Our dissection of Barron’s 400’s results in 2014, presented in our January Newsletter, concluded that the index’s failure to keep up with the market benchmarks last year was clearly attributed to its small to mid cap bias. In closing that missive, we promised a look ahead at 2015 in our next newsletter, and here we are.
 
We have learned by now that short-term predictions are a fool’s errand, at best, and given our geeky bent, we figured we’d look at 2015 from the bottom up and focus on earnings. It is earnings, after all, or the expectation of what companies will earn, that ultimately drives shareholder value and thus capital appreciation for equities in the long term. And as we’re now well into the New Year, with 2014’s fourth quarter squarely behind us, a look at what companies have reported this earnings season thus far seems to us like the best place to start. Before we dive in, a few points. First, given the dynamics between small and large stocks last year, we focused our analysis on B400 vs. the S&P 500, as the market’s preferred measure of large capitalization companies. Not only will this allow us to expand on last newsletter’s theme but it also appears timely given the continued strength in the U.S. dollar against pretty much all currencies from around the world, notably the Euro and Yen. As the thinking goes, smaller companies in the U.S. are less exposed to foreign exchange fluctuations, considering they derive a larger share of their revenues state side, whereas the larger companies that populate the S&P 500 tend to derive a much larger share of their income from overseas. A stronger dollar also makes our exports more expensive to foreign buyers when converting their price into a depreciated currency. Second, we’ll present our results also from the perspective of Energy companies in both indexes, since the precipitous drop in the price of oil since last summer, and its recent bounce, have been front and center on investors’ minds. And lastly, no respectable financial commentary in the U.S. these days would be worth its populist salt if Apple (AAPL) was somehow not weaved into the narrative; so we’ve obliged.
 
Through Wednesday’s close, 256 companies in the Barron’s 400 had reported fourth quarter earnings, equivalent to 64% of the index. On the other hand, almost 83% of S&P 500 companies had done so. Positive earnings surprises have, so far, come in at almost the same rate for both indexes: 74% of all B400 companies that have reported have met or beat their estimate, slightly lower than the 77% that have done so among S&P 500 members. Our focus today, though, is not so much on reported earnings but on the changes in investors’ expectations for what they expect these two sets of companies to report during their current fiscal year, a pretty good proxy for calendar 2015.
 
As is usually the case, analyst estimates tend to drop over time as more information is available to them and as companies’ guidance is better incorporated into their view. What matters, though, in analyzing these estimates, is not the direction of their change (down) but rather the magnitude of such change and how it affects certain groups of companies more than others. In this case, the difference between expectations for B400 vs. S&P 500 components is what we’re looking for.
 
Analysts that track all B400 companies, based on our bottoms up analysis, have lowered their fiscal year 2015 estimates, in the aggregate, by only 0.8% in the last three months. By contrast, analysts following S&P 500 constituents have lowered their expectations for FY 2015 earnings for those companies by 3.4% during the same period, a rate four times as high as that for B400 constituents. At least from this perspective, the strong-dollar-favoring-small-caps theory seems to hold. We then broke the numbers down further and looked only at companies with a market capitalization below $10 billion, both within B400 and S&P 500. The results are equally surprising, though not so much for us equal-weighting veterans. Fiscal year estimates for all sub-$10 billion companies in B400 have fallen in the last three months by 0.8%, the same amount as it did for the index as a whole. There were 276 companies in B400 under this threshold (69% of the index). For S&P 500 companies below the $10 billion mark, the downward adjustment in earnings expectations in the last three months averaged 2.7%, almost three and a half times as high as for the B400 set. 110 companies in S&P 500, by the way, fall below this threshold (22% of the index). The list below illustrates the ten companies in each index with the most improved earnings outlook for fiscal year 2015.

How much of this deflation in earnings expectations can be attributed to Energy companies within each index? For the 35 Energy companies in B400, analysts lowered their fiscal year estimates, on average, by 7.4%. In comparison, for the 40 Energy companies in the S&P 500, the average reduction in expected earnings came out to be 13.7%, a full 6.3 percentage points worse than for the B400 set. So, energy clearly has played a role.

How are these changes in investor expectations, which are clearly starting to differ between small and large companies, affecting stock prices and index levels? Well, through last night’s close, B400’s total return for the year thus far added up to 3.69% while for the S&P 500 it was 2.16%. What matters this early in the year, for purposes of our current analysis, is not the nominal difference between both of these values but rather how they have been achieved. We therefore took the bottom half of all companies in each index, based on their market cap, and looked at how much they had contributed to each index’s performance so far this year. The results speak for themselves.

The 200 smallest companies in B400 accounted for a total return of 2.98%, or 80.8% of the entire index’s return so far this year. By contrast, the 250 smallest companies in the S&P 500 accounted for 0.38%, of S&P 500’s total return thus far in 2015, which is only 17.6% of the index’s performance in the period. Considering the weighting differences between the two indexes this should not be surprising yet it is always an interesting illustration of where B400 places its bets and where it doesn’t.

At this point you might ask, where is Apple in all of this? AAPL accounted for 0.05% in total return for B400 through last night’s close, which comes out to 1.4% of the index’s 3.69% total return this year. For the S&P 500, composed of the 500 largest public companies in the United States, AAPL accounted for 0.62% of the index’s 2.16% total return year to date. Or, put another way, AAPL accounted for a full 28.7% of the index’s year to date performance. To put it into perspective, this was 11 points higher than the entire bottom half of the S&P 500 based on market capitalization. Thankfully for large cap investors and closet indexers, Tim Cook and his crew continue to rocket along.