Preston Athey runs the T. Rowe Price Small Cap Value Fund. He’s produced around 12% annual returns for the past 22 years, making him one of the top mutual fund managers in his category. I would imagine it’s hard to run $8 billion (the size of his fund), and have to invest in small caps only, so although 12% isn’t shooting the lights out, given his mandate and the constraints that come from the size of his fund, I’d say his results are exemplary.
In the recent Graham and Doddsville Spring 2013 newsletter, he gave an interview. The following passage was taken from this interview in a response to a question on the inherent bankruptcy risk that comes from investing in small companies. I found that his answer was interesting, and provided a key lesson to keep in mind regarding the behavior of crowds, especially during a bear market. This passage reminds me of the famous investment Sir John Templeton made when he bought all of the stocks on the NYSE trading under $1.00 on the eve of World War II.
Here is Athey discussing how he looks at risk when evaluating small cap stocks (emphasis mine):
“There’s absolutely some bankruptcy risk in investing in small-cap value companies. By definition,they are considered value stocks because there’s something wrong. Perhaps their record isn’t very good or they’re overburdened with debt or they’ve had some bad news that’s really knocked the stock. In the 22 years that I’ve run the Small-Cap Value Fund, I’ve averaged less than one company per year go bankrupt while I own the stock… I consider it an overblown concern and it’s not something I spend a whole lot of time worrying about.
“In March 2009… I gave an interview to Barron’s on the topic ‘Stocks selling for below$1.00’. After giving the interview, I decided to check how many stocks I actually had below $1.00. Remember, this was at the bottom of the market. At the time, 20 stocks out of 300 in the fund were selling for below $1.00… most were bought at prices significantly above that, often above $5.00, so that shows you how much they had come down. So what was going on?
“First of all, we were in a horrible bear market, so a lot of stocks were down. Secondly, these were probably the lower quality stocks of the group that I held, so in a scary market where people are worried about balance sheets or businesses that maybe aren’t as solid as others, the stocks are going down a lot more. The bottom line is they’re all below $1.00. The question was asked by the reporter, ‘Doesn’t that mean they’re all going bankrupt?’
“In a normal market, I would say if the stock goes below $1.00, the market is telling you they think it’s going bankrupt. In a market like today,that’s probably a reasonable guess… 20% to 30% of those companies probably will go bankrupt. But, at the bottom of a bear market when people are worried about everything, my experience was that they’re not all going to go bankrupt.”
“There were 20 of my positions trading at below $1.00. I believed that from that point on, when the market came back, most of these stocks would recover. A small fraction would probably go bankrupt, some would track the market,some would do substantially better, and one or two would be home runs.
“The question was asked:
‘Well if that’s the case, why don’t you sell the ones that are going to go bankrupt and buy the ones that are going to be home runs?’
“If we knew that, obviously we wouldn’t hold the ones that were going bankrupt. Two of those 20 companies were literally selling for less than the value of the cash on their balance sheet, and another half-dozen met Ben Graham’s favorite net-net standard where they were selling for below their net working capital. I felt pretty comfortable holding those stocks.
“Fast forward a year, four of those 20 actually did go bankrupt. Let’s say that I sold them at some point either right before or right after they filed and realized something less than $1.00. Of the remaining 16 companies, all of them eventually recovered well above $1.00. Some tracked the market, while some went up two times to four times. One of them, Dollar Thrifty, went from $0.60 to $45.00 in a year and half, at which point I sold it.
“If you took that portfolio of 20 companies and evenly weighted them at 5% each, I guarantee you the two-year returns on that portfolio were better than the number one small-cap value fund in the country. But who has the guts to invest a lot of money at the bottom of the market into what the market perceives as horrible companies? I didn’t sell them, but I held on and when the junk rallied, I realized my fair share of profits.”
It’s always good to be reminded that “if you want to have a better performance than the crowd, you must do things differently from the crowd.” That Templeton quote stands at the foundation of my investment philosophy.