Over the past six months, I’m not the only one who has seen the value of my investments plummet. After a 6 year bull run, the stock market was over-valued to begin with. On top of that, the housing bubble popped, poor sub-prime loan decisions have come back to haunt lenders, the national debt has been ballooning, and Ben Bernanke’s interventions have had the effect of socializing risk while privatizing profits. In short, it’s been brutal.

Double the pain for small-caps and the obscure

Due to their long-term outperformance of the market as a whole, and the fact that it’s easier to find pricing-inefficiencies, I’m a small-cap enthusiast. I’m convinced that in the long-run, small caps are the most reasonable way to go, but there is a price– when the market takes a dip, small-caps take a dive. Last fall, some of my holdings were absolutely gutted. Loop.net, which was cheap when I bought it, fell 40%. Buffalo Wild Wings took so many plunges that I began to worry there was some vital flaw in the business that had escaped my analysis. Don’t even get me started on what happened to Chinese stocks! Suntech-Power, which isn’t really that small, lost over 65% of it’s previous value. My entire collection of Chinese video game companies got battered around like level 1 NPCs caught in an epic war.

Value wins in the end

Had I been a technical investor looking just at price charts, or a caffeine-pumped active trader, I probably would have fled my entire portfolio in terror… thus, cashing out at the worst possible time. Fortunately, every stock purchase had been based on a level-headed business valuation. Far from being lottery tickets or some mindless speculative bet, buying a stock is buying a piece of a company, and in the long-run if the value of a company increases, the stock price will as well. Yes, there are wild, sometimes irrational fluctuations, but in the long run value wins. Knowing this, I briefly did some online searches to see if the actual business fundamentals of each company had deteriorated. In most cases they had not, and the best possible response would have been to buy more shares.

Earnings, earnings earnings

These companies, with superior management and/or core businesses did not disappoint. LOOP.net jumped up by over 10% in a single day after its earnings release reported that it’s revenues, earnings (EBITDA), and registered members went up by 33%, 31% and 39% respectively and it’s price has been heading up ever since. Shanda (盛大) got a similar boost at the end of February. Buffalo Wild Wings has absolutely screamed back up to 34.54, from the 19.25 I paid in January. I haven’t checked, but something tells me there weren’t any large restaurant chains that managed a 79% increase over this time.

Companies, especially those less followed by Wall Street, can definitely diverge from their stock prices. Valuations can get ridiculously optimistic, as they did with Chipotle last year, or they can become overly pessimistic as has been the case for much of the market recently. Sometimes risks are difficult to quantify. If Buffalo Wild Wings hadn’t had a top executive such as Sally Smith at the helm, maybe they wouldn’t have been able to secure long term supply agreements and rising food costs would have destroyed their profits. Maybe people could have stopped going out to eat so much, due to the (likely) recession. There are a lot of “what if”s. One thing that is clear though, is that the companies that do manage to perform will see their stock prices rise in the long-term. And those companies tend to be small-caps with good management, solid balance sheets and strong insider ownership.

I for one welcome volatility. It just gives rational contrarians more chances to trade at bargain prices.

Remember, you are responsible for your own investment decisions! I own shares in Loop.net, Shanda, Suntech Power and Buffalo Wild Wings at the time of this writing. See the disclaimer.

This entry was posted on Sunday, May 18th, 2008 at 2:37 am and is filed under Investing. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.