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The Daily Reckoning PRESENTS: Historically, small caps outperform larger companies...but it was not so during the bubble years. Jim Davidson argues small caps will make a resurgence once a major flaw in tracking of stock deliveries is rectified.

THE LAW OF ACCELERATING RETURNS
by James Davidson

More than 20 years ago, in 1981 to be exact, a graduate student produced an important research paper comparing the returns on stock investment based on market size from 1926 through 1969. Much to everyone's surprise, he proved that large-cap stocks - the ones that everyone knows about, such as IBM and GE - significantly underperformed smaller companies that most people have never heard of. He showed that small-cap stocks had risen at a compound rate of return of 12.1%, as compared to 9.8% for large- cap stocks.

The premium performance of small caps resulted in a huge difference in wealth accumulation in the long run. Portfolio theorists were fascinated by the findings and immediately began to seek explanations for the divergence in returns. A few simple explanations seemed to account for most of the difference.

The first explanation suggests that smaller companies can be more effective than larger ones in evading competition. Smaller companies can serve "niche" markets, where they may face less competition and consequently can charge higher prices. Higher prices then lead to higher earnings, and thus a higher stock price. For obvious reasons, large companies are seldom found engrossing niche markets, although Microsoft might have been an exception for a time. The idea was that the "niche" strategy provides a sustainable competitive advantage that could explain why some small-cap stocks have outperformed larger companies over time.

Of course, sometimes the "niche" market is also a new market, and among the factors forestalling competition is patent protection. Many fortunes have been made on investments in small-cap companies employing patent protection to develop niche markets.

The second reasonable explanation shows that smaller companies are often in emerging industries, and therefore have the possibility of generating huge earnings growth in the future. The greatest opportunities for wealth creation arise from buying the stock of a small-cap company that has the potential to grow into the next Microsoft or Intel.

For reasons of simple arithmetic, it is implausible that an investment in Microsoft or Intel today could compound as far as investments in companies like GeneMax, a company developing immunotherapy treatments, can if they attain their potential.

At $8 per share, GeneMax has a market cap of about $121 million. If its immunotherapy, which has effectively cured cancer in laboratory animals, works as well in people, it is easy to imagine that GeneMax could be worth $80 per share, or even $800 per share. I don't know what a cure for cancer would be worth. But it could be worth a lot. GeneMax could grow a hundredfold in value. Or maybe a thousandfold. To attain a market cap equivalent to that of Microsoft, GeneMax would have to reach a share price of approximately $15,500 per share based on the current number of shares outstanding.

The Microsofts of the world cannot easily grow a hundredfold in value. At its recent price of $43.77 per share, Microsoft had a market cap of $234.76 billion. While it is unlikely that the GeneMax stock price could appreciate by almost 2,000-fold, it is impossible that such an appreciation could happen again to Microsoft. To be more precise, for Microsoft to compound by 1,960 times, equivalent to the growth that GeneMax would require to become the size of Microsoft now, Microsoft's market cap would have to exceed the GDP of the United States by about 45 times over.

It does not take a divine genius to see that that is unlikely. Put simply, very-large-cap companies cannot grow much faster than the economy as a whole. They certainly cannot duplicate the growth rates that are possible for mini- and small-cap companies.

Given the strong track record of small-cap companies in the half century prior to 1981, it is hardly surprising that a number of new-money management firms were founded in the early '80s with the express purpose of investing in small-cap stocks.

We know small-cap stocks dramatically outperformed large- cap stocks from 1926 to 1969, but over the last 15 years, from 1987 to 2002 - after the small-cap "anomaly" was discovered in 1981 - the returns have not met the expectations that the research supported. In fact, after the experience of the 1990s, most investors probably feel that large caps outperform small caps. Almost everyone has had a personal experience of a small-cap holding that seemed promising but ended up plunging in price.

From 1987 to 2002, the S&P 500 generated a compound annual rate of return of 12.1%, while the smallest capitalization stocks averaged only marginally better - 12.6%. The strong performance of the large-cap S&P relative to small-cap stocks is particularly noteworthy in that there are strong reasons to expect large-cap stocks to underperform ever more significantly.

For example, Ray Kurzweil, a computer scientist at MIT, has recently calculated that we will see a century of technological change in the next 25 years. Kurzweil believes that exponential growth of computational power - up by an astonishing 40 billion times in the past 40 years - has set the stage for ever-accelerating technological change. This exponential growth, which he calls "the law of accelerating returns," proved predictive of many of the technological advances at the end of the last century.

According to Kurzweil, "the rate of technological progress is speeding up, now doubling each decade." Kurzweil believes we will see 20,000 years of technological progress by the end of the 21st century. Rapid-fire technological change of the kind foreseen by Kurzweil turns the logic of 20th century investment strategy upside down. It makes investment in smaller companies with simpler business models, paradoxically more attractive than blue chips like Cisco Systems or conglomerates like Tyco or even General Electric.

No one has ever become wealthy buying shares in companies that were already successful. To make big money, you have to buy when companies look like dogs, and most people doubt that they will ever succeed. John Templeton based his fortune on buying shares of the hundred lowest-price companies he could find listed on stock markets before World War II. Even during the Great Depression, profitable stocks did not trade below earnings.

That said, it is important to understand why the over- performance of small-cap stocks has virtually vanished at a time when technological change should have given an added impetus to smaller companies.

This is a complicated issue. Part of the explanation for the greater performance of large-cap stocks is the buoyancy of the market itself during the decades of the 1980s and 1990s. During the 1980s, for example, stocks as a group returned 17.57%. During the 1990s, returns were even higher - 18.17%. Only during the 1950s did market returns exceed those in the last two decades of the 20th century.

Obviously, when markets are compounding at a high rate, small-cap companies soon become large-cap companies, and thus escape from the category. Microsoft was a small-cap company when it began trading on March 13, 1986. But after the rapid growth of its business and eight stock splits, it migrated into the "large-cap" category. So paradoxically, part of the reason that small-cap investment appeared to be less successful was precisely because it was so successful.

But there is also a darker subtext to the issue. It involves market manipulation made possible by well- meaning institutional responses to the staggering increase in trading volume on U.S. stock exchanges. Prior to 1829, total stock trading volume in America never reached even 50,000 shares a day. By 1886, daily volume first ballooned to more than one million shares.

Yet even in the heady days of the 1920s, stock ownership remained relatively narrowly based and volume relatively small. Indeed, the last time daily trading volume fell below 1 million shares was in the Eisenhower administration, on Oct. 10, 1953. By 1972, daily trading volume exceeded 15 million shares per day. By the end of last year, volume had exploded to more than 2.5 billion shares per day, more than a 10-fold increase from the early 1990s and thousands of times greater than in the early '50s.

This stupendous explosion of trading volume created a logistical challenge of the first magnitude, namely how to transfer stock certificates to reflect the changes in ownership from sales and purchases by customers. In the infancy of stock trading, when volume was light, it was relatively simple to effect delivery of shares. Messengers scurried around and delivered paper certificates by hand from one investment bank to another. In 1924, the Stock Clearing Corporation was established to facilitate trading. But with trading volume escalating into the billions of shares daily, securities dealers and stock market officials sought a better way to clear their trades. The result was electronic clearing organized through the Depository Trust Company.

The Depository Trust Company is a trust company organized under the banking laws of New York State. It is owned by banks and broker-dealers. It is a custodian of securities that effects "book-entry delivery" in which "transfers of securities within the DTC system are processed by debits and credits to Participants' accounts."

In reviewing a lot of material about the DTC, which I must say is obscure and boring in the extreme, I got the distinct impression that its organizers were more concerned with effecting payment for securities than with the niceties of securities delivery. The DTC says, "DTC does not itself guarantee any funds or securities transfers which its Participants are obligated to make." The DTC is organized on the assumption that broker- dealers, market-makers and clearing agents are all operating in goodwill and need looking at mainly to ascertain that their wire transfers in payment for securities don't go astray.

Where this electronic settlement becomes an issue is when it comes to the shares of mini- and small-cap companies traded on the Pink Sheets, the OTC and the Nasdaq. The rules and conventions that have arisen around electronic settlement effectively permit unscrupulous operators among the many thousands of broker-dealers to counterfeit large quantities of stock, which they can sell for payment.

Given the magnitude of the logistics problem in clearing trades, it is understandable that this could happen. It is much easier to monitor the delivery of payment than it is to authenticate the delivery of shares, especially in an electronic clearing system where every broker-dealer has the de facto capability of counterfeiting securities by simply finding a buyer for them.

Say you want to buy a million shares each of GeneMax and another small cap company. Market maker Doaks has shares of neither. But, either on behalf of some client or on his own account, he sells them to you, crediting your broker's account with 1 million shares of GeneMax and 1 million shares of the other. Your broker now has an electronic credit for those shares, against which he wires funds or nets funds against his credit at DTC to Doaks' Participant account there. Thus are counterfeit shares created and put into circulation.

Doaks or his client has pocketed a lot of money for counterfeiting shares he did not have. And your broker has an electronic credit for those shares at DTC. When another of his clients dies, the executor of his estate orders the liquidation of his account, including 500,000 shares of GeneMax. The credit for those shares originally concocted by Doaks now transfers to the account or accounts of the participating broker-dealers whose clients bought the GeneMax shares from the estate. And so on.

Ostensibly, broker-dealers have the capacity to sell securities they don't own and don't have to borrow - as you would if you were selling short - to facilitate market-making. In theory, the broker-dealers can sell quantities of stock they don't own in order to make an orderly market and prevent the price from spiking on big buy orders. In theory, abuses are limited by the requirement for the market-maker to post capital and limit "naked short sales" of any one issue to 10% of the capital account.

That is the theory. The reality is a bit more ugly. No one is really monitoring the aggregate impact of the counterfeit sales on any given issue. It is simple to confirm that payment has been rendered for a sale. When the cash credit is transferred between participants within DTC or the Fed wire hits, the issue is resolved. But in an electronic, book-entry deposit system, every credit for a share purchased is indistinguishable from an actual share issued by the company treasury, even if it was counterfeited. No one bothers to reconcile the share credits in the DTC system with the authorized, freely trading shares of the company.

Consequently, it is quite common for the effective float of small-cap companies to be inflated significantly by electronic counterfeiting. In some cases, the total effective float has been multiplied many times over.

Hence the sometimes weak performance of mini- and small- cap stocks. Their stock prices plunge because the supply of stock is artificially multiplied by naked short selling, better understood as electronic counterfeiting. Unscrupulous broker-dealers and market makers can effectively drive the prices of stocks into oblivion by selling vast quantities of stock not issued by the company.

Having come to understand this, I see an urgent need to curtail this electronic counterfeiting of the shares of small-cap companies. It not only fraudulently deprives investors in the affected companies of wealth but it is also destructive to the economy. And the news media seldom deign to report on it. Other than a few minor squibs on the news pages of The Wall Street Journal, there has been virtually no coverage of this issue.

Indeed, it is so obscure that you may not even know what I am talking about.

If so, that only underscores the need to shed more light on this predatory practice. I should also say that I am confident that this problem will be rectified. Maintenance of honest and orderly capital markets is tremendously important to the economy of the United States.

Sincerely,

Jim Davidson,
for The Daily Reckoning

P.S. Having made the argument for small caps, and shed light on the potential for small cap manipulation...you should also know that small-cap stocks are more volatile and "riskier" than large-cap stocks. Small-cap companies generally are more heavily indebted relative to their income than their large-cap counterparts, meaning their earnings are more leveraged. Small-cap companies have fewer assets than large-cap companies. Small-cap companies are statistically more likely to go bankrupt than large-cap companies. So portfolio theorists calculate that the extra return you get over time is a result of investors being compensated for bearing more risks. Keep that in mind if one or more of your "high- upside" stocks bites the dust.

Editor's note: James Davidson is a best-selling author and venture capitalist. His articles have appeared in The Wall Street Journal, Investor's Business Daily, The Washington Post and USA Today. Mr. Davidson currently sits on the boards of over 20 small-cap companies, and has been invited to join Merrill Lynch's technology advisory board. Davidson's latest research and investment picks can be found in:

The Vantage Point Investment Advisory

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