Editor’s Note: Wishing you a fantastic New Year!
Today, I want to introduce you to a piece by Anthony Summers, our Director of Trading, which was featured in the December edition of The Oxford Income Letter. In the article, he explores where you might find the most promising investments by 2025.
I’m curious about what you think—are there any particular stocks or sectors you’re focusing on this year? Feel free to share your thoughts in the comments below.
– James Ogletree, Managing Editor
Buffett’s on the Move Again…
Warren Buffett, the legendary investor, has been busy accumulating the largest cash reserve in his career—an impressive $325 billion stash.
So, what insights does Buffett have that might escape other investors?
Contrary to what some alarmists in the media would suggest, I don’t believe Buffett is preparing for an immediate market downturn. Instead, he’s attuned to a couple of crucial realities:
Firstly, while stocks offer substantial rewards, they inevitably come with inherent risks. Secondly, the appeal of those risks versus rewards isn’t as attractive as it once was.
There’s a financial concept known as the "equity risk premium." It’s basically the bonus you earn for choosing stocks over safer investments, like Treasury bonds. Usually, when you take on the added risk of stock investments, you expect higher returns compared to government bonds. However, right now, that additional return is dwindling to levels we haven’t seen since the early 2000s.
This signals that the stock market is edging toward being overvalued, especially when it comes to large cap stocks, which have hit worrisome valuation levels.
Currently, the S&P 500 is trading at 25 times its projected earnings. To return to historical norms, valuations would need to decrease annually by about 3% over the next decade.
But here’s the upside: For those willing to hunt in less-trodden paths, value is out there.
Small cap stocks, particularly those with robust value attributes, are now offering some of the best valuations compared to large caps we’ve seen in a quarter of a century. Amidst the frenzy for mega-cap tech giants, these smaller firms have been quietly enhancing their value.
History also points out that small caps often outperform significantly following interest rate cuts. From the start of rate-cutting cycles since 1957, small caps have delivered an average return of roughly 11% in the first three months, 19% in the first half-year, and nearly 29% within the first year.
The gains after a stretch of underperformance are even more remarkable.
When small cap stocks underperform over a three-year span, as they did from 2021 onwards, they tend to bounce back with a vengeance. Market data from 1982 shows that after such periods, small caps rallied 99% of the time over the next three years.
Additionally, small caps are projected to exhibit stronger earnings growth than large caps this year and the next. This, combined with their current attractive valuations and compelling historical data, makes for an enticing opportunity.
However, there’s a caveat: Not all small cap stocks are worth buying.
The goal is to target quality companies that boast strong balance sheets, reliable cash flows, and enduring competitive edges—essentially true value stocks. They currently offer the most sensible risk-reward balance.
Thinking Small Can Pay Off
It appears that major investment firms align on the view that the larger market looks overpriced. Big names like BlackRock, Vanguard, and Goldman Sachs foresee below-average returns for U.S. stocks in the near future.
When we examine dividends, buybacks, earnings growth, and valuations, the prevailing consensus is that the S&P 500 might only yield around 4% annually over the upcoming decade. Not much better than the returns on virtually risk-free Treasury bills.
In an environment where risk premiums are contracting and Warren Buffett himself is amassing cash, finding authentic value isn’t just wise—it’s crucial. At this moment, small cap value stocks could be one of the few remaining avenues for discovering that value.
When investment legends like Buffett are building their cash reserves and market valuations are inflated, it’s wise to explore less crowded paths. While others chase yesterday’s successes, savvy investors are shifting their focus towards small cap value stocks.
