BACKGROUND This article, written on June 21, 1996 is a condensed and updated version of the Equities Conference talk that I gave on December 12 ,1995 at the Palace Hotel in New York before leading brokers and investors. This conference puts emphasis on small growth stocks and is sponsored by Equities Magazine, Bob Flaherty, Editor.

GEGC's task was to pick three global small cap stocks using its investment discipline, cyber-quant expert systems, and also provide a theoretical and practical framework for the investor.

The topic of my presentation was called: Global Small-Cap Investing, What The Computer Shows.

The results of the three stocks were truly outstanding in performance indicating that the average investor can invest in the global small-cap arena on a low cost basis, providing that the investor has a good investment discipline, expert computer systems, and savvy. Therefore, it is not believed that one must have lots of frequent-flier analysts and offices around the world to do this type of investing. With lower costs one can better achieve excess returns in this rewarding asset class.

     GLOBAL SMALL-CAP INVESTING,
                         WHAT THE COMPUTER SHOWS

                                  By V. John Palicka CFA CMT


THEORETICAL AND PRACTICAL CONSIDERATIONS

Predicted increases in the power of computer and expert systems indicate that by 2002 a computer will be able to pass the Turing Test. The Turing test is a series of questions given to a computer whose answers cannot be distinquished from human response. This indicates that most financial decisions will be done by computers and investors should avoid stock analysis and just resign themselves to index funds as they will not be able to outperform the market. Similar to chess, only the very brightest and judgmental minds can keep up with computers, and a draw (index results) are the best solution for investors. Even now, enough literature indicates the success of index funds versus active management. A recent casual glance reinforces this notion as the Lipper mutual fund managers in popular areas such as the SP 500, Growth, and Emerging Market stocks are lagging behind Vanguard Index returns in the same area so far this year. So too, when I gave my talk last December (1995).

Of course there is an opposing school of thought. Godel's Theorem states that no mathematical algorithm can be created to solve all mathematical problems with certainty. Hence we will get unhalting responses or ones where the computer program will not stop to give a definitive answer. Even if an answer is given we cannot be sure that it is an answer or only an intermediate result. Thus if a manager is underperforming for 10 years, maybe in another 10, 100, or even 1000 years the tables can be turned. Isn't this the pitch of the mutual funds who explain poor performance by saying that investors should invest for the long term ( and keep paying fees)?

Global Emerging Growth Capital (GEGC) believes that global stock investing should be done on an index basis as Turing computers will have an edge, EXCEPT in one area. In areas where results are affected by widely perceived and abundant quantifiable information, Turing computers will have the analytical edge. In areas where information is less known and where judgments are critical, the individual investor will have a much better chance. In academic literature lesser known stocks, regardless of size, tend to outperform the market than their better known counterparts. This area tends to include the small sliver of companies that are not easily quantifiable and require a good deal of savvy or judgment-- emerging global growth stocks. GEGC invests in the high growth area of the GODEL-TURING chart ( see chart icon below). These companies offer products and services that are not readily perceived to be future household names and even offer controversial postions. In the early 1800's many thought the railroads were useless and a fad and few in the 1950's thought that hamburgers and milkshakes (Mc Donald's) would prove to be profitable.

Godel - Turing Chart

INDIVIDUAL ELECTRONIC TOOLS

Information processed by an expert system is very useful in the small sliver segment of our chart as it better leads one to the judgment part. But at what cost on a global basis? Individuals are increasingly able to tap into a global small-cap data base for low or no cost, thus eliminating the need for frequent-flier analysts and "branch banking" analysis. For example, developing an expert system alleviates the grunt work on massaging numbers with low cost software tools such as Lotus. Free use of global databases at public libraries such as Worldscope Disclosure enable screens to be set up with financial criteria. Use of global clipping services such as Lexis and Tradeline enable investors to get information on any company anywhere in the world. Companies are Internet oriented and give much information on their Web pages. Long distance phone calls on the Internet save on costs when talking to management. Financials in foreign tongues can be scanned and simultaneously translated with programs such as Globalink. Many of these sources can be programmed ( with programs purchased at COMPUSA and Egghead) into an expert system to create sentient responses to a financial situation. Key phrases that excite analysts such as, " the company has no other competition" or "earnings are above estimates" can be programmed into a positive alert for an investor. One can also blend resulting financial ratios with technical chart criteria to create buy/sell decisions which can be translated as a trade to brokerage on-line companies such as Scwab ( using Street Smart) with full paper documentation. These tools free up the portfolio manager to devote time to using prudent amounts of judgment in new and creative situtations. In general, prior analytical systems consisting of consuming time, travel, people, and money are replaced by lower-cost digital sources.

STOCK IDEAS USING THE ABOVE

       In my December 1995 speech at the Equities conference, I recommend 3 stocks using the above discussion. All three were changed companies that were digitally sourced but required a good deal of judgment to assess their sliver of growth prospects. A quant analysis with a Turing bent would have alerted investors but missed the firms' potential as the historical data was not representative of future prospects. They were also underfollowed and underowned by institutions. Some of these companies also offer the aformentioned electronic tools such as Internet analysis or popped out on Worldscope, and even more remote publicly available databases. The stocks and their abridged profiles are listed below in the chart, Stock Ideas.

STOCK IDEAS, Abridged Profiles

NAME	PRICE	EPS	P/E	GROWTH	MARKET CAP
Manchester United	$3.17	$0.34	9.3 x	18 %	$193 MM
Barra	$14.00	$0.85	16.5 X	17 %	$107 MM
Hanna Microelectronics	$3.74	$0.28	13.3 X	23%	$137 MM

Comments are as follows on these stocks which were priced using the trading day's close before the conference.

Manchester United - the famous British soccer team now gets most of its revenues from licensing and TV satellite contracts versus attendance receipts. U.S. teams of Dallas Cowboys and N.Y. Yankees already had this. British soccer just found this out. Our perception 3 years ago that Manchester would follow U.S. team footsteps and hence explode its earnings upward was correctly made and the stock moved up sharply. Also, whenever I mentioned the stock to my rivals, they said," I didn't know they were publicly traded" -- talk about undiscovered ( or the old hamburger milkshake analysis discussed above).

Barra - a U.S. financial service company has made its money selling performance analysis to portfolio managers. GEGC perceives that in the future most of its money will come from active portfolio management itself using advanced algorithms ( which it now does in funds with Schwab). Hence its past financial profile didn't reflect future earnings potential. I call this the " Terminator" fund; programmed to kill (outperform). Barra was also evident in many electronic databases.

Hanna Microelectronics - a Thailand company, was a mundane company making quartz watch components, a commodity business. Now Hanna makes less than 10% in this area and spends its efforts in growth areas such as anti-piracy computer devices, chips on board installations, and smart cards.

GEGC PICKS ABOUT 6 MONTHS LATER, June 21, 1996

NAME	GAIN
Manchester United	+115%
Barra	+107%
Hanna Microelectronics	+85%

 Since our recommendation in the December conference, all 3 stocks have appreciated by June 21, 1996 by a very large amount as follows: Manchester up 115%, Barra up 107%, Hanna up 85% -- all outperforming any emerging/global/U.S. index in sight. Now you may ask, what does our expert system show? The P/E multiples have all doubled now making them not cheap. GEGC has sold one-half of its position in Manchester and Barra as its expert systems show a slight sell now. From a judgment point of view, a negative is that Manchester has attracted an institutional following and is now valued more than than the Yankees and Dallas Cowboys. Barra has made an unimpressive acquisiton in Rogers and Casey. Hana comes up neutral and GEGC will hold its position for now.( Editors note: Hana was completely sold shortly after this article was printed at slightly below the price in the article. All stocks subsequently sold down10-30% over the next 2 months as the world markets declined).

FUTURE CONSIDERATIONS

  International investing adds more opportunities and is not expensive to do. Don't be fooled by statements such as "we have 3 portfolio managers and 20 analysts in Mexico" -- yet none predicted the currency devaluation. There are plenty of elephant funds that can't beat an international index. Smart investors such as CALPERS and CalSTRS are dumping them in favor of more index funds. Today, technology enables the average investor many tools that are more efficient than the old style of global investing with many offices and a high body count of analysts. Staying with small cap stocks can enable small investors to beat appropriate indices ( we use Salomon-EMI in global small cap stocks), with expert systems and electronic tools. International trading is easier now as companies, such as Schwab, take overseas orders. Electronic idea boutiques, including foreign brokers and publications can quickly disseminate ideas. The ability to meet and talk with management is easier than ever given video conferencing, Internet communication, and digital contacts. At least one can do one's homework better in preparation for a face to face meeting, if necessary. By concentrating on global small-cap stocks with these cyber tools, an investor with some good judgment can produce rewarding results.

SOURCES AND READINGS

For a discussion of indexing and inabilty of investors to beat an index read the works by Burton Malkiel,especially,"A Random Walk Down Wall Street"(New York: W.W. Norton, 1973)

For a discussion and debate on the Godel-Turing argument read Roger Penrose's "Shadows of The Mind" ( New York: Oxford University Press, 1994) and Frank J. Tipler's ''Physics of Immortality" (New York: Doubleday 1994).

The implications of the above debate and the need for faster computers lead some to speculate that quantum physics is ready to change our mathematical thinking. The creation of a quantum computer is a possibility. See the section on quantum computing in the April,1996 issue of BYTE magazine, page 51.

PERS accounts control a lot of money, even if some feel they are not that smart. An article that shows how a large PERS account may be moved to go passive, read "CalSTRS Mulls Big Emerging Markets Change", Money Management Letter, October 23,1995. CalSTRS has about $50-billion in its plan and CALPERS has $100-billion.

An argument that punches holes in the idea that international diversification can diversify U.S. portfolios ( because it's different there) is by Rex Sinquefield's " Where Are The Gains From International Diversification?", Financial Analysts Journal, January-February 1996. If more important reasons, such as value and small cap international stocks add value rather than geographic presence, then why have bodies of analysts in a country in the first place.... that is our feeling.

Last modified on Wednesday, October 01, 2008