The Value of Turning Over More Rocks

Authored by John Carraux, CFA

“The person that turns over the most rocks wins the game.  And that’s always been my philosophy”

- Peter Lynch

Not long ago, several members of our research team took a scenic road trip down the Mississippi River to visit a small-cap company in Iowa.  The company is a good-sized furniture manufacturer with a gleaming new headquarters right on the banks of the river.  As we do with many companies we are seriously researching, we had a full afternoon of meetings scheduled with the senior executives of the company, followed by a plant tour of the nearby upholstered seating division.

After the usual introductions and pleasantries with the CEO and CFO, we casually asked how often they hosted meetings with investors like us.  “You’re the first to come visit us in five years!” was their reply.  When we hear that from a company, it tends to get us excited.  It’s also not that unusual.

We get excited about unknown companies in the same way that a beachcomber might get excited when his metal detector starts beeping over a clump of sand.  The beeping alone doesn’t tell us what lies beneath; it could be a dime or a diamond bracelet. The simple fact that we are one of the few to take notice is significant. 

Taking notice of companies that are unknown, under-researched, and hard to find (the nearest airport was three hours away) isn’t all that unusual for us because those are exactly the types of opportunities we seek. Information is a valuable commodity in investing, and the scarcer it is the more valuable it becomes.  We believe that performing due diligence research that others are unwilling or unable to perform is a real competitive advantage. 

Investors who make the time and effort to find, research, and invest in lesser-known companies—those who turn over more rocks, as Peter Lynch would say—gain insights into three critical areas that we think are significant drivers of value and, therefore, investor returns over time:

1. Corporate Strategy
2. Competition
3. Culture

Doing the hard work of traveling to companies, interviewing management teams, and touring facilities isn’t easy, but we believe that the unique insights that such activities usually render to the intrepid investor can translate into attractive returns over time.

Corporate Strategy

When doing due diligence on a public company, many investors start by perusing the publicly-available regulatory documents of a company.  These filings (Annual Reports, Quarterly Reports, Prospectuses, and the like) offer excellent information, and plenty of it.  It isn’t unusual for a Fortune 500 company’s Annual Report to run several hundred pages long.

What quickly becomes apparent when reading these voluminous filings, however, is that much of it is written by two categories of authors: accountants and lawyers.  There is usually an abundance of accounting arcana, and what qualitative descriptions there are of the company’s operations, reporting segments, and risk factors tend to be heavily redacted as if they were sterilized to be only as descriptive as required by law.  Understandably, it makes little sense for a company to go overboard on explaining the nuances of its business and strategy in a public government filing that is accessible by customers, competitors, and the like.  Excessive transparency could ultimately be detrimental to the company.

Investors, however, do need to know these nuances to make intelligent, rational judgments about the strength of the company and the sensibility of its strategy.  We’ve found that the best way to gather these insights is through direct, face-to-face management interviews.

Management interviews should ultimately yield answers to two important questions: does the company have a cohesive strategy?  And does that strategy truly differentiate the company from its competitors?

Amazingly, some companies do not have corporate strategies.  Quite simply, they lack an overarching vision for their enterprise, as well as the framework to translate vision into action.  Especially among smaller companies, there can be a tendency to simply do business the way it’s always been done, or to seemingly run the company for the benefit of management’s lifestyle, or to lack serious directors or shareholders who are willing and able to hold the company accountable.  We believe, that over time, this is surely a recipe for investment disaster.

Most of the time, though, serious companies have taken the time and effort to thoughtfully articulate where they want their company to be in the future and what the roadmap for getting there looks like.  The articulation of this vision, and more importantly, the operating philosophy animating it, is critical to investment success.

Is management aggressive, willing to pursue a win-at-all-costs fight for market share?  Or are they more conservative and tactical, picking battles where the odds of success are stacked in their favor?  Is their attention to the opportunities before them more scattershot, or focused?  Do they prioritize ethical business practices, or is regulatory compliance of secondary concern?  How do they think about creating value for shareholders over time, and what are the metrics used to gauge this progress?

These are the questions whose answers often cannot be found in public filings.  For those companies who do not command much attention from Wall Street, the answers to these important questions must be ferreted out by investors willing to engage companies on their own terms.

Competition

Corporate strategy only makes sense when viewed through the prism of competition.  A company’s ability to generate and sustain returns on capital is largely determined by the structure of the industry or industries in which it chooses to operate.  The difference between a concentrated, monopolistic industry and a fragmented commodity one is enormous.  Engaging a management team on the issues of competition can produce extraordinary insights for investors into both the quality of the company itself, as well as the quality of its competitors. 

Whether a CEO respects, fears, or ignores a competitor can also be revealing.  More than a few times, we have walked away from meeting with a management team more impressed with one of their competitors than the company itself.

Culture

While there may be external clues to a company’s culture, such as communication style, performance track record, or outside reputation, there is nothing like standing inside a company’s offices and facilities to truly touch and feel its atmosphere and aura.  Even small clues like décor, employee perks, and the location of the executive suite say a lot about how and why a company operates.

We get particularly excited about a company when we can discern a passion or mission from within the organization.  Usually the tone and tenor of this passion begins with the CEO.  Do managers and employees appear to be simply working to collect a paycheck and accrue vacation time?  Or is there a larger purpose, a raison d’etre, which emanates from conversations and motivates activity?  This is the fuel that feeds the engines of ingenuity, work ethic, and ultimately profitability.

It can be especially exciting to visit companies with recent leadership changes, where an old, slow-moving culture may be giving way to something more dynamic.  Several years ago we visited a company that had gained a reputation for infighting and stagnation after fifteen years under a CEO who seemed to be happy to extract his multi-million-dollar salary while the company and stock price flat-lined.  After his retirement, he was replaced by an outside CEO who was ten years his junior and brought with him a lot of passion and energy.  On his first Thanksgiving as CEO, after purging much of the old leadership of the company, he personally gave every employee a frozen turkey and a hug.  We were impressed.

Conclusion

We believe that there are structural reasons why most of Wall Street does not pay much attention to smaller companies that are out-of-the-way and out-of-favor.  The brokerage and research business is largely built on trading commissions and advisory and banking fees.  Many asset managers are focused on gathering assets in a business where scale drives profitability.  Consequently, public companies that are too small, too illiquid, or over-capitalized fall through the cracks.  There is little economic incentive for large, sophisticated investors to invest in them.

And yet, there is a whole swath of these companies that are worth paying attention to because they have defensible business models, attractive competitive positions, and the right kind of culture to grow and thrive over time.

By rolling up our sleeves and doing the hard work of uncovering and understanding these companies’ strategy, competition, and culture, we can glean important information from them and develop unique insights that give us the opportunity to generate alpha over the long haul.

The information presented herein may incorporate Punch & Associates’ opinions as of the date of this publication, is subject to change without notice and should not be considered as a solicitation to buy or sell any security.  Certain information contained herein may constitute forward-looking statements.  Forward-looking statements are subject to numerous assumptions, risks, and uncertainties, and actual results may differ materially from those anticipated in forward-looking statements.  As a practical matter, no entity is able to accurately and consistently predict future market activities.  While Punch & Associates makes reasonable efforts to ensure information contained herein is accurate, it cannot guarantee the accuracy of all such information.  This material should not be construed as accounting, legal, or tax advice.  Punch & Associates is not qualified to provide legal, accounting, or tax advice, and accordingly encourages clients and potential clients to consult their professional advisers with respect to such matters.   

"Swing Thoughts" for this Market

            With apologies to the non-golfing readers, I am going to go with a golf analogy this quarter. We have, after all, just emerged from Masters week which is the equivalent of Holy Week for the avid golf fan. Years ago, I picked up a book by legendary golf teacher Harvey Penick called Penick’s Little Red Book. Penick’s resume included teaching many successful tour players like Ben Crenshaw, Tom Kite, and Kathy Whitworth while remaining an active instructor well into his 80’s. Despite Penick’s relative anonymity, the book succeeded, selling more than one million copies to become the best-selling sports book of all time.* Why? Because Penick’s teaching worked. It made the average golfer play better.

            Penick relied on short, memorable anecdotes to drive home important points. He gave his pupils a “swing thought” – the one thing they were to think about before stepping up to hit a shot. For example, when Penick’s student, Betsy Rawls was in a playoff for the 1951 US Open Championship he sent her a one-sentence telegram. It said: “Take dead aim!” This was her ONLY thought when she approached her golf ball. Betsy won the playoff.**

            Many golfers don’t experience similar success not because they lack talent, good instruction or sound equipment but, in large part, because the swing thoughts they have in their head before they bring the club back are wrong (or, perhaps, they have too many of them).  Likewise, individual investors don’t achieve the returns they should because of flawed thinking prior to and while they are deploying or monitoring their personal capital.  Barry Ritholtz, a leading Wall Street commentator and strategist, notes that since ERISA was passed in 1974 enabling IRAs and, eventually, 401(k) accounts, the market has returned about 11% annually.  However, the average investor has gained only 3% per year. ***  This is commonly known as the “behavior gap.”  Bad thinking leads to bad investment behavior in the same way that bad swing thoughts lead to bad golf swings.  In both cases, the result is bad.  In one case, the cost is some lost golf balls and a bad afternoon outside; in the other case, the cost might be a college tuition payment or a deferred retirement date, or worse.

            Just as people hired Harvey Penick so that they would score better versus how they might score without his input, we believe folks hire Punch and Associates so they might achieve better results versus what they might achieve without our involvement.  So what is the equivalent of a good swing thought for putting money to work or staying invested in THIS market?  We have several, in particular, for folks taking a passive approach toward overseeing the active management of their portfolio:

•       Think “Zig,” think “Zag,” but mostly, think long term.

        "The market timers’ Hall of Fame is an empty room."   -- Jane Bryant Quinn

         

Despite having heard this quote early in my career, I had to lose some of my own money to realize the veracity of it.  Nobody on the Forbes 100 list got there by jumping into and out of businesses on a regular basis.  Why should we advise our clients to do differently?  We are contrarian investors, so it is in our nature to examine parts of the market that have a) attracted the least amount of attention, or b) declined recently or have not participated in the market’s advance.  In many cases, these areas have the most upside over our expected holding period.

• Forget the headlines. 

         “News is to the mind what sugar is to the body.”   -- Rolf Dobelli (www.dobelli.com), 2010

I challenge anyone to name a time when you read a mainstream headline and it allowed you to make a better decision.Think of what it takes for something to become a headline.  Many people —not just one or two—have to be clubbed over the head with the effects of an issue or the concern over what might happen; they then  gather in a room discuss it some more, ping-pong the issue back and forth, and maybe table the headline for future publication.  Something more happens in the real world – stocks go up, stocks go down, the dollar spikes, oil crashes, etc. – and they decide to create the headline.  How is this headline going to help you?  The fact that it was created means that its effects have already been felt.  You can’t profit from it, and it will likely create unneeded angst.

•          Volatility does not equal risk.  

With markets up and a Fed tightening in the offing, markets will no doubt fluctuate more.  Warren Buffett dedicated several paragraphs in his annual letter to the difference between volatility and risk.  He is the world’s most successful investor, and he does not buy into the conventional wisdom about it: “stock prices will always be far more volatile than cash-equivalent holdings.  Over the long term, however, currency-denominated instruments are riskier investments — far riskier investments — than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions.  That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk.  Though this pedagogic assumption makes for easy teaching, it is dead wrong:  volatility is far from synonymous with risk.  Popular formulas that equate the two terms lead students, investors and CEOs astray.”

Warren’s business partner, Charlie Munger, defines risk more succinctly: “using a stock’s volatility as a measure of risk is nuts.  Risk to us is 1) the risk of permanent loss of capital, or 2) the risk of inadequate return.”

•              Don’t get too excited/depressed.
  
  
  “We have met the enemy, and he is us.”         -- Pogo, 1970

The market has recovered over 200% from its bottom in 2009.  That’s a 20% + annual return for the S&P 500.  Pretty exciting, right?  The previous 10 years (1999-2009) was different.  The S&P lost about one-third, or almost 4% annually.  Pretty depressing, huh?  Excitement causes people to want more of what excites them.  Depression causes people to want to stop the pain.  While these emotions are normal, acting on them with your money is not recommended.  Most of our clients have been with us during both of these historical periods, and we believe most will be with us during distinct periods which will evoke similar extreme emotions in the future.  This is when proper swing thoughts are critical.

3

4.     

*         Golf.com/instruction/Penick

      **     The Little Red Book, Penick 1992

     ***    www.ritholtz.com/blog

A Behavioral Margin of Safety

                In 1991, one of the least-known, best investors of our time wrote a book called Margin of Safety. Seth Klarman, the author and Chairman of the highly-respected hedge fund, Baupost Group, did not take long to figure out that publishing was not going to be where his bread was buttered. He published only 5,000 copies and stopped printing what many value investors  now consider “the bible”. Today the book fetches $2500 a copy on Amazon but might be found used on eBay for $1000. Klarman could now likely turn a tidy profit publishing a few more copies but that clearly was not his objective in the first place. His objective was to get out of his head and on to paper what is the truth about why very few people are highly successful investors and most range from average to outright failures. Most investors, he concludes, focus on return and not risk.

                In the book, Klarman goes out of his way to focus on risk. He notes, “A margin of safety is achieved when securities are purchased at prices sufficiently below underlying value to allow for human error, bad luck, or extreme volatility in a complex, unpredictable and rapidly changing world."

                Klarman goes on to discuss several methodologies for examining what the true value of a company is versus the perception of its value as portrayed by its stock price. He mentions many methods for evaluating the “real” value of a company -- practices which can be executed by most undergraduate-level finance students. Klarman knew that his formulas and assumptions could be perfect, but unless perception (stock price) and reality merged, he would not make money. The gap needed to be wide enough to account for uncertainties and peoples’ perceptions needed to change.

                While this all seems dull and mathematical so far, great investors like Klarman, Buffet, and Soros are acutely aware that current circumstances  and the corresponding investor behavior they elicit is what leads to any disconnect between the market price and the true value of each of their holdings. They believe that the ideal circumstance for identifying the widest gap (best margin of safety) is when the fewest number of people agree with them. This happens when the behavior of other investors is contrary to their own.  Great investors also know that extreme behavior is not permanent behavior.  Attitudes can change more rapidly than fundamentals and money can be made anticipating these attitudinal shifts.  Money can be made buying companies (or industries, or markets) with the highest “behavioral” margin of safety. Capital can be protected by avoiding (or shorting) those with the lowest behavioral margin of safety (crowded trades).

           What is also quite clear to us is that the longer an investment behavior persists (e.g. buying bonds, selling energy stocks, buying large cap growth stocks, etc.) the greater the likelihood that this behavior will sow the seeds to its own reversal.  At these "behavioral inflection points" the selling will dissipate and turn into buying and the buying into selling.  Said differently, the stocks (or bonds, commodities, real estate) with the lowest behavioral margin of safety are those that have already  gone up the most for the longest period of time.

        When I think of recent history, I think of the stock of Apple.  In September of 2012 the stock eclipsed $700 per share.  Since October of ‘08 Apple ascended to that level in a mesmerizing fashion growing at an annual rate of more than 60%.  Few managers who expected to beat their benchmarks could afford to be left out of this stock.  At $700 per share there was still a cogent argument as to why the stock had a fundamental margin of safety.  Excluding the over $120 of cash per share the company had on its balance sheet,  Apple was still trading at under 12 times its forecasted earnings. This was cheaper than many slower growing, lower quality companies in the S&P 500.  But how high was its behavioral margin of safety?  Did everybody who was going to buy it already own it?

        While this practice is difficult to quantify, I would hazard to guess that the behavioral margin of safety was not high for this investment.  According to Nick Murray Interactive, Apple was one of the top ten holdings in over seven hundred equity mutual funds; four hundred had it as their single largest holding.  400 mutual funds quantitatively demonstrated that this was the single stock that was going to help them the most in beating the market averages over the foreseeable future after it had already gone up more than just about any other stock over the previous four years.  It takes some courage to own any single company.  With Apple it took a great deal more courage not to own it.  I have no idea how this company will perform from current levels ($500 per share a/o 1/2012) but Nick Murray said it best when he commented, “We may no longer be willing to accept even excellence from Apple, because we have in some sense started pricing in magic.”

            The behavioral margin of safety for the stocks in general can vary over time. As we enter 2013 stocks have recovered over 100% from their lows in March of 2009.  One would think that the average investor increasingly participating is one of the reasons for this recovery.  This is not the case. According to Gallup, every year since the recovery began the “participation rate” of American household in stocks has declined.  The participation rate sits at 54%, the lowest level since Gallup started measuring the data in 1999.  Everybody who can own stocks clearly does not own stocks. Every dollar that could come into the stock market has yet to be committed.  We would need to see more investors behaving with impunity before waving the caution flag to our loyal constituency.

The Search For Oracles

"The greatest blessings come by way of madness."  -- Socrates on the Oracle of Delphi

     The focus on recent headlines and worries about the Fiscal Cliff has distracted investors away from the factors critical to long term investment success.  We are content to leave the predictions to others and instead spend our time trying to find value-priced companies that have the potential to grow substantially over time, thereby unlocking the powerful force of compounding.  

     I recently had the privilege of traveling to one of the most important sites of the ancient world:  The Temple of Apollo at Delphi.  Delphi was the longtime home of the priestess of Apollo, an Oracle who was believed to be able to predict the future based on her ability to communicate directly with the Greek Gods.  The Oracle's prominence began to grow immensely sometime around 800 BC and held steady for over 1,000 years ending only with the fall of the Roman Empire.  Citizens from all over the Mediterranean made the long and difficult journey through the mountains simply to seek the Oracle's divine prophecies.  In fact, many of the best known figures of the period (such as Alexander the Great, Cicero, and the Roman Emperor Hadrian) based their decisions for war and politics on her responses to their questions.  The Oracle's prophecies were widely credited as being highly accurate, which is reflected in the incredibly vast store of wealth that was accumulated by the temple (satisfied visitors were expected to make significant donations and gifts).  In many ways, the Oracle can be said to have started the first, and perhaps most enduring, global consultancy.*

     So what does the story of the Delphic Oracle have to do with investing?  When I was touring the site, I couldn't help but think that it speaks to a core element of human behavior.  We all would like to be able to know the future before making decisions regarding inherently uncertain events.  This dynamic is perhaps strongest in today's investment world which is obsessed with predicting the future and constantly in search of modern day Oracles.  CNBC interviews filled with questions about the course of short term events illustrate this quite well with common questions along the lines of, "How will the Greek Parliament vote?", "Where is the price of Gold headed this week?", and our recent favorite, "How are you positioned for the Fiscal Cliff?".  This tendency has helped create a headline-focused trading culture built on the mistaken belief that investing is a predictioneer's game--that those who can most accurately predict the outcome of headline events perform the best.**  The end result is that many investors:

• Spend considerable time trying to predict headlines
• View their portfolio in the context of recent news (shows such as Fast Money and Options Action are indicative of this mindset)
• Trade incessantly, holding securities for increasingly short periods of time (the current average holding period of a stock is now only 3.2 months)
• Engage in herd-like behavior, crowding in and out of the popular stocks and industries of the moment
• Spend little time examining fundamentals and the underlying value of businesses

     The most successful investor of our time has been dubbed the "Oracle of Omaha" by the media.  This title strikes us as particularly ironic given Mr. Buffett's well articulated philosophy of generally avoiding predictions.  That doesn't stop people from asking him to predict the future, though, and the most recent Berkshire shareholders' meeting was filled with questions about recent headlines.  His response: "In 53 years, Charlie and I have never had a discussion about buying or selling in which we talked about macro affairs."  Indeed, Buffet has repeatedly advised investors to "stop trying to predict the direction of the stock market, the economy, interest rates or elections."  This sage advice has not been heeded by the masses.  It is clear to us that Buffet's success has had almost nothing to do with his ability to predict the outcomes of events.  Instead, it has been a direct result of his behavioral investment philosophy combined with a keen analytical ability to value businesses and buy them at prices which offer significant value--something we attempt to do on behalf of our investors each day. 

*As a footnote, an interesting question is how the Delphic Oracle held prominence for over 1,000 years while being engaged in such a difficult activity as predicting the future?  With the benefit of history, we now know that the Oracle had a secret.  Upon reaching the large Temple, guests would be lead to a small chamber, the Adyton, where the Oracle (typically a young woman) would receive guests while sitting on a tripod over a smoky vent.  Upon hearing a question, she is said to have become hysterical and begin to speak in "incomprehensible tongue" which was explained to come straight from Apollo.  Male priests would interpret her rantings and write a short, one or two sentence prophecy.  Research now indicates that her erratic behavior was due to the fact that the vent emitted a natural hallucinogenic gas.  While it is incredible to think that ancient visitors would give credence to the rantings of a drug induced teenaged girl, her behavior would have been something most visitors had never seen before, making the experience more believable.  The real power of the Oracle resided in the Priests who actually wrote down the predictions.  It is believed that the priests were great scholars who turned Delphi into a large information gathering center (a powerful tool in an ancient world where information was scarce).  They were able to research questions beforehand and dispense appropriate wisdom and advice.  For uncertain events (such as, "Will my unborn child be a boy or a girl?"), there was more gamesmanship, and the Oracle is famous for delivering prophecies which could be interpreted as being correct regardless of the outcome (the answer: the double entendre, "A boy not, a girl.").

**Notably, this behavioral tendency has also created incentives for pundits to make bold and extreme predictions.  A correct prediction of a low probability event has the potential to instantly elevate the media profile of the individual making the prediction, while a failed prediction is forgotten or can easily be explained away.  Thus, making a bold prediction has a favorable risk/reward trade-off especially for individuals seeking increased notoriety. 

Small Cap Valuations: Market Cap Bias and the Dangers of Headline P/E Ratios

       Using headline valuation metrics as a barometer can be particularly dangerous and misleading, especially for the Russell 2000 Index.  In addition to distorting the index, a market cap "blind spot" has created persistent inefficiencies (and opportunities) at the smaller end of the small cap universe.  Our small cap strategy, with a current median market cap of roughly $350 million, concentrates on smaller companies because this is precisely where thorough research matters the most.  

  

      During our recent conversations with institutional investors and consultants, we have frequently heard that "small caps look expensive."  Indeed, the Russell 2000 currently sports a headline P/E ratio of nearly 30x trailing earnings compared to around 14x for the S&P 500.  Is this conclusive evidence that small caps are overvalued -- especially relative to large caps?  

      We have been somewhat puzzled by this conclusion, as it contradicts what we have been seeing "on the ground."  As bottom up investors, we spend our time researching one company at a time.  While we are inherently intimidated by high valuations, we continue to come across plenty of small, well-run enterprises which appear to be both undervalued and out of favor.  Likewise, many of the quarterly earnings conference calls we tune in to have continued to garner muted interest at best (with some having no Q&A participants at all)--not exactly a sign of "irrational exuberance" for small caps.  Both of these observations are confirmed by the most recent additions to our small cap portfolio which are valued well below the Russell 2000 Index by most metrics.  So...what gives?

      One part of the explanation lies in the structural market bias we have previously referred to as the "market cap blind spot."  A majority of sell side analysts and professional money managers concentrates on the largest companies in the small cap universe and ignores the smallest ones.  This stubborn reality is reflected in the holdings data for buy-siders:  the average small cap mutual fund in the Bloomberg universe has a median market cap of $1.8 billion - a full three and a half times the $491 million median of its Russell 2000 benchmark.  In addition to creating persistent inefficiencies in the small cap marketplace, this bias has distorted valuations within the index itself.  An average of the valuation metrics presented indicates that the largest quintile of the Russell 2000 is 20% more expensive than the smallest.  This relationship underpins a counterintuitive dynamic in small caps, namely, the size of the company--not necessarily the merits of the business--is often the determining factor of its valuation.  This contrasts sharply with large caps, where size generally plays no discernible role in company valuations.

Evidence of the Blind Spot

 Russell 2000 Median Valuations by Quintile (10/31/2012)*

	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts
1 (Largest)	1,642	18.6	15.2	13.5	10
2	854	16.7	14.1	12.4	8
3	491	16.3	13.9	13.3	7
4	269	16.4	13.6	11.8	5
5 (Smallest)	150	14.9	13.2	11.3	4

 S&P 500 Median Valuations by Quintile (10/31/2012)*

  

	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts
1 (Largest)	56,433	15.2	13.2	12.3	28
2	19,999	14.7	13.8	12.4	24
3	7,722	16.4	13.8	12.2	19
4	7,668	16.8	14.5	12.2	19
5 (Smallest)	3,932	15.5	12.8	11.5	16
*We chose to use median data to eliminate the effect of extreme numbers and also believe it is more representative of company valuations found in each quintile. Data assembled from Bloomberg, L.P.

      Because of market cap bias, the Russell 2000's headline P/E (a weighted average) is inflated, as the most expensive companies have the greatest representation in the index.  This dynamic is further compounded by the fact that the Russell 2000 has more than twice the proportion of companies with exceptionally high P/E ratios* (often caused by marginal recent profitability).  In our view, median data produces a far more meaningful comparison because it is less affected be these distortions.  We also believe that median data is more indicative of the valuations of a "typical" company in the index and also more representative of the characteristics which an active manager is most likely to uncover during his or her research.

*10% of Russell 2000 names have a P/E ratio over 40 compared to only 5% of S&P 500 names.     

Median Data Comparison (10/31/2012)
	Market Cap (Millions)	Trailing P/E	Forward P/E	Trailing EV/EBITDA	# of Analysts	Sales Growth	Earnings Growth
Median R2K Company	491	16.9	14.2	8.9	7	5.5%	7.0%
Median S&P 500 Company	12,495	15.9	13.6	9.0	23	2.4%	4.5

      When examined on a median basis, the valuation disparity narrows substantially: small caps are only 4% more expensive than their large cap counterparts despite appearing twice as expensive on a headline P/E basis.  We think that this slight valuation premium for small caps is more than warranted considering their stronger sales and earnings growth characteristics (in red). 

Mis-Impressions

I’m a huge golf fan. I’m a bigger Ryder Cup fan. So Friday morning was the start of a golf fan’s “best 3 days”. The TV was on but I was not tuned in. I had to work.  I looked up every once in a while to see how my American favorites were doing against their European counterparts, and every time I did something bad was  happening to the  Americans. I saw Tiger hit balls into the woods, I saw Furyk “ lip out” putts, so I naturally assumed we were getting our “collective American butts” kicked in the morning session. Much to my surprise this was not the case. Americans and Europeans were tied when the morning session concluded. It occurred to  me that this must be how many  individual investors feel about stocks and the stock market.

Research points out that this is exactly the case. Franklin Templeton surveyed one thousand Americans in 2010, 2011 and 2012, and asked them how they thought the stock market had finished at the end of the previous year. For the year 2009, in which the S&P 500’s total return was 26.5%, 66% of the thousand respondents said that it had been down or flat. For 2010, when total return was 15.1%, 48% of those surveyed said that it had ended down or flat. For 2011, the return was 2.1%, and 53% of respondents said that the market had been down or flat. What’s worse is that, based on these “embedded impressions” and the continuous negative media drumbeat, these same folks are likely deferring investments or vacating well thought out financial plans. Over $300 billion has been withdrawn from actively managed equity mutual funds since the market bottomed in March of 2009(The S&P 500 is up 115% since then). The money is still trickling out because when people glance up at the screen it looks like Phil or Tiger missed another putt.

I guess the  choice is to pay attention or turn the TV off. 

Institutional Bias and the Story of Allied Capital

Over the past weekend, I started and finished the real-life tome Fooling Some of the People All of the Time by famed hedge fund manager David Einhorn of Greenlight Capital.  You could be forgiven for reading the book and thinking it fiction, as the story takes some unexpected twists and turns and at times reads more like a detective novel than a financial narrative.  It's a quick but thrilling read (although that may be over-selling it; I'm the kind of guy whose blood starts pumping when reading a really good 10-K).

The heart of the story is this: really smart hedge fund guy uncovers accounting irregularities at said public company and wages a years-long campaign to raise awareness of the likely-fraud and to ultimately force regulators to intervene.

While the mere existence of practices of aggressive accounting, management opacity, and outright fraud at a public company are distressing, unfortunately they are more common than many investors think.  Mr. Einhorn has done an exception job over the years of rooting out other public companies with such questionable practices.

What is more distressing to me was the burning, unanswered question I was left with at the end: why did it take so long--years, in fact--for the issues at Allied Capital to ultimately be recognized by its shareholders, by the market, and eventually by its regulators?  The stock price of Allied over the ensuing three years from May 2002 (when allegations were first made public) did not visibly discount this information (except in short blips) and actually outperformed the S&P 500 by over 7% per year.

More simply, it paid to be an investor in a company that had decent odds of being fraudulent!

I think the answer to my question, at least in part, lies in the "institutional biases" that motivate many shareholders, private and professional alike, and prevent markets from being perfectly efficient.

To wit:

1.  Few investors do their homework.  While the nitty-gritty details of Allied's accounting practices were laid bare for all to see in the company's regular SEC filings, few investors were willing to roll up their sleeves and do the analysis that ultimately proved incriminating.

2.  Investors love a check in the mail.  Allied's shareholder base had a large contingent of individual shareholders who, as long as they received regular, predictable dividends, did not pay much attention to how those dividends were generated.  They ate the sausage and didnt really care to see how it was made.  These dividend payouts also formed the basis of valuing the company.

3.  Wall Street is a deal machine.  Despite evidence of "irregularities" that should have been as plain as the nose on the face of your average Wall Street analyst, bulge-bracket analysts defended the company "to the death."  Addicted to Allied's regular and lucrative securities offerings, these analysts did not dare to jeopardize investment banking revenues for the sake of honesty.

And so it was, with this biases cemented in the minds investors and professionals alike, that Einhorn's allegations were taken less-than-seriously, and the stock was allowed to work its magic.

*     *     *

In our own search for investment ideas, we constantly remind ourselves to be on the lookout for these biases in other investors.  They are the means by which securities become over-priced and by which they become under-valued.  They are the reason that markets always have been and always will be inefficient.

Many times, these recognizable biases can be a starting point for finding undervalued securities:

Companies with complicated financials whose small but meaningful nuances dont make it into the quarterly press release.

Companies that dont pay dividends in an industry where all of their peers do.

Companies who have no interest in playing the Wall Street game: no continuous equity offerings, unending road shows, or investment bankers on the payroll.

These biases lead other investors to shortcut their decision-making process, usually reaching a conclusion as to whether they should or should not own a stock based on reasons that don't always relate to the fundamental value of the company.  That is our opportunity, and one we seek to exploit every day.

Stock Market Inefficiency You Can Set Your Watch To

It's that time of year again.  The time of year of which every small cap money manager is acutely aware: the annual rebalancing of the Russell 2000 Index.


The Russell 2000 is the de facto standard in small cap equity benchmarks.  It's tracking ETF, the iShares Russell 2000 (IWM), has a whopping $15 billion in assets.  That's a lot of money moving around in what can be a very illiquid asset class (the smallest stock in the index today has a market cap of only $7.7 million).  So when Russell makes its once-a-year additions and deletions to the index at the end of June, it can create some very interesting movements in stock prices.

Consider this: while the Russell 2000 Index overall is up 3.3% year-to-date, the 123 stocks being deleted from the index are down an average of 23.9% and the 189 stocks being added are up 49.0%.  While companies that have seen their stock prices decline over the past year are naturally the ones who are most likely to be booted from the index, these stocks have seen accelerated selling pressure ahead of the rebalancing as investors anticipate the event.

All of which creates an interesting quandary for the efficient markets crowd: what happens when stock prices move significantly for reasons clearly not related to the economic value of a firm?

Perusing the list of stocks that have been sorely punished for the simple reason that they will no longer be included in a passive index, we have found numerous examples of extreme mis-pricing.  Several stocks trade below their net working capital (liquidation value).  Several others trade at low single-digit multiples of cash flow.  A few have seen consensus estimates of their sales and earnings rise recently while the stock was falling precipitously.  These are not rational valuations but rather the result of mindless trading.

While the stock market is efficient much of the time, there are periodic pockets of inefficiency that are often easily distinguishable and predictable.  In the small- and micro-cap universe, these pockets are more frequent and generally of greater magnitude.  To the patient and intelligent investor, these occasional moments of insanity are the fun parts.

Winona? Who would ever go there?!?

Want to know what the best performing stock in the U.S. has been over the past twenty-five years?  No, it’s not Apple.  Or Microsoft.  Bloomberg Businessweek recently reported that Minnesota’s very own Fastenal (NDQ: FAST) holds that distinction, rising 27% per year since 1987.  That’s double the annual return of Apple and triple the S&P 500.

Fastenal, the Winona-based* distributor of nuts and bolts, is a fascinating story.  Founder Bob Kierlin started the business with a single store, a used car, and boxes of nuts and bolts in the late 1960s and through years of hard work and drive, the company has quietly grown to over 2,500 store locations and 15,000 employees.  It is an all-American story that warms our capitalist hearts.

Fastenal is pretty well-known among investors today, after this amazing period of creating significant wealth for its shareholders.  In fact, it is what you might call a “darling” stock, especially among growth-oriented money managers.  But how well-known was it back in 1987, and what characteristics back then might have led an astute investor to join the party before the run began?

As it turns out, not many investors were paying attention at the beginning.  In 1987, Fastenal had a market capitalization of a mere $50 million, small enough to put it in the bottom decile of public companies at the time and well below the radar of most professional money managers.  Moreover, it was based in a small Midwestern town that most New Yorkers had likely never heard of, and much of its stock was held by employees of the firm.  Far from being the latest, greatest technology company, its operations served a very basic purpose: get nuts and bolts to the people on the manufacturing line who needed it.

The reason that we bring up Fastenal is that there are hundreds of small public companies around the country that share many of the same characteristics as the Fastenal of 1987, many in our own backyard.  These are companies that serve basic needs, are run by honest and hardworking folks, and quietly generate significant returns to their shareholders over long periods of time.  And yet because of their size, or their location, or their unwillingness to play the Wall Street game, their stocks remain below the radar of most investors. 

They are the reason we get excited about investing in small- and micro-cap stocks.

*Several years ago we met with a well-healed investment consultant on the east coast and happened to mention the hamlet of Winona, Minnesota, when talking about a portfolio company.  The consultant, oblivious to how arrogant he was about to appear, exclaimed: “Winona?  Who would ever go there?!?”  Sometimes the best companies come from the most unknown places—just look at Fastenal.

We Like Good Companies, Maria

If we’ve heard it once, we’ve heard it a hundred times. A money manager, being interviewed on CNBC, describes his or her investment philosophy: “we like good companies.” Akin to the politician who is for “the American Dream,” it’s a statement so benign it’s hard to argue with.

What is a good business? And can that be an objective standard, or is beauty in the eye of the beholder? Our sense is that most people, having been trained to think like efficient-market investors and not like in-the-trenches businesspeople, don’t really get—or care about—the distinction. Good or bad, a company’s stock price already fully reflects its future prospects, so instead of trying to distinguish between them, you should just buy an index fund and hit the beach.

But if owning stocks is really owning fractional interests in real businesses (as we think it is), as opposed to pieces of paper to be traded for quick profit (as most peoples’ behavior seems to imply), the distinction is everything. Here are a few of our thoughts on just what defines a “good business.”

Perhaps the place to start is to first define the ideal business. If you were to start a business tomorrow and it could look like anything you wanted, you would want it to look like this:

1. Customers are required to buy your product
2. You are the only one who can provide it
3. There is unlimited demand
4. Little or no capital is required to start the business or grow it

Since we are financial guys and the objectivity of numbers gets us going, here’s how we would describe the same characteristics but in financial terms:

1. Consistent, predictable revenues
2. High profit margins
3. Steady growth over long periods of time
4. High and consistent returns on capital

Sounds pretty good, eh? Of course, no business enjoys all of these characteristics perfectly or completely; and if so, not for very long. But a unique few share many of these elements to a startling degree. Once one of these diamonds in the rough is uncovered, the question then becomes: how likely are these characteristics to persist? That is where the real work of research and analysis begins, and we spend much of our time trying to answer that question for ourselves.

Although markets are not perfectly efficient, they are quasi-efficient much of the time. Superior businesses usually carry superior valuations, giving credence to the old saying “good companies don’t always make for good stocks.” We agree wholeheartedly and avoid buying into “the hype” at all costs, except in two important cases: (1) when markets are distressed and the distinction between good businesses and bad ones becomes less important to other investors and (2) when superior businesses are too small to gain the attention of a majority of investors.

We believe the great advantage to being small- and micro-cap investors is that we are often early to the party. We traffic in a part of the stock market that doesn’t get much traffic and as a result get a crack at investing in some pretty exceptional businesses before they even show up on other investors’ Bloomberg screens. The absence of hype or even attention gives us the opportunity on a regular basis to buy truly great businesses at attractive prices.

Yes, Maria, we do like good companies.

Detecting Deception: "Trust, but verify" (Part One)

We recently concluded another earnings season, a quarterly time period that our team spends listening to tons of calls from public company executives of all sorts. During these calls, the vast majority of management teams trumpet the merits of their strategy, the quality of their businesses, and almost always argue that the "best is yet to come".

With literally thousands of public companies touting their prospects, it is a mathematical certainty that some are not telling the truth. Which management teams should investors trust? Who should be avoided? Is there a way to identify purposefully deceitful executives?

We believe that the quality of the jockey is often more important than quality of the horse.  As a result, gauging the personality of a management team is an integral part of our investment process.  We have historically favored the "quiet trumpets", that is executives committed to honestly assessing their business rather than cheer-leading their stock price. We are focused on finding passionate operators (not promoters) who are dedicated to capably executing a specific long term vision.

Making this determination is largely a subjective process that often depends on our "gut feel" (sometimes simply the absence of a slimy feeling) after meeting or speaking to a team directly. Admittedly, our batting average has not been 100%, and we occasionally are surprised to find out that we have misjudged a management team.  However, we have had success avoiding trouble by applying a checklist of sorts that seeks to eliminate self interested or overly-promotional management teams.  This list of "red flags" is pretty straight-forward and includes: 

• Excessive compensation or perquisites (company paid jets, private clubs, etc.) 
• Historical "Blow Ups" (Previous failures as public company executive) 
• Nepotism (Executives & Board members who all share the same last name)
• Dual share structures (granting majority voting control to executives who own a minority of the shares)
• Questionable related party transactions or other evidence of self dealing
• Excessive wearing of Jewelry
• Location of the company (Typically avoid Miami,  Las Vegas and Atlantic City)

After speaking to management teams we seek to confirm the accuracy of what we have been told.  This is our application of Ronald Reagan's famous "Trust, but verify" doctrine.  We get in touch with competitors, suppliers, and other industry experts to get their take and impression of the company we are researching. We also dig through archived conference calls, listening to what management was saying three or four years ago and comparing it back to reality. The tone of these calls, especially how management has responded to difficult shareholder questions, can be particularly revealing.    These additional steps help establish (or destroy) the credibility of a management team.

As students of behavioral finance, we have long been interested in improving our process to identify deception and weed out poor management teams.  We have enjoyed reading several recent studies which explore this topic in more detail and will discuss in subsequent posits:

• Detecting Deception on Conference Calls
• What we can learn from the prevalence of diving in Soccer matches
• Related Party Transactions and the incidence of fraud