It’s the choppiest market in memory, lurching forward or back in 5 percent chunks every few days, but evidently small investors are holding pat, if local stock clubs and advisers are any indication.

“We have a buy-and-hold strategy. We invest for the long term. The recent downturn in the market, in particular the much lower price of individual stocks, is now a buying opportunity,” said Mary Citron, who operates an investor club in the San Fernando Valley that is affiliated with the National Association of Investors Corp.

Other NAIC investors concur. “(The market downturn) gave us a chance to buy some stocks we couldn’t afford before,” said Henry Bernard, who has operated the Buttonwood Four investor club since 1982 in Lake View Terrace (The NYSE was started under a Buttonwood tree). Bernard alluded to certain investing guidelines, such as price-earning ratios, to which the club must adhere.

Gordon Peay, chairman of the Los Angeles Chapter of the Society of Certified Financial Planners, said his clients echo the sentiments of those in investor clubs. “With just a few exceptions, everybody is very comfortable,” he said, describing his 200-or-so clients. “People are in the market based upon long-term expectations, and are looking for future growth. We fully expect the market to go up and down in the short term.”

The stolid fortitude of local investors and investment clubs is matched nationwide, said Jonathan Strong, spokesman for the Madison Heights, Mich.-based NAIC, a non-profit umbrella organization for 37,560 investment clubs with 730,000 members nationwide. “We are finding that members prefer to hold during market ups and downs. If anything, in down periods, they like to add to their holdings,” said Strong.

Junk is good

Market turmoil and fears of weakened economies are bad news unless maybe you are in the junk-bond business.

Investors tend to shy away from junk bonds when the economy starts to look iffy after all, most junk bonds are called “junk” because they are more risky than corporate blue-chip bonds, or government gilts. Typically, a junk-bond company carries more debt than a well-rated company, and thus may have trouble honoring that debt if the economy unravels a bit.

But economic gyrations mean higher yields on junk bonds, and thus investment opportunities, said Howard Marks, founder and chairman of Oaktree Capital Management LLC in downtown Los Angeles, a junk-bond firm with $11 billion under management.

“The spreads have widened on junk bonds to about 500 basis points over (U.S.) Treasuries. It has been as low as 200 and 300 basis points. All of a sudden, we have some of the highest spreads ever, exceeded only in 1982, then in 1986, and then in the early 1990s,” said Marks, a 20-year veteran of buying junk bonds.

Institutional investors are back in the junk-bond market, attracted by the yields. If anything, Marks is concerned that the junk-bond market has been too good.

“Buyers aren’t showing enough discernment and selectivity when buying bonds. There has been a little bit too much euphoria,” said Marks, and that is allowing some second-rate issues, even by junk-bond standards, to come to market.

Re: small caps

What you call a small-cap stock may not be what the next guy calls a small-cap stock, especially if the next guy is Scott Leonard of Santa Monica-based Leonard Capital Management.

“You want to know what the market cap is of a small-cap stock according to Morningstar? Anything under $1 billion,” says Leonard, who puts the upper limit at $250 million.

Actually, Chicago-based Morningstar Inc., an investor service that rates mutual fund performance, even puts some companies with market caps well in excess of $1 billion under the “small-cap” banner. That’s because Morningstar considers any mutual fund a “small-cap fund” if the median company in its portfolio is below $1 billion, meaning as many as half the fund’s holdings could have market caps above $1 billion.

Leonard argues that the definition of small cap is more than just semantics: The performance of small-, mid-cap and large-cap stocks varies greatly, depending on how one defines each of those class sizes. For example, the Russell 2000 the stocks just below the largest 1,000 stocks, in terms of capitalization have been laggards during the 1990s compared with the S & P; 500.

The S & P; 100, an index of the biggest blue-chip companies, has done even better. Since 1980, the S & P; 100 index is up about 675 percent, compared with 450 percent for the Russell 2000.

But wait before disregarding small caps as an asset class, says Leonard.

“What makes the Russell 2000 a good benchmark for small caps? It’s just an arbitrary index the media likes, similar to the Dow Jones Industrial Average of 30 stocks,” he points out.

To truly assess the performance of small caps, one must look at stocks whose market caps (shares outstanding times share price) are in the bottom two deciles (tenths) of all stocks, says Leonard. Measured another way, that would be all publicly held companies today that have market caps below $250 million. An average market cap of a small-cap stock is $156 million, by Leonard’s estimate.

An index of small-cap stocks under that definition, those in the bottom fifth, has risen 899 percent from 1990 to present, beating even the handsome S & P; 100 performance for that time period, according to the Chicago-based Center for Research in Security Pricing.

Some call these small companies “micro-cap stocks,” which Leonard takes exception to. “Mutual fund guys call them that, because they are too small for them to invest in. But they are just small-cap stocks,” he said.

For Leonard, the question of small caps outperforming blue chips is interesting on its merits, but even more important when one creates a portfolio of investments. The stocks in the bottom two deciles have low “correlation coefficients” with the S & P; 500 stocks. That means the blue chips often go one direction while the “micro caps” go another.

That translates into diversity, says Leonard. “For my clients, I put about one-third of their equity investments into small caps, to balance what happens in the S & P; 500 stocks.”

By the way, Dimensional Fund Advisors, the big money shop in Santa Monica with $23.4 billion under management, runs several mutual funds devoted to the smallest stocks. Two of those funds are known as the DFA 6-10 Small Cap Portfolio and DFA 9-10 Small Cap Portfolio. The numbers serve to indicate into which deciles (as measured by market cap) the funds invest.

Contributing Reporter Benjamin Mark Cole covers the local investment community for the Los Angeles Business Journal. He can be reached at [email protected].

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