While investors in the public markets have been shunning small-cap value stocks (and large-cap value stocks until recently), some private-market investors have been snapping up those small companies.
Tim Dalton Jr., chairman and CEO of Dalton, Greiner, Hartman, Maher & Co., Naples, Fla., a small-cap value manager, saw almost 20% of his portfolios bought away from him last year by merger and acquisition activity or by groups taking the companies private.
Among the companies taken out of DGHM's portfolios last year were Berkshire Realty Co., Optek Technology Inc. and Amsted Industries Inc.
The average premium the acquirers paid for the stocks was about 60%. "We see a lot of smart buyers buying whole companies," said Mr. Dalton. That, he believes, is a portent; it is a bullish sign for small-cap value. It means the smart money sees real value in the stocks and is getting in before public-market investors realize it and react.
"These stocks are as cheap today as they were at the bottom of the '73-'74 bear market," he said, "and the companies are better today. They have better balance sheets, relatively little debt, better earnings and good management."
But the market has been focused on high-tech stocks and has driven their prices and p/e ratios to extraordinary levels and has ignored the value sectors, and the small-cap value sector in particular.
The result: "A classical reverse arbitrage opportunity with the public market for these stocks priced at a discount to the private market," Mr. Dalton said.
All of this convinces Mr. Dalton that growth's time in the sun is passing and that value's time in the sun is on the horizon, especially for small-cap value. "We have turned the corner," he said.
The private money flows are the first stage of the process, he believes. The next stage is for institutional investors to recognize that growth cannot continue to outperform value by as much as it has in the past few years.
Next the institutional investors will begin to buy the small-cap value story, and finally the mutual fund investors will follow.
But there could be a period of pain before all of that happens. The current market has some resemblance to that of 1972-'73, when investors in the "nifty 50" were convinced those stocks were invulnerable, while the prices of other stocks were falling.
"We have begun to see weakness in the Nasdaq," Mr. Dalton said. But money flow into mutual funds is still positive for growth and positive for technology. The public is not ready to throw in the towel, he said. It will need convincing, and that will take a catalyst. The catalyst could be the Federal Reserve's actions. If the Fed can slow the economy, that will slow capital spending, and slow the prospects for tech stocks.
But the process of correction could be painful for all stocks, including value stocks, Mr. Dalton conceded. "When the Fed is taking away the punchbowl to slow the party, it usually drags the piano player out as well," he said. "While we're in the eye of the tightening it's going to be difficult to make money in the market."
But when the market begins to rally again, value will be the primary beneficiary. The weakness in the Nasdaq might indicate the long-expected correction is coming. If so, it will be good news for value managers and value investors. They haven't had much to crow about since the third quarter of 1994.
