Zombie Beta
The Blind Squirrel's Monday Morning Notes, 4th November 2024.
Small cap US equities have been a key feature of the ‘Trump Trade’. The Russell 2000 (both futures and tracking ETFs) are the ‘one stop shop’ for this factor. The 🐿️ is wary of this ‘zombie beta’.
Zombie Beta
Last week, Mrs. 🐿️’s dad invited me to join him at an ASX-listed microcap conference organized by some of his old friends and former colleagues. Many thanks to Chairman Craig Dunstan for including me.
Incidentally, the title of this week’s piece has absolutely nothing to do with 2 days well spent here in Melbourne’s CBD. We shall move on to the referenced zombies later on.
Regular readers will know that the 🐿️ does not spend much time thinking or writing about microcaps. However, an opportunity to listen to 24 CEOs set out their stalls should never be passed up. A fascinating microcosm of the (global) real economy.
The presentations covered everything from a pre-production copper miner and a house builder (mandatory down here!) to an emerging brand in the global infant milk formula market (Bubs) and a (tiny) intriguing cleantech business 20%-owned by legendary metals investor Robert Friedland and Fidelity (no recommendation yet but more work still to be done by the 🐿️!).
According to the Australasian Investor Relations Association (AIRA), the median annual maintenance cost for smaller companies to be listed (those outside the ASX200) surveyed at A$4.4m (almost US$3m). Am sure that many of the companies above have cut a cheaper deal on their audit fees, however even a fraction of this median cost represents a significant percentage of market cap for many of these issuers.
This rodent is not simply lobbying for the local accounting and legal firms here. I celebrate the fact that many of these companies are not sitting in the portfolios of private equity funds. The discipline and transparency created by public disclosure requirements significantly derisks these businesses for potential strategic acquirers and partners and a public (if illiquid) float gives these companies a ‘currency’ in M&A roll-up markets (many of them are fairly active on that front).
For individuals, participation in standalone private equity deals poses multiple risks beyond the business risks of the underlying company. I am sure that many readers have ended up ‘losing’ on those (very rare) private market winners when they have found that their minority protections were lacking in the event of dilutive ‘emergency’ capital raises or ‘non-negotiable’ squeeze-out provisions in the event of a sale to a strategic or private equity buyer.
Microcaps play an important role in the capital markets food chain. It would be a massive shame to see this market disappear. However, as the world of ‘Big Retirement’ continues its ‘pincer movement’ drift towards market-cap weighted passive indexation of its public equities and the full embrace of ‘volatility laundered’ private asset markets, the world of active mid and small cap investing has become more fraught.
The ‘reach for small caps’ has become one of the major factors in the ‘Trump Trade’ thematic of recent weeks. The performance of the Russell 2000 small cap index (albeit still below the pre-Biden withdrawal peak in late July) has correlated closely with Trump’s election odds.
Back in July, the 🐿️ was certainly guilty of celebrating (while not fully embracing) the ‘great rotation’ out of large cap tech stocks into value / midcaps. However, even the strong recovery of the Russell 2000 (‘R2K’) in recent weeks has been unimpressive when compared with the tech behemoths.
Nevertheless, the promise of extended corporate tax cuts, deregulation, ‘America First’ trade policies and other promises of the Trump campaign seen as pro-growth has seen increased investor interest in small cap exposure (although momentum does appear to have stalled somewhat in the past 2 weeks).
Better technicians than this rodent such as my pal ‘MC’ over at
are sensing all the hallmarks of a bull trap in the Russell. Crayons aside, the 🐿️ has, over the past few years, been coming to the conclusion that the Russell is a curious instrument for investors to trade.The 🐿️’s forensic critique of the index may not matter. Politics aside, we are of course entering the strongest absolute and relative season of the year for small caps.
There are many ways in which the R2K and the ETFs and futures that track it could be viewed as ‘Zombie Beta’. And here the 🐿️ finally gets to the point where he justifies the Halloween-ish theme for this week’s note!
I am not disinterested in the idea of small cap and value equities having a decent ‘Santa Rally’ end to 2024 but please do not ever forget that the R2K/IWM is a deeply flawed ‘trading sardine’.
Nevertheless, in Section Two this week, we crunch the numbers and explain why the Russell could be a very unsuitable can of (preserved) oily fish.
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