A Golden Age for Small Caps? An Interview with Barry James

A Golden Age for Small Caps? An Interview with Barry James

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Barry James of James Investment Research thinks 2014 will be a year for small caps. Here's why. 

You seem more skeptical about QE than some of the other people I've talked to. How do you think it affected pricing in 2013?

Commodities have done very well under QE, and stocks have done very well. But bonds and, well, basically everything else haven't done so well. We've actually got an academic paper we're publishing soon on this, that shows how historically QE adds value to stocks at about a 23% annualized rate.

And when you take the market off of QE there's an adjustment where the market falls about 20%. Now, they're trying to let the air out of the balloon as slowly as they can, so to speak. But it's not unlike a drug-addict. The market gets addicted, you need more and more. 

Does this mean your firm is bearish on 2013?

Not bearish, just careful. Look, there's no question that American companies did well in 2013 and they're sitting on a mountain of cash. But there were also 17 new tax hikes and a bunch of new regulations that were put into effect as well. I've talked to CEO's of small companies who are spending as much as $10,000 per employee on compliance alone. And this is on top of a fiscal and monetary easing policy which quite frankly just hasn't worked that well.

When we feel an improving economy what we're really feeling are productivity gains: which are gains you get by cutting costs and improving technology making up the difference. We've still got the lowest percentage of Americans in the workforce we've ever had. 

Are there signs of hope?

Absolutely, and we think a lot of it has to do with energy picking up. Natural gas is so cheap here, that a lot of the stocks in our fund are adding substantially to their earnings simply by converting existing technologies from oil to natural gas. I see the Midwest having a renaissance as a result, because cheap energy is incredibly helpful to manufacturing so much so that factories in Dayton, Ohio are already starting to be reclaimed and repurposed. And we think that the prices of energy are going to keep falling. America could easily be meeting 100% of its energy demand right at home within the next few years. And manufacturing is one of the most direct beneficiaries of that. 

You mean cars? But didn't Ford lower its sales projections for next year? 

Yeah but we still see bright spots in the automobile sector. The reduced sales expectations came from a glut in 2013. What happened was you had a lot of people driving old cars – the average road time for American cars was something like 11 years. In 2013 car prices got so low, and financing was so attractive, that Americans had something of a splurge on new cars which they hadn't been able to afford to replace before. But we're optimistic about cars looking into the future.

Do you see these gains being made by the big three, or do start-ups like Tesla have a role to play here as well?

I think we're on the verge of a big change from gas to hydrogen or electric or whatever. There are car companies working on motorized wheels and all sorts of things that are completely outside of what we think about when we picture a car. Right now someone's probably tinkering in a garage somewhere who's going to completely blow us all away. 

What about China? Your firm's bullish on China at a time when much of the market seems to be going in the other direction…. Is there room there for it to keep on growing?

Well nothing can keep on growing like that forever – and each year China needs to employ 30 million new people, which would be a challenge for anyone. The thing we like about China is that the problems they do have are obvious ones: the big one being pollution, water, land, and their financial system. We think the new Minister is pretty serious about, and capable of dealing with some of them, especially with regards to their banking system.

On the corporate side, a lot of companies don't really consider "The Government" as a typical lender – so they're borrowing all this money without any intention of paying it back. That's got to change. You've also got big problems with their power sector. How are you supposed to run a manufacturing business if you're in a region with unpredictable brown-outs and power shortages. As the country switches from being an investment based economy to a consumption based economy, we think you're going to see a rapidly growing middle class.

And you see a greater risk of asset bubbles here?

Not necessarily. We've brought down all our debt levels, normal people have realized they can't borrow as much. And we've still got 2008 on our minds, which reigns in some of the mania regarding the riskier asset classes. But we also expect a market adjustment in 2014, and we think this is going to be more of a slug than a slap – of about 20%, maybe more.

We haven't seen this much bullishness since 2000, or this little bearishness since 2007. And that's led to levels of margin debt which are at record highs – margin debt is borrowing money to buy stocks. I hate that. When the market gets too inflated on high-margin buying, the correction is usually really bad. 

So how does your fund go about picking stocks in this volatile climate?

We've got a very unique time frame right now, if you'll permit me to set the scene some. Prices on stocks are not cheap, the average P/E ratio on the S&P is something like 34, and the ratio for the Russell 1000 is even higher. Price to equity, price to book, dividends, none of these are pointing to cheap valuations. However in the next few years we know that interest rates are going to go up, and so for the next 10 years we think that stocks are still going to be a safer asset than bonds.

And what that means is you get a "stock picker's market." Now, to do that we like to use an all-seasons approach which we've used for over 40 years: find something cheap, find something that's being ignored, and look at earnings history, not earnings projections. When the market goes haywire, it's usually Wall Street's darlings that are hit the hardest. If we're only seeing 90% or so of the market gains, then we're happy, because it also means we're only going to see about two-thirds of the losses. We think in particular next year is going to be a "golden age of small-caps."

But aren't small caps riskier?

Sometimes, but they also fare the best in a high-inflation environment which is what 2014 will almost certainly be. The trick is to control your own behavior. Most people buy stocks when they're on their way down, and sell them when they about break even. You've got to water your plants and pull your weeds. You've got to have reasonable expectations about how your stock will perform, have a time frame in mind.

If a stock hasn't done what it's supposed to do in six months, we know we were wrong. You can't get stuck on stupid. The definition of insanity is doing the same thing over and over, and expecting a different result.

Click on the interactive chart to see data over time. Sourced from Zacks Investment Research. 

Do you see investment opportunities among some of James Investment Research's top picks? Use the list below to begin your own analysis. 

1. Deere & Company (DE, Earnings, Analysts, Financials): Provides products and services primarily for agriculture and forestry worldwide. Market cap at $33.64B, most recent closing price at $89.91.
 

 

2. Exterran Holdings, Inc. (EXH, Earnings, Analysts, Financials): Provides operations, maintenance, service, and equipment for oil and natural gas industry. Market cap at $2.19B, most recent closing price at $34.41.
 

 

3. Republic Services, Inc. (RSG, Earnings, Analysts, Financials): Provides nonhazardous solid waste collection, transfer, and disposal services in the United States. Market cap at $11.77B, most recent closing price at $32.82.
 

 

4. 1-800-Flowers.com Inc. (FLWS, Earnings, Analysts, Financials): Operates as a gift retailer in the United States. Market cap at $341.79M, most recent closing price at $5.30.

 

 

(List compiled by James Dennin, based on an interview with Barry R. James, President and Portfolio Manager with James Investment Research, and President of the James Advantage Funds. You can read more about the firm's work here.)

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