This Day On The Street
Continue to site
This account is pending registration confirmation. Please click on the link within the confirmation email previously sent you to complete registration.
Need a new registration confirmation email? Click here

The Curse of Overcapitalization Pervades the Stock Market Today

Experience has taught us that those who believe their superior money management firm in a field is going to be the freak winner in an outgoing tide are dreaming. Remember those who bought Cisco (CSCO) and Microsoft (MSFT) in 1999 as the "pickaxe" companies? They weren't direct dot-com companies and investors felt they could participate in the growth of the Internet through them without getting burned when the bubble burst.

Not only did these "pickaxe" stocks lose a great deal of money from 2000-2002 but they have never made it back to the price they were at their peak 14 years ago. They were a part of a massive overcapitalization, a curse, with unbelievable investors -- enthusiasm, high prices and too much capital.

Secondly, most major tech companies of any kind became large-cap companies by 1999, and the large-cap growth and core categories drowned in capital as a result of the way large-cap indexes were overwhelmed. This spread the overcapitalization curse to most of the large-cap sector because managers either adapted in the late 1990s towards owning some, or saw their asset base shrink through redemptions.

The problem with private equity, from our perspective, is not just that it could do very poorly from this overcapitalization, but it might have caused a large misallocation in less esoteric common stock investing. We think massive money in the hands of LBO firms has had a huge impact on the outperformance we've seen the last 14 years in small- and mid-cap stock indexes in the U.S. relative to large-cap U.S. long-only investments.

Professor Eugene Fama won the Nobel Prize for Economics last year. Some of his more notable work showed that small capitalization could be a factor generating alpha for investors over long time periods. Is it possible Fama and his theory have gained adulation as an accidental byproduct of a once in a lifetime movement into an esoteric asset class? Has his theory been massively dependent on cheap money propagated by the tech bubble recession and the effort by the Federal Reserve to counter the 2007-09 financial meltdown?

Below is a chart showing the 30-year decline in U.S. interest rates and how expensive small-cap U.S. long only-equity is in relation to its somewhat larger brethren as represented by the Russell 2000 Index (small-cap) and the larger Russell 1000 Index.

If you compare the Russell 2000 to the S&P 500 Index, as we do below, from the beginning of 2000 to today, it is easy to see how much the move into private equity might have affected asset class returns and the attitudes of those practicing asset allocation.

Writing on June 23 for the Wall Street Journal, Gregory Zuckerman noted that institutions such as endowments and pension funds missed out on the stock rally entirely at the expense of adding alternative investments such as hedge funds and private-equity funds to their portfolio. Here's what Zuckerman learned from one of the institutional participants:

Those shifting to alternative investments more recently could be "too late to the game," said Scott Malpass, chief investment officer at the University of Notre Dame, which has had more than 50% of its $9.2 billion endowment in alternative investments for more than a decade.

Betting on hedge funds and private equity "can be a knee-jerk reaction to the crisis," he said.

As with prior overcapitalization curses, we don't know how this one will get rectified. We do have great confidence in avoiding both the asset class involved and any other asset class that has been involuntarily distorted.

This article represents the opinion of Smead Capital Management and not necessarily that of TheStreet or its editorial staff. It should not be construed as personalized or individualized investment advice. Past performance is no guarantee of future results. It should not be assumed that investing in any securities mentioned above will or will not be profitable. A list of all recommendations made by Smead Capital Management within the past twelve month period is available upon request.

>>5 Stocks Under $10 Poised to Pop in June

2 of 2

Check Out Our Best Services for Investors

Action Alerts PLUS

Portfolio Manager Jim Cramer and Director of Research Jack Mohr reveal their investment tactics while giving advanced notice before every trade.

Product Features:
  • $2.5+ million portfolio
  • Large-cap and dividend focus
  • Intraday trade alerts from Cramer
Quant Ratings

Access the tool that DOMINATES the Russell 2000 and the S&P 500.

Product Features:
  • Buy, hold, or sell recommendations for over 4,300 stocks
  • Unlimited research reports on your favorite stocks
  • A custom stock screener
Stocks Under $10

David Peltier uncovers low dollar stocks with serious upside potential that are flying under Wall Street's radar.

Product Features:
  • Model portfolio
  • Stocks trading below $10
  • Intraday trade alerts
14-Days Free
Only $9.95
14-Days Free
Dividend Stock Advisor

David Peltier identifies the best of breed dividend stocks that will pay a reliable AND significant income stream.

Product Features:
  • Diversified model portfolio of dividend stocks
  • Updates with exact steps to take - BUY, HOLD, SELL
Trifecta Stocks

Every recommendation goes through 3 layers of intense scrutiny—quantitative, fundamental and technical analysis—to maximize profit potential and minimize risk.

Product Features:
  • Model Portfolio
  • Intra Day Trade alerts
  • Access to Quant Ratings
Real Money

More than 30 investing pros with skin in the game give you actionable insight and investment ideas.

Product Features:
  • Access to Jim Cramer's daily blog
  • Intraday commentary and news
  • Real-time trading forums
Only $49.95
14-Days Free
14-Days Free
AAPL $94.28 -0.95%
FB $117.86 0.37%
GOOG $696.58 0.61%
TSLA $223.43 -3.80%
YHOO $36.02 0.01%


Chart of I:DJI
DOW 17,645.92 -104.99 -0.59%
S&P 500 2,051.14 -12.23 -0.59%
NASDAQ 4,727.6040 -35.62 -0.75%

Free Reports

Top Rated Stocks Top Rated Funds Top Rated ETFs