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Why Hedge Fund Titan Stanley Druckenmiller Is So Bullish On Small Caps

This position is his fund's largest single holding, representing 13% of the total portfolio.
Garret/Galland Research provides private investors and financial service professionals with original research on compelling investments uncovered by our team.
Garret/Galland Research provides private investors and financial service professionals with original research on compelling investments uncovered by our team.

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Combing through recent SEC filings for Stanley Druckenmiller’s Duquesne Capital, we found something interesting.

In Q4 2016, Duquesne opened a $134 million long position in the iShares Russell 2000 Index (IWM). IWM is an exchange traded fund (ETF) that tracks the price of the Russell 2000—the bellwether US small-cap index. This position is their largest single holding, representing 13% of the total portfolio.

Given small caps are up over 17% since November, are they something retail investors should consider?

The Small-Cap Rally Has Legs

A major reason small caps have outperformed the market since the election are Trump’s policy proposals.

Regulation does greater harm to small firms, so if Trump lowers the burden, they will benefit greatly. Also, many small companies are unable to lower their tax liabilities using legal offshore structures like large firms do. Tax reform would help them “big league” their operations.

Another factor is that most small caps earn the bulk of their revenues domestically. That means that protectionist policies like tariffs would hurt them less than they would the large multinationals.

The strong dollar is another element. A rising dollar renders US-made goods more expensive for foreign buyers, and that hurts exporters. Small firms tend to be largely “US-centric” and are less exposed to currency risk.

The interplay of these and other influences have pushed share prices upward for firms that get 90% or more of their revenue from inside the US. In fact, they’re 5.2% higher since the election. Those with large exports have only edged up 2.2%.

Institutional investors are also bullish on small caps. The January edition of the Global Fund Managers Survey found that a record number of respondents think small caps will outperform large caps over the next 12 months.

What other insights can we glean from his recent filings?

Golden Opportunity

Druckenmiller held a $39 million stake in the world’s largest gold company Barrick Gold (ABX) in Q2 2016. Although he liquidated the position last quarter, he still has exposure to the yellow metal.

Druckenmiller sold his Barrick holding on election night and told CNBC, “I sold all my gold the night of the election. All the reasons I owned it for the last couple years, it seems to me they may be ending.”

Well, it seems those reasons have resurfaced. In February, Druckenmiller told Bloomberg, “I wanted to own some currency and no country wants its currency to strengthen. Gold was down a lot, so I bought it.”

Since its December bottom, gold is up 8%. Also note gold’s steady rise after the Fed’s rate hike. In theory, gold should fall as rates climb. However, as we showed this month, rising rates are actually good for gold.

The real force for gold is higher inflation expectations. In January, the Consumer Price Index recorded a 2.5% year-over-year growth—its highest reading in almost five years. As gold is the ultimate inflation hedge, creeping inflation could be the catalyst that drives it higher.

Having analyzed the recent trades of this market wizard, what should investors keep in mind looking ahead?

Strict Screening

Buying the proverbial waterfront doesn’t give investors the best ‘’bang’’ for their ‘’buck.’’ Like Druckenmiller, it’s important for investors to have a predefined investment strategy. Otherwise, their own biases will lead them to losses. One man who developed an exemplary strategy was Benjamin Graham, the father of value investing.

Graham details his thesis in his seminal work, Security Analysis. The book is well worth the read. But at 725-pages long, it will collect dust, not profits, for most. For investors who want to quickly learn how to apply Graham’s strategy in today’s markets, download our free report 3 Proven Strategies for Investing in Uncertain Markets Like These.

Around $21 billion has flowed into US small-cap ETFs since November. That has pushed the price-to-earnings ratio for small caps 14% above its 20-year average. Astute investors should avoid the ETFs and look for specific opportunities. So, where does one start?

Each year from 2009–2015, the Russell 2000 Growth Index outperformed its value counterpart. However, fortunes changed in 2016 as value beat growth by 65%. History shows that long periods of growth outperformance have been followed by long tenures at the helm for value. This suggests that value small caps could be a good place to put your capital to work.

Investors should also focus on small-cap cyclicals, like financials. Since the election, cyclicals have outrun the market.

Risks to Be Aware Of

In closing, Druckenmiller looks to have timed the market perfectly once again with his moves into small caps and gold. Both assets look to be good bets going forward. However, as there have been big inflows into small caps recently, investors should proceed with caution. Having a predefined investment strategy is the perfect way to do just that.

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