds, and they all have to do with the promise of better performance. If a fund fails to deliver this, there just isn’t any reason why people should be investing in it, unless lesser returns is actually the goal, or if they are confused by the need to diversify with these funds and see this as an end in itself.

We can never just look at diversity in isolation, even though we still may want to account for the potential need for it. What diversity seeks is to spread the risk around more, which first requires that we look at how well it may do this and then calculate what price we will pay in lesser returns for this feature.

Without the consideration of diversity, we would just select the investment with the best potential and put all of our money in that, although that’s not always the best way to go, because that may expose ourselves to too much stock risk. Tesla would be a good example of how we should consider such risks carefully, where the potential for this stock to lose a lot of value is higher and the company may hit a snag and this additional risk may hit home if it plunges on account of something.

A stock like Apple may be suitable enough to do this with though, and this all has to do with measuring risk over time, not just look at its volatility. Stocks this reliable are not plentiful though and people still and almost certainly would want to mix in some other stocks, probably a lot of them, probably way more than it would make sense to, and when we do that, we need to look at both the benefits and costs involved to get any sort of sense of whether we are doing the right thing or acting without thinking enough.

Doing this need not involve any sort of advanced calculation, and although there are some to use, we really haven’t even come up with a good formula for this, although we can get by well without one by just following sensible principles.

The truth is that risk calculation is too complex and too individualistic to come up with a one size fits all formula for this, and the tendency with the calculations that we use for investments tend to not make very good assumptions and end up not all that useful for our purposes. Among the problems with the commonly-used Sharpe ratio is that uses treasuries as the benchmark for risk-free return, which we should actually find comical because the returns with treasuries are far from risk-free, and the virtually risk-free part applies only to default risk, not return risk.

While there are other problems with this, when the foundation of your formula is based upon such a blatant error, this is going to contaminate the entire calculation, where we don’t even need to worry about how appropriate using standard deviations are, or why we only apply this statistical calculations to the excess return over the so-called risk free return when we’re actually supposed to be measuring risk.

This at least tries to use return prominently when trying to measure risk, which puts it well ahead of the way we usually understand risk, without even thinking of return much, but we don’t want to be relying so much on return without considering risk enough, like this formula does.

Even if we had a good formula, we don’t require any great amount of accuracy to decide this, although if we did have it and people used it, they would surely see that they are overdiversifying by incredible amounts. Just wanting to own all 500 components of the S&P 500 would put us over the moon because there are so many bad stocks in there that are well beneath any reasonable threshold of diversity benefits that need to be simply excluded.

Investors love the easy though and it’s just too easy to buy shares in an index, and they may want to throw in several more, and even mix it up with categories of funds such as those by market capitalization, sector, type of investment strategy, stocks from other countries, different types of bonds, and on and on.

While the minimal amount of diversity with investments is just one, the maximum is owning everything you can, from penny stocks to commodity funds, but this does not provide the ability to distinguish between the good and the bad, what good investing is all about. Good investing means holding good investments, not just any investment, and not poor investments either.

The idea here is to add enough diversity to bring down the real risk of investments while not giving up too much to do it. The article that we did on the biotech sector really makes this transparent, where ideally you would be investing in all the more promising biotech stocks out there, and not necessarily just the ones in a particular index, because there will likely be some of your more promising selections that may make a breakthrough and take off, but you’re not sure which ones.

We can use the race for a COVID vaccine as an example. We don’t really want to go with all the companies in this race, as some will have too little of a chance, but going with the more promising stocks allows us to hedge our bets and provide ourselves with a better opportunity to do well, provided that the dogs on the list who probably will hurt rather than help if they don’t win, and likely won’t, aren’t in there to drag down our potential.

With a stock like Tesla, it’s not hard to find something that will add more stability to this wild child, but we don’t want to be picking stocks like Ford or GM either, because the price measured by the differential in performance would be way too high. The task is one of finding the right balance between performance and stability, although that’s far from the task that people use, instead treating this like a shopping spree where they fill their cart with all sorts of shiny and not so shiny things in a way that could only be described as mindless.

Someone might own shares in the S&P 500, and then think that since this is a large cap index, why not throw in some indexes of different sized market capitalization? They may see a small cap one and think that variety is the spice of life they say and toss that in our cart as well.

Just like we wouldn’t add Ford and GM to Tesla in our cart without having a look at them, we should never diversify without at least having a good idea of what they put into these things and how they run.

People who sell funds hope we won’t though, and their telling us how funds compare within the narrow category that they are in assumes that we don’t care. If you want a small cap fund and this is a good one, they will ring it in for you.

Our Funds Need to Deliver Performance First and Foremost

Small cap funds are quite inferior generally, inferior enough that just looking at the label and not even the ingredients should have us tossing them back. If the Nasdaq simply clobbers you this much, and goes down even more in the bad times, they would simply be a terrible choice.

We will compare the results of certain categories of funds from time to time, just to give people a sense of how they measure up, including small caps, and small caps come out very badly generally.

However, this does not mean that all small cap funds are like this, and while we regularly bash them, Eddie Brown’s small cap fund deserves praise instead, as this is one of the most solid funds out there, bar none, and we cannot ever afford to bar any.

The fact that Brown is doing this with a small cap fund is all the more impressive, because give that small cap stocks don’t do anywhere near as well overall, you have to be really good to find the gems since there are so much fewer gems in this category.

The fund in question is called the Brown Capital Management Small Company Fund (BCSIX), and big things do come in small packages sometimes. There is actually more potential for growth with small companies over larger ones, if you really pick the right ones that is, but t’s just harder to pick the right ones with this type of stock.

The biggest factor in this and the one people totally miss is the fact that stocks go up from investor demand, and stocks that few have ever heard of just won’t be attracting as much as an Apple or the other famous companies that are driving large cap indexes these days.

People who think that this doesn’t matter and believe instead that business results are the only thing that moves stock prices will find themselves kicked to the curb particularly with smaller stocks, because while this correlates poorly with large caps, the correlation is even poorer with small caps.

The small caps that both do very well and attract enough interest do have real potential, although it takes more skill to figure all this out then just going with the names you know. It is not that this should be anywhere near as challenging as this is in practice, if these people knew how to use charts, but they prefer strategies that are set up to fail by poring over fundamentals and then wondering why the stock price isn’t playing nice.

We are not in the least bit impressed by a fund beating 99% of its small-cap peers, or even that impressed with a fund boasting that they beat the S&P 500, but if you can hang with the much better performing Nasdaq, the king of the broad indexes, that deserves a bow. Brown does.

In the left corner, we have Brown’s BCSIX, the challenger, and in the right corner sits the ETF for the Nasdaq 100, QQQ, the current belt-holder. Funds don’t even take on QQQ, they instead look to pick on its smaller brother, SPY, the ETF for the S&P 500, even though so few funds in general beat SPY consistently, and especially not small cap funds who are for the most part out of their weight class in such a bout.

Brown’s fund is feisty enough to want to put it in an actual title match though, which are the only ones that should ever count. Funds should be embarrassed, not proud, to beat little brother but lose to big brother, since this is about who we should be betting our money on.

Those who wish to invest in a small-cap fund need to make sure that the fund comes at least close to the champ in terms of results, because the benefits of this as a hedge are pretty negligible. It never makes sense to look to mitigate risk by adding more, and a significantly poorer return rate raises, not lowers the risk of your not achieving your goals.

The QQQ throws its first punch, their mighty 10-year return of 18.96%. This would in itself knock many opponents out, and clearly pounds SPY’s 13.04%, and QQQ is especially tough on lighter fighters such as BCSIX. When the little guy swings back with 17.28%, we have a real fight on our hands.

We can’t just look at one timeframe though as we have to see how the fight progresses as we look at more recent results. Over the last 5 years, QQQ has an annual return of 17.32%, BCSIX comes in at 15.54%, compared to SPY’s 9.77%. BCSIX isn’t quite keeping up with the champ, but they sure are laying a beating on SPY.

QQQ’s 3 year is 19.23%, BCSIX is next with 16.56%, and SPY once again lags the field with its 10.15%. QQQ does finally deliver a big enough blow to stagger BCSIX a bit with QQQ’s 35.30% compared to BCSIX’s 20.18%, but the Nasdaq has performed famously over this time and increased their lead over the other indexes considerably, and not keeping up with this pace isn’t anything to be ashamed about. Going with SPY’s only 12.84% might be though.

In spite of being rocked, BCSIX delivers a surprising punch to the head of QQQ with their 3-month return of 17.64% versus QQQ’s 13.63%. SPY really lags the field this time with their paltry 3.35%. BCSIX follows this up with a year-to-date return of 11.29%, besting QQQ once again who has had to settle for just 9.99% thus far in 2020.

We Need to Account for Risk to Measure How Reliable our Performance Is

Brown’s fund keeps up pretty well in the return department, but we also need to look at the risk side as well. This is where QQQ really shows its pedigree, where it is not really any more volatile than the “market,” which people use SPY as the benchmark, while delivering considerably higher returns.

It is amazing how so many investors assume QQQ is considerably riskier than SPY and this is by far the biggest reason why they see SPY as preferable and are willing to accept lower returns from it. This is because they don’t bother checking and just believe the rumor.

Looking at beta, the tendency for an investment to drop certain amounts during lean times, represents the part that we may need to hedge, although the part people miss is that there are two ways to hedge this while staying in, by having it offset by lower beta investments and by it offset by internal performance, and we need to look at both to determine the real risk of an investment. There’s also hedging by simply getting out when risk rises too much, which we do not want to exclude just because we may be that lazy or that afraid to act.

The way to view this is to look at not only how far something has fallen not just relative to where it was at the top of the mountain before the descent, but to also look at the mountain range it travels in to see how well it gains altitude over time. If your valleys end up higher, where you drop to points that still have you ahead nicely, even having the misfortune of getting out at the bottom is still going to have you looking good, where with investments that don’t climb as well, you will be more subject to exiting at a lower altitude, which is what we worry about when we consider risk.

This effect is why QQQ is actually considerably less risky than SPY even though their betas are around the same. They give up similar amounts during pullbacks, but QQQ starts higher up on the mountain and their valleys also tend to be higher over time, and when the bears come, they give up about the same amount but have so much more to give.

For example, if we put a given amount of money in both, and know that both will drop at various times, and we’re not just concerned about how much we give up during these events, we also need to view the running total. If both drop by 20%, and SPY has gained 20% prior to this, they give it all back. If QQQ instead gains 30%, this leaves us with 30% to give instead of just 20%, and that’s why QQQ is less risky overall when you look at risk dynamically as we need to.

Small caps are famous for having higher betas, and combined with their typical lagging performance, they don’t make enough in the good times, have less to give up during the bad times, and also give up more during these times. That’s a prescription for a bad investment overall and especially in terms of the risk side.

BCSIX’s beta is in Apple territory, although Apple more than makes up for this by way of its growth, having way more to give when we get these pullbacks than QQQ or just about everything else, and if people misunderstand the relative risk of QQQ, they really get lost with Apple and other high flyers that grow so much and so reliably.

BCSIX keeps up with QQQ as far as building this buffer, but does definitely drop more. We can really see this play out by taking a certain point in time, like March 2014, and see how the subsequent valleys compare to this reference point.

BCSIX got hit particularly hard by the bear market of late 2018, dropping by 56% versus the 21% that QQQ fell and the 20% that SPY declined by. From March 2014 until where they were in September 2018 before the bear struck, they had gained 62%, and gave up all but 4% of that, coming this close to going underwater.

In March of this year, they managed to go all the way and drop a little under the water, where we dipped a little below where we were 6 years ago. At the bottom of the 2018 move, QQQ was still up 67% from its March 2014 level, and in March of this year, their lowest point had them up 93% over those 6 years.

BCSIX beats SPY handily in the returns over time department, but they can’t keep up with it on the risk side, where from our reference point in 2014, SPY still had 37% to give at the bottom in 2018 and 17% at their lowest point in March, although these much smaller numbers really show how much riskier this is than QQQ.

We don’t just want to cast BCSIX into the dungeon that just about all small cap funds belong in just from this, as the risk side can be managed, and as long as we get good returns we can just step aside when the weather turns bad. We need our investments to perform well at least some of the time though, and if your fund is crappy during the good times and crappier during the bad times, that’s just a bad idea, but if it does well during the good times and you can avoid a lot of the pain of the bad times, now we’ve at least got something we can work with.

While we may prefer the easy road, just buying and holding these funds, we do not want to be so obstinate that we choose to hurt ourselves during times when the market has big decline written all over it and allow ourselves to bash otherwise good strategies and ourselves with our inability to act. BCSIX may not be an all-weather fund like QQQ, but it does well enough when the sun is shining to beat the pants off of SPY and keep up very well or even beat QQQ at times, while allowing us to add a little diversity as well.

This one had to be decided on points, and while QQQ won the bout, BCSIX was a very worthy opponent overall and much more so than SPY and virtually all other actively managed funds, and just about all of the rest save for those in hot sectors like technology.

The fact that Brown’s fund performed so well overall in the face of a difficult year that wilted so many stocks and funds is even more testimony to his skill level in picking stocks and managing a fund. People dream of home runs with small caps, and Brown has really hit some big ones, and has kept the chaff down enough to have the fund keeping up very well with the best out there.

Neither Brown or his fund are all that well known, nowhere near as well as he deserves. Brown, who will turn 80 this year, has been managing this fund company himself for almost 40 years and is still at it. Experience is very often unhelpful in this business, among those who just keep making the same mistakes year after year, the majority of Brown’s competitors, but he serves as a fine example of experience really mattering.

Brown is also doing a lot to promote greater opportunities in the business for African Americans, who often aren’t given much of a chance. T. Rowe Price took a chance on him, and he sure has shown that that opportunity was deserved, making significant contributions to the firm before he set off on his own. Brown does this right, merely seeking to ask the question about why a group of people who perform so well overall are given so little money to manage. Merit needs to be the focus if we’re going to solve this lack, and Brown has his head in the right place.

Our regular readers can attest to just how hard we are to impress. There is so much junk out there that you just don’t find that much of real value and find yourself spending most of your time rummaging and getting steered away from these things. We do know the good stuff when we see it though, and both Eddie Brown and his fund definitely qualify, a real diamond in the very rough terrain of small cap stocks.

Monica

Editor, MarketReview.com

Monica uses a balanced approach to investment analysis, ensuring that we looking at the right things and not confined to a single and limiting theory which can lead us astray.

Contact Monica: monica@marketreview.com

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