I Just Played Poker Against Wall Street’s Elite

I’m glad it was you, Frankie…
 
Those were the last words my former colleague Doug Kass said to me before I knocked him out of a charity poker tournament earlier this week. 
 
REACH (Rewarding Achievement), a non-profit organization founded by T2 Partners’ Whitney Tilson, organized the tournament for New York City’s low-income students who want to go to college.
 
Hundreds of Wall Street‘s most prominent hedge-fund managers, analysts, and traders participated in the event, which took place at Manhattan’s upscale Gotham Hall. 
 
From an investment perspective, it was a great place to network and find new investment ideas. I have one takeaway after talking to some of Wall Street’s elite analysts…
 
It’s time to buy small-cap stocks.
 
#-ad_banner-# On my way to the final table, I played against traders from Bank of America and Goldman Sachs. I also met one of David Einhorn’s (founder of Greenlight Capital) research analysts, and Adam Oestreich, who runs the opportunity desk at Merrill Lynch.
 
After talking to some of these analysts, I was surprised about their lack of interest in small-cap stocks. In short, with large caps trading at attractive valuations, most of the analysts did not see the need to take on extra risk.
 
After talking with them, I was surprised how few were bullish on small-cap stocks. In short, with large caps trading at attractive valuations, most of the analysts did not see the need to take on extra risk.
 
Whitney Tilson shared that sentiment. I spoke to him about investing in distressed debt opportunities in Europe. He said, “Why deal with so much uncertainty when you can buy Microsoft at 10 times earnings or Berkshire Hathaway for 1.2 times book value?”
 
There are certainly some great opportunities in large-cap, dividend-paying stocks right now. However, I’ve never seen so many analysts bearish on small caps. If you are a contrarian investor, that’s a bullish sign.
 
As you can see from the chart below, large-cap stocks outperformed small caps by 8% over the past 12 months. If you include dividends, it’s close to 10%. That’s the widest margin of outperformance for large caps over small caps dating back to 1998.
 



 
It gets better… After 1998, small-cap stocks outperformed large-cap stocks for six straight years!
 
Sure, there are macro risks. I heard them at least a dozen times at the tables. Europe will not solve its credit crisis… China is a disaster… And most stocks in the emerging markets are trading at new 52-week lows.
 
However, large-cap stocks have much more exposure to these areas than small-cap companies that generate most of their revenue in the U.S.
 
Personally, I see a ton of opportunities in small-cap stocks right now. Technology, mining and energy companies have lost more than 40% of their value over the past six months. Some have strong balance sheets and solid earnings growth potential.
 
Based on the negative sentiment I heard at the poker tournament – along with valuation – it’s a great time for investors to venture into small-cap stocks. In fact, you may see some opportunities open up in the weeks ahead as small-cap companies get set to report second-quarter earnings.