The heart and soul of this blog is deep value investing at the micro-cap level. It’s turning over rocks that no one else looks at to find stocks w/ high potential for appreciation w/ tons of downside protection. Why?
Quite simply: to beat the pants off the market in the long run. To generate significant amounts of alpha. If I’m not doing that, what’s the point of spending all this time researching stocks and writing this blog (trust me, it’s not for the google advertising fees. They don’t even cover the cost of hosting!)? And if you don’t think I can help you beat the market, why waste the time reading this blog???
All of that may seem obvious, though I think we sometimes overlook it when we’re putting together our RSS feed with our favorite blogs and getting stuck in the sometimes tedious task of researching stocks day to day. And I’ve mentioned all of this before, though perhaps not quite as succinctly.
But let’s drill down deeper- why do I think using a deep value approach when investing in stocks, or looking through micro-caps, will allow me to beat the market?
It’s because I think doing so will give me an edge. Again,this shouldn’t come as news to you if you’ve been following the blog for a while.
But here’s a question that I haven’t mentioned before, and I haven’t seen it discussed anywhere else. It’s a question I don’t have a good answer to.
When you’re searching for an edge, is it best to keep things simple, or should you go for complexity?
Let’s start with simple. Look at yesterday’s write up on MPAD. That’s as simple as it gets. The stock has a steady and consistently profitable operating history. It’s trading for under tangible book value, under net working capital levels, and about net cash levels. If they could buy the whole company for the price the stock market is offering today, any rational business person would leap at the opportunity.
Boom. Done. Simple.
But does that give you a real edge?
Honestly, anyone with basic accounting and finance skills could have told you all of those stats after a fifteen minute glance at the financials. You could do the same for most of my net-nets.
How can something be undervalued if the value is that clearly discernible?
I mean, how is this different then simply looking at a stock and saying “it’s P/E is under 8x, it’s a great buy!” or “it traditionally trades for 2x EV / Sales but it’s trading for 1.5x EV / Sales today. Discount!” They both require about the same level of effort and expertise. And in both cases, the investor could simply say they are taking a long term value approach to the stock!
Maybe you’ll argue that the net-net approach is based in harder values than sales or earnings, which mean different things for different companies. A dollar of sales of Microsoft is a lot more valuable than a dollar of sales for Wal-Mart! But you again come back to the fact that identifying net-nets takes no special skills and could easily be done by a computer.
Then there’s the other end of the spectrum. Look at the recent write ups for GKK, NCT, RAS, or ATPG (bonds or equity). All of them are super complex. They involve some degree of industry expertise, advanced knowledge of accounting, and tons of balance sheet adjustments. They involve extraordinary amounts of work to determine what the value is and where to find it.
Clearly, not everyone can do that. As a matter of fact, very few people can. Even a rather advanced investor would initially balk at GKK if they just did a quick look at the financials. Heck, it took me reading about them three or four times and then reading through their 10-K (which is hundreds of pages long) multiple times to even begin to figure it out. A computer certainly couldn’t find value in these.
So obviously, there’s an edge to be found here. But the chances for error greatly increase. So if the “complex” idea works out and you make money, how do you know you’re not just getting rewarded for taking on more risk? Consider that if you’re wrong on any of your assumptions, you’re in for a world of hurt- shouldn’t the reward for that sort of investment naturally be high?
Also consider this- What if (like me) you’re just starting out in the high yield space? How can you really know what is an effective covenant and what isn’t? For that matter, with all the preferreds I’m talking about, how do you know for sure all of those non-recourse liabilities can’t eat into any of the assets at the corporate level? I mean, management is the one who says that- do you just take their word for it?
Speaking of management, they’re the ones who should know their company and the value of it the best. If Wall Street is truly grossly mispricing their stock and there’s huge value to be found in it… why aren’t they buying up shares hand over fist??? Isn’t the lack of insider purchasing showing you’re misinterpreting a complex situation when you see huge value? Or that maybe there’s huge value, but, again, it’s only because the risk justifies the reward???
And let’s not forget that all of these complex situations are in existence because the company struck a deal with a Wall Street bank to raise publicly traded debt (in ATPG’s case) or preferreds (in the other three cases). If Wall Street was key in raising the deal, that means the “pros” know about the company. If they know about it, why are they letting it trade at such a huge “discount?” With the micro-cap net-nets, many of them are the size of a banker’s weekly paycheck. Not so here- Wall Street could put a significant amount of capital into any of these companies if they believed in them.
So what’s the right answer? Simple or complex?
I’m not sure.
Simple is easy. To some extent, it’s tough to make mistakes with simple. But it’s also tough to argue you have a true edge.
Complex is tough. You can certainly get an edge here. But it’s tough to know if you’re just being rewarded for taking on extra risk. And one small mistake can kill you.
So there’s upsides and downsides to both.
I wish I could give you a definitive answer with which to focus on, but I can’t. I hate to end an article with an “I don’t know”, but that’s investing for you. Sometimes, there just isn’t a definitive answer.
But I still think this post is important to keep in mind as you continue to develop as an investor. If there’s one take away from this post, it’s this: true edges are incredibly difficult to find as an investor, and if you have one and determine a situation is deeply undervalued, bet and bet big.
Disclosure- Long all securities mentioned in this article expect Microsoft and Walmart, and may be looking to buy more.
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The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. Read that last line again. Also, this blog is not a solicitation of business. The content herein is intended solely for the entertainment of the reader and the author(s).
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Keep up the good work! I read your blog almost every day. I look forward to seeing your ideas and seeing what your opinion is.
You are right, the end result of all this work is to beat the market. Have you been doing that? By how much?
If you had the liquidity and presence of mind in this latest financial crisis, you could have made a LOT of money. I did very well, but not anywhere near as well as I could have, lesson learned.
I see a lot of opportunity right now in the small community banks. Some of these are trading for 1/2 of TANGIBLE book and have mid single digit P/E’s. A few of them even pay dividends!
I am invested in and also watching closely some truly small companies that are clearly mis-priced…They are out there for sure.
Thanks for the kind words Roberto!
Yeah, I did very well in 2009 + 2010, ~40% in both years. I was down just under 5% last year.
Interesting post, I just have a few comments:
1) I think you have stars in your eyes over complex stuff.
I think the complex stuff is like this, consider there are people who all will focus on a small niche part of the market for their entire career. You talk about having an edge, I have no hope of ever having an edge in some non-vanilla security because those are the areas hedge funds and banks love to deal.
I would rather focus on simple issues, mistakes are easy to identify and avoid. You do well investing by avoiding mistakes not by picking the next Starbucks.
2) I consider the time value of my investment research. If it takes me two hours to research Micropac and I invest $1000 which turns into $2000 I just made $500 an hour. I don’t have to have a ton of conviction to invest $1000 and my hourly research rate of return is high.
If I spend 120 hours on GKK and it’s a double I need to invest $60k to get my same $500/hr return. I would rather find 60 Micropacs and spend 2 hours on each than concentrate all my money on one GKK.
Then again this is just me, I don’t invest full time. I see based on your disclosure you’re an advisor so I’m guessing clients are paying you to do this research so your dynamic is a bit different. If you only spend two hours on a stock what do you do the rest of the work week? In a sense you’re biased towards complex situations because you need to fill your time. I’m guessing clients wouldn’t be happy if they found you built a portfolio out on Monday then went and golfed Tues-Friday.
I don’t necessarily disagree with you, maybe I am too attracted to the complicated stuff. But it offers advantages similar to micro-caps in that few people look at them. Also, many of them have relatively hard catalysts in the form of dividend, puts, calls, etc, which micro-caps certainly don’t have.
And I think if you look at the world’s best investor, all of them engage in relatively complicated securities. Buffett when he was starting out was hyper into arbitrage and odd securities, Einhorn shorts potential frauds, Paulson and Burry w/ arb and CDS markets, Marks w/ high yield, Klarman with bankrupt debt.
(btw- I’m not an advisor. I just grabbed that disclosure. It pretty much covers all possible legal scenarios!)
This is a very candid note. I am new to this blog and the world of micro-caps. I also wonder about the issues you raised here. I normally deal with larger companies. But feel I need to be more versatile/resourceful with ideas. Thanks for sharing your research and thoughts.
wy
happy to share. Thanks for the kind words!
You ask what the edge is in investing in simple companies – I think the answer is right there – it’s in the discipline. Just being patient and continuously searching for micro-caps is not the stuff that’s going to bring you glory. It doesn’t feel as intellectually satisfying as having the GKK preferred’s work out but it takes discipline and patience. These are an edge.
A lot of investors are too focused on other factors – P/E’s, relative valuations, technicals and don’t pay attention to DCF or Net-Net type investing. Some get how to do it but for some reason or another cannot stay focused on this and move on.
Buffet but more than him – Munger / Klarman have talked about staying focused in your circle of competence, being patient and not getting too engrossed in the complicated stuff. Now, when it comes to GKK or NCT – you have done the work that gives you the edge. Reading through the statements and unwrapping the balance sheet is complex stuff that a lot of investors just dont want to deal with. Does that give you an edge? it depends on how many others are looking through the securities in as much detail. In some cases you probably have an edge, in others like ATPG it might be harder given their wider following.
i think you are not giving yourself enough credit when you say there is no edge in concentrating on micro-caps. keep up the good work on the blog. i certainly enjoy reading it and researching some of your ideas to see if i want to invest in them too..
MB,
Very good comment. It’s tough to stay in one market area especially if it’s dull like the micro-cap space.
I think the reason a lot of investors move on from net-net investing is eventually bargains dry up as the market rises and if someone wants to be fully invested they need to look elsewhere. I’ve tried to combat this myself by looking overseas. And just like the quote “there’s always a bull market somewhere” the same applies “there are always loads of net-net’s somewhere”. Right now that’s Japan, and most US investors have a stigma attached to that. For the record on ALL the net-net’s I’ve invested into that are in Japan I’m positive (all double digits as well) 6-9mo later whereas over that same period the benchmark is down.
Small stocks, net-net stocks, international small stocks make American’s uncomfortable. Most investors would rather buy JNJ at fair or slightly over valued then a company like MPAD even if MPAD is selling below net current assets.
great comment mb. I (of course) agree that there’s an edge in micro cap net net investing. This post was more designed as a thought reflection on really why there is an edge in the spirit of questioning everything!
You also can’t ignore the benefits of small size and a prolonged timeframe; these were the main reasons Buffett famously quipped he could easily return 50% annually on a $1million portfolio, and that the portfolio would almost always be fully invested. For instance, just take Nate Tobik’s comment from the MPAD post, “I am content to wait for a few years in this one.” How many funds can invest with relative size in a $14million company, now how many can do it on that timeframe?
All great points. I certianly agree there is an edge in micro-cap investing; this post was more designed towards thinking through the “why” and “how could I be wrong” scenarios.
There is a basic problem with complex, hard to value, small assets that *nobody* really looks at:
IF it is so difficult to discern where the (potential) value sits that the price of the asset went below net value, who’s then gonna buy it from you at a higher price ? What would make this negative sentiment go away?
What would attract interested parties to the game?
I met a few net net small caps during my research, I own some of them, but in my very own investment circle people think I am crazy (there might be truth in that, no doubt) owning that sh*t which is hardly traded at all while *they* are making trading *profits* on “candles”, “resistance levels” and other “signals”. They wouldn’t touch them with a barge pole.
But I don’t mind keeping them at least 20 years and accumulate at depressed prices, while profitable.
Then again, my prime objective is NOT beating any market. My objective is to acquire during my working life (=net saver period ) as many income generating assets as possible, preferably totally uncorrelated to each other.
And since I do believe that income from micro caps … is not very correlated to my other income streams, I am interested in your thoughts. Keep up the good work.
Thanks Panly!
Whopper,
Thanks for blogging your ideas. I like not only the company analysis but also these broader questions about investing that you’ve been addressing lately. Great discussions.
Thinking about this question, including some very good comments comments, I might frame your question a little differently. As you point out, you are really asking if you have an edge. Obviously with complex companies, your edge is analytical. But as MB points out, when investing in simple micro caps, the edge can be behavioral. I think this syncs with Michael Mauboussin’s theory that there are three sources of an edge – behavioral, analytical or institutional (I think individual investors can have institutional edges in long term time horizon, small size, and absolute performance vs. relative).
Maybe the first question to ask about a security is “Why is it cheap?” I’m sure you ask this already, but it leads right into the question of what your edge is. If it is cheap because the markets believe a company is holding toxic assets, and you can comb the K’s and decide the assets are not toxic or will not sink the company, you are looking for an analytical edge. If it is cheap because it is tiny and wholly ignored, you looking for a behavioral and institutional edge. As commenters discuss above, to invest in micro caps, you need to exercise patience, discipline, and possibly even withstand ridicule!
I think there is a definite question of style – simple or complex – but the right answer is more personal and depends on your skill set and disposition. I don’t think there is a right or wrong answer.
Personally, while I would love to add complex to my skill set, I don’t have the chops yet. So I keep it simple. I got into investing because after two bubbles and crashes in my adult life I realized Wall Street was insane – chasing the same hot stocks regardless of price, being closet indexers invested in everything despite obvious risks, calling dismal performance a success because they “beat” the market. So I’m happy to keep it simple, and keep my behavior edge by reminding myself why I’m doing it in the first place.
Thanks for the insightful comment Greg!
Gee, whopper, after reading quite a few of your blogs, I have come to the conclusion that you are pretty clever. Just out of curiousity, how has your analysis worked out in the past, i.e. have you ever had a really strong conviction , but misread the tea leaves as to what is really going on? (I don’t mean market returns- I mean within the actual working of the businesses under question). As an aside, I commend your humbleness, and appreciate your wisdom and wit.
Hey Baruch,
Thanks for the kind words.
O, so, so, so many examples of situations where I’ve completely misread what’s going on.
Let’s see, off the top of my head, the best examples would be RSH and ARO (both of which I wrote up extensively). I made these investments last year based on huge share repurchase programs, market overreaction to poor short term results, and exceedingly cheap valuations compared to both current and past earnings.
Well, low and behold, the market knew something I didn’t. I was investing in large cap retailers, and it turned out the market had forseen troubles that I had missed- namely, even small decreases in sales for those companies, due to all of their off balance sheet leverage from operating leases, could crush the businesses.
Wait, I’m just finding this site now? This stuff is great.
I wouldn’t worry too much about how much your picks are making you on a per/hour basis. ESPECIALLY when you blog about it too! (because, as we all know, blogs are the path to riches) All the time you put into it cannot be easily quantified in a cash/hour basis. If you spend 6 hours looking into a company and find out it’s a big steaming pile, that is no time wasted. Now you know what big steaming piles look like, and it will be beneficial in the future.
You just got a new dedicated reader!
Hey Graeme,
Thanks for the kind words. I really like the “now you know what…” line; I will likely steal it from you in the near future.