Buy Small, Sell Big

It is getting zero news coverage (MSM bias of omission?), but last week small and midcap stock indices reached all-time highs. Yes, you heard me right. While most investors are weighed down by the stocks of the last bull run, the Russell 2000 and S&P Mid-Cap indices are percolating.

Why are those large cap funds and indices not participating? The answer is simple math. A huge portion of these stocks are represented by Cisco, Oracle, Intel, Sun Microsystems, IBM, General Electric, Microsoft, etc. Those stocks are all trading near 1999 levels.

Here is a little investment math. If a mutual fund manager had a big stake in say Microsoft in the early 1990s, as that stock exploded, his fund would of course benefit. But since Microsoft was appreciating so much, its percentage of the mutual fund’s total investment would keep rising. (Microsoft has appreciated to 144 times its IPO price.)

Invariably that fund manager would have to pare back his MSFT shares. Mutual funds, by law must adhere to their prospectuses which limit individual stock exposure to a certain percentage. So while MSFT, EBAY, CSCO, etc. were doubling every six months or so, these fund managers were forced to sell their best performing stocks. How much sense does that make?

The S&P 500 index benefited from the other side of this math. As Dell, GE, SUNW, etc. appreciated, their index weights grew as well. So index funds were not forced to sell their best performers and in fact benefited disproportionately. These are the intrinsic workings of a market-capitalization weighted index and they wholly explain the underperformance of mutual funds during the last bull market.

Recently, the additions to the S&P 500 have not zoomed into positions of market leadership, a la 1997-2000. So what we have is top heavy index funds and a bunch of sheep mutual fund managers who are afraid to diverge too far from the index averages.

So the large cap averages probably won’t do much until we have a bunch of new companies displace these slow growth stocks of yesteryear. Right now it looks like Google is the only prospect and that won’t be enough.

Google update: Google Search is still gaining share at the expense of MSN Search and Yahoo. I think it will soon have an unassailable market position similar to EBAY.


I may be the polar opposite of a blue-collar homeowner, yet Home Depot has got to be my favorite store to peruse.

Without looking, how do you think Home Depot’s stock has fared in this housing boom?

It may be surprising to many, but in the last 7 years, with home prices up nearly 150% and 3% home equity loans selling like hotcakes – Home Depot’s stock is unchanged over this period. Investors have fared much better owning shares of Lowe’s (up 400%). This example really highlights the wisdom of buying small growing companies over large stagnant ones.