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March Issue Of Hidden Value Stocks

March Issue Of Hidden Value Stocks

NOTE: Existing members can skip to the bottom to find the full 40 page issue.

We asked a ton of ValueWalk readers what their #1 goal was for improving their value investing.

Can you guess what they said?

No, it wasn’t more coverage of Apple or Tesla, those are already well covered by the likes of CNBC, sell side firms and blogs.

Nor was it more coverage of risky leveraged trades, ETNs.

They wanted good small-cap investment ideas that are vetted and have liquidity, but not well covered by Wall Street, Bloomberg, CNBC, sell-side analysts, blogs or even closed sites like SumZero or Value Investing Club.

This answer makes sense: we all want to collect more winners in our portfolio.

But after following investments of ultra-famous investors (Buffett, Dalio, Icahn), reading diligently through 10-Qs at night, and even combing through article after article on obscure forums and blogs, it can be hard to find qualified “special situation” ideas that aren’t already widely known.

So, to meet this key need of our readers, ValueWalk launched the Hidden Value Stock newsletter.

The Hidden Value Stock newsletter is a 30+ page deep dive report that gives you detailed analysis behind specific small and mid cap stocks that two under-the-radar value investing hedge funds like, as well as interviews with the fund managers about their investing process.

The latest issue of Hidden Value Stocks is out this week and if you want to sign up to receive an issue.

Below is an excerpt from our interview with Steven Kiel of Arquitos Capital Partners. At the bottom of this page, there’s a teaser copy of the new issue.

Interview With Steven Kiel Of Arquitos Capital Partners

Arquitos was founded with a goal of emulating the success of Warren Buffett’s early partnerships. Even your mission statement is lifted directly from the Buffett Partnerships. A lot of people have tried to replicate Buffett’s success in the past and failed. What made you think you could succeed?

Buffett has been an inspiration to a generation of investors, myself included. Investors should learn from him, but ultimately you have to apply your own personality to the way you approach research and the construction of the portfolio. You should try to emulate the process, but in a way that fits you.

The goal for any investor should be to compound funds at a better than average rate with less exposure to long term loss of capital. How do you improve on that statement? It’s kind of like the Declaration of Independence. The ideals stand the test of time. If you were starting a new country, just copy the first 273 words of the Declaration of Independence as the foundation of your country. That’s how I felt about the mission statement.

As far as what made me think I could succeed, it’s a constant process of proving it. Just like a baseball player, you’re only as good as your last year.

Do you have three special investment buckets similar to those of Buffett?

I break the portfolio into several segments but in a different way from the Buffett Partnership approach. We have core holdings that I would like to own as long as the company has internal reinvestment opportunities and as long as they effectively allocate capital. I also have a portion of the portfolio focused on arbitrage or special situations such as mergers, spin-offs, or other short term opportunities. I also keep on a more general market hedge.

Arquitos returned 54.9% for its investors during 2016, a tremendous result. What would you attribute this return to?

Well, we definitely had a great year. I would not expect that our run over the first five years of the fund is sustainable, but I’ll certainly keep trying. It’s important to remember that you can only control the inputs, not the outputs. Because our portfolio is fairly concentrated (12-20 stocks) good results will come when the largest holdings do well. The results haven’t historically been connected to the general markets. The timing is just luck and can’t be controlled, but the goal is to be consistent on the process. This may sound trite, but our biggest holdings went up the most, Intrawest Resorts, MMA Capital, Berkshire LEAPs, and Bank of America warrants. There is still value in all of them, though I exited the Berkshire LEAPs.

Your best-performing stock last year was Intrawest Resorts Holdings. Can you give a brief description of what happened here and how you stumbled across to opportunity?

That one is a good example of the importance of being flexible. Intrawest was cheap on the merits, but what caused me to make it our largest holding in the beginning of 2016 was their tender offer. They had sold their time share business and bought back about 12% of their outstanding shares. Fortress owns 60% of the company and did not sell any shares despite having a need to exit the investment. Clearly, Fortress thought that shares were trading too cheaply and it seemed to me that they had a plan to realize the value. Their plan seems to have come to fruition and recently Intrawest announced that they were putting themselves up for sale. Shares have passed $20, up from the $9.00 tender offer price a year ago.

On that note, what do you look for when you’re assessing a potential investment, what makes you say, “yes we want that” or “no we don’t”?

There are patterns. The Intrawest example is a good one because the situation was similar to previous investments I’ve made and witnessed where there was a large tender offer and the controlling shareholder does not participate. Seeing that definitely makes my ears perk up. On the negative side, there are a lot of things that make me want to stay away. The biggest ones are ethics issues. There are too many opportunities out there to get hung up with a company that has a poor culture.

So a company’s management plays a significant role in your decisions?

It plays a big role, especially with regards to incentives. My favorite investments are ones where the management is effectively allocating capital. The best companies are the ones that have high returns on equity and continue to find internal reinvestment opportunities. Those are the ones you can own for a long time. Sometimes the managers are inherently good capital allocators. Other times they are responding to incentives that cause them to focus on returns on invested capital and cash generation.  

Do you get involved with managements at all in an activist way?

I’d prefer not to. The frustration of dealing with negative things just kills too many brain cells. As a passive investor if management is doing something I don’t like, it’s just better to move on. Chances are they’ll continue to frustrate you. The one time I didn’t follow that path led to me taking over Sitestar (OTCQB:SYTE) with two other partners, Jeff Moore and Jeremy Gold, and led to a lot of work to clean the company up. I wouldn’t want to go through that experience again though we have a lot of interesting opportunities within Sitestar. Once was enough for me. I have supported other activists on occasion and am happy to ride their coattails.

Let’s move on to another of your winning positions last year, which was Berkshire Hathaway. You own the stock through long dated options. Can you explain the logic behind this trade?

Berkshire traded below 1.3 times book value at the beginning of 2016 and even lower if you considered what they were likely to report the next quarter. Of course, Buffett has said that he will buy back shares under 1.2 times book value. Given that situation, the easiest thing to do is either buy shares directly or buy long dated call options at the 1.2 times book strike price. I bought the call options. I don’t typically buy options, but you had to believe that at some point in the next two years either the multiple would be higher than what I bought the options at or book value would have grown or both. It turns out both happened and we made a really nice return. The risk/reward profile was better for the long dated options than the stock. It was a pretty simple thesis. It really required willpower more than anything else.

Do you do any shorting and if so do you have any short positions on at the moment?

I don’t have any short position though I keep a small hedge on. I just haven’t had luck with specific company shorts. It doesn’t seem suited to my approach.

Sure. Moving back to your investment strategy, reading through your letters to investors, you seem to focus on a company’s Net Operating Losses (NOLs) more than any other metric when analyzing its future potential. Why do you prefer to use NOLs to evaluate a company, rather than more traditional valuation methods?

That may be a trade that goes away if corporate tax rates are lowered. Tax reform would bring other opportunities such as partnerships converting to C corps, so I’m keeping an eye on any changes that occur….

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March 2017 teaser

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Hedge Funds We Profiled Killed It In 2016

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The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

This is part five of a ten-part series on small-cap investing.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.


For the other parts of this series please follow the links below:

So far in this series, I’ve looked at the academic research on small-cap investing but while academic research is always interesting, it’s no substitute for real-world experience. With that being the case, in the next few parts, I’m going to explore some tips, tricks, and experiences from the world’s most successful small-cap investors.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s rules   

Peter Lynch is without a doubt the most successful small-cap investor to have ever lived. Anyone can generate 20%+ p.a. returns from small-caps for a few consecutive years but few have been able to establish a record similar to that of Lynch.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

While managing the Fidelity Investments Magellen Fund, Lynch produced an average annual return for investors of 29.2% between 1977 and 1990, double the return of the S&P 500 over the same period, and catapulting the fund into the ranks of the best performing fund in the world. No doubt, if Lynch had continued to manage the fund throughout the 90s during the great dot-com bull run, the fund’s long term returns would be even more impressive.

As well as managing Magellen, Lynch also wrote several books on the topic of investing and these timeless investing books have really helped cement his reputation as one of history’s greatest investors. Within these books, Lynch made it extremely apparent that the average investor has what it takes to beat Wall Street at its own game and by following a few simple rules, investors could make money from small caps.

These 25 (26) Golden Rules Of Investing, are printed at the end of Lynch’s book, Beating the Street and no series on small-cap investing would be complete without them.

So, without further ado here are Peter Lynch’s 25 Golden Rules Of Investing:

  1. Investing is fun, exciting, and dangerous if you don’t do any work.
  1. Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.
  1. Over the past three decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You can beat the market by ignoring the herd.
  1. Behind every stock is a company, find out what it’s doing.
  1. Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.
  1. You have to know what you own, and why you own it. “This baby is a cinch to go up!” doesn’t count.
  1. Long shots almost always miss the mark.
  1. Owning stocks is like having children – don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in the portfolio at any time.
  1. If you can’t find any companies that you think are attractive, put your money into the bank until you discover some.
  1. Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.
  1. Avoid hot stocks in hot industries. Great companies in cold, no growth industries are consistent big winners.
  1. With small companies, you’re better off to wait until they turn a profit before you invest.
  1. If you’re thinking about investing in a troubled industry, buy the companies with staying power. Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.
  1. If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you’re patient. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile.
  1. In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.
  1. A stock-market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
  1. Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.
  1. There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
  1. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.
  1. If you study 10 companies, you’ll find 1 for which the story is better than expected. If you study 50, you’ll find 5. There are always pleasant surprises to be found in the stock market – companies whose achievements are being overlooked on Wall Street.
  1. If you don’t study any companies, you’ll have the same success buying stocks as you do in a poker game if you bet without looking at your cards.
  1. Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.
  1. If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds. Here, it’s a good idea to diversify. You should own a few different kinds of funds, with managers who pursue different styles of investing: growth, value, small companies, large companies, etc. Investing in six of the same kind of fund is not diversification.
  1. The capital gains tax penalizes investors who do too much switching from one mutual fund to another. If you’ve invested in one fund or several funds that have done well, don’t abandon them capriciously. Stick with them.
  1. Among the major markets of the world, the U.S. market ranks eighth in total return over the past decade. You can take advantage of the faster-growing economies by investing some of your assets in an overseas fund with a good record.
  1. In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.

The Small-Cap Investing Handbook Part Four: Quality Over Quantity

This is part four of a ten-part series on small-cap returns.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small-cap investing magazine Hidden Value Stocks.

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.

Also see

Handbook Part Four: Small-cap investing returns

As covered in the first three parts of this series, there is plenty of evidence which shows that small caps outperform their large cap peers but not on an aggregate basis.

The small-cap premium has disappeared since it was first discovered in 1980, but some small-cap stocks, particularly those that are high quality, continue to outperform. As covered in part three, these rare breed stocks are difficult but not impossible to find, and the rewards on offer certainly justify the additional work required to find these hidden gems.

A November 2015 Research Affiliates article by Vitali Kalesnik and Noah Beck succinctly summarizes small-cap investing as, “Small caps are not the fish, they are the fishing spot—not the source of alpha, but rather a place where alpha can be found.” This is, I believe, one of the most accurate ways of describing the small-cap market based on everything I have read so far. However, it is imperative for investors to understand the need to appreciate quality when looking at small caps, something Kalesnik and Beck’s article goes into detail on.

One of the metrics the duo considers is the distress and volatility characteristics of stocks by size. Using data from 1988 to 2014, the researchers find that the S&P credit rating difference between small-cap stocks (B rated) and large cap stocks (A+ rated) indicates the higher likelihood (over 200 times) of smaller stocks being delisted, often because of default.

Unsurprisingly, portfolio volatility for the firms with the lowest credit ratings is also higher at 20.6% compared to 14.3% for the larger companies with a higher credit rating. Small caps have a delisting rate of 2.38%, 23,700% times greater than that of large caps’ delisting rate of 0.01%. Volatility too is much greater in the small-cap arena when you dig below the surface. The article notes:

“A comparison of the median stock volatility of the highest and lowest quintiles is significantly more striking: the median volatility of the smallest stocks (50.5%) is almost 100% more volatile than the median volatility of the largest stocks (25.5%). Also, the dispersion in stock volatility is much greater for small stocks than for large stocks, with a 25th–75th percentile range of 32.1%–76.0% compared to 19.8%–33.2%, respectively.”

Small-cap returns are worth the risk

This additional volatility and risk of bankruptcy is worth trying to navigate thanks to the higher returns on offer from (high quality) small caps. So far in this series, we’ve seen evidence which shows that the small-cap premium exists, although there’s been little in the way of discussion as to why this premium exists. The Kalesnik and Beck article attempts to answer this question by taking a look at the average bid–ask spreads for each of the size quintiles over the period 1988–2014. The bid–ask spread serves as a proxy for trading costs. Higher trading costs reduce the attractions of equities; some investors will avoid stocks with high bid-ask spreads altogether as it severely limits profitability.

A stock with a spread of 5% instantly gives you a loss of 5% after the initial purchase excluding dealing costs, which is unpalatable to investors. Institutional investors also avoid such equities as the widespread and illiquid market means it’s difficult to build a position. Longer term investors, however, have no need to worry about a 5% spread — especially if they are targeting gains of 100% to 200% in the long term.

Still, Kalesnik and Beck find in their article that over the 27 year period studied, the average bid-ask spread for the smallest quintile of the market averaged 4.56%, compared to a spread of 0.46% for the largest quintile. These findings go some way to explaining why the small-cap premium exists and why it is possible to find more mispriced securities in this area of the market than any other.

The authors of the Research Affiliates small-cap article go on to look at the performance of value strategies in large-cap and small-cap universes between 1967 and 2014, and what they find only supports the conclusion that small-cap strategies do outperform but to achieve the best results you have to focus on quality.

The figures show that by using a traditional price-to-book value strategy for large caps over the period studied, investors were able to achieve a return of 13.1% per annum. The same approach used for small caps produces the return of 16.6%. However, where small caps really show the greatest level of outperformance is on the cash flow-to-price value (and quality) metric.

Using this ratio to screen market produced a return of 17% per annum for value small caps, compared to 13% for large-cap peers. What’s more, for the long-short study, the t-stat of the cash flow-to-price metric was significant the 1% level. More evidence that quality small-cap returns are the key to outperformance.

Small-Cap Investing: Quality Over Quantity all-cap returns

Alluvial Up 12.1% In Q1 On Small Cap Picks


Dear Alluvial Clients,

I am pleased to report strong results for Alluvial’s strategies this quarter. Alluvial has now completed three full years of formal operations, a milestone I was not sure would be reached when I began in 2014! Since its March 31, 2014 date of inception, Alluvial’s flagship Global Focused Value strategy has produced annualized returns, net of fees, of 17.6%. This compares quite favorably with the Russell 2000 Index at 7.1% and the Russell Microcap Index at 4.9%. I have been consistent in requesting clients assess Alluvial’s performance over time periods of multiple years. The small and often neglected or illiquid securities that are Alluvial’s focus often move (or don’t move) for no fundamental reason, and patience is required to see this investment approach to its fruition. In my view, a track record of minimum sufficient length to be meaningful has now been achieved, and I hope clients find Alluvial’s results acceptable. In general, I am satisfied with Alluvial’s investment decision-making processes and the results of those processes these three years. That does not mean I have not made errors. I certainly have and I have made efforts to discuss them candidly. But, I can say with confidence that I am better investor than I was three years ago. This is the result of constant effort to accumulate knowledge and understanding. An investor must never cease learning, because there is always more to know! More knowledge creates clearer sight, which allows better decisions and eventually, better results. I do not know if market conditions will be conducive to continued out-performance over the next few quarters or even years. I am exceptionally confident that Alluvial’s approach will continue to bear fruit over any reasonable timeframe.

Alluvial is growing, and with growth always comes change. Alluvial Fund, LP commenced operations on January 1 and has already welcomed several limited partners. With the launch of the partnership, Alluvial’s separately managed accounts are now closed to new clients. I believe the new partnership offers several advantages over the separately managed accounts. If you are an accredited investor and are invested in becoming a partner, please let me know.

Since Alluvial Fund, LP is now Alluvial’s only open investment vehicle, I will no longer be reporting performance for Alluvial’s legacy accounts. Doing so would only invite confusion and distract from efforts to attract new partners for Alluvial Fund. Because of rules surrounding general solicitation I am limited in my ability to provide information and commentary on Alluvial Fund’s holdings and results to non-accredited investors. Writing two different quarterly letters, one for separately managed account clients and one for limited partners in Alluvial Fund is untenable, so I am currently assessing strategies for continued communication with separately managed account clients. Future quarterly letters to nonaccredited clients may be summary in nature. Regardless, Alluvial will continue to provide its services to both its separately managed accounts clients and to Alluvial Fund limited partners for the foreseeable future.

But that’s the future, and this is now. Let’s discuss a few of Alluvial’s holdings and their pertinent developments.

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Stanphyl April 2017 Letter

April  letter from Stanphyl Capital. The hedge fund was profiled in our second edition and returned 31% in 2016. Check out the post and especially the end of the PDF for more on their small cap stocks.

For April 2017 the fund was down approximately 4.4% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 1.0% while the Russell 2000 was up approximately 1.1%. Year to date the fund is down approximately 9.3% net while the S&P 500 is up approximately 7.2% and the Russell 2000 is up approximately 3.6%. Since inception on June 1, 2011 the fund is up approximately 109.7% net while the S&P 500 is up approximately 101.1% and the Russell 2000 is up approximately 79.4%. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two.
As in March, our shorts killed us this month while our longs (collectively) had little impact. I thought April’s €20 billion ECB taper would be enough on the margin to start deflating a worldwide asset bubble that—by many metrics– was topped only in 1929 and 1999-2000; I was wrong. Despite ridiculous equity valuations and signs of a U.S. economic slowdown via increasing defaults in auto loans & credit cards and an awful Q1 GDP number, worldwide central bank balance sheet expansion may still be too massive to fight in significant size on the short side. Although the S&P 500’s current Shiller PE is an absurdly high 29, one must acknowledge that it hit almost 33 just before the 1929 crash and 44 just before the 2000 crash, and in neither of those instances were central banks printing over $100 billion a month (in 2017 dollars) as they are now, nor were major worldwide real interest rates almost universally negative. Belatedly acknowledging the possibility that this market may grow from the third-biggest bubble in history (as measured by Shiller) to the “first biggest,” in April I covered our Russell 2000 short position (fortunately, mostly before the French election) while maintaining our shorts in non-US sovereign debt (“the bubble that enables the other bubbles,” via our BNDX short), and—in reduced size– in Tesla (the market’s biggest single-stock bubble, with so many red flags that it could—and should– collapse regardless of what the broad market does). Once significantly more ECB tapering is at hand I may again put on a broad-market short position; alternatively, if we get a major sell-off prior to that we’ll have plenty of liquidity to buy when others are glued to their “sell” buttons.
Meanwhile, beginning this month (April) I’m waiving the fund’s 0.5%/year management fee until we’re back above our high-water mark. (We’re currently approximately 9.3% below it.) I didn’t do this when we drew down 17% between 2014 & 2015 because we had lots of deep value longs then that I felt would take off and make us a lot of money (and they did in 2016, when we were up over 30%). But on an “absolute value” basis (I don’t play the game of “relative value”) I’ve yet to find any cheap new long positions to add this year (which tells me how overvalued this market is), and don’t want to charge a management fee in a down year while positioned defensively. Here then are the fund’s positions…
As noted above, we continue to hold a short position in the Vanguard Total International Bond ETF (ticker: BNDX), comprised of dollar-hedged non-US investment grade debt (over 80% government) with a ridiculously low “SEC yield” of 0.74% at an average effective maturity of 9.2 years. As I’ve written since putting on this position in July 2016, I believe this ETF is a great way to short what may be the biggest

asset bubble in history, considering that Europe and Japan (which comprise most of its holdings) are printing approximately $115 billion a month (¥6.7 trillion + €60 billion, yet are long-term insolvent due to their massive liabilities. When will the bond buying end? For Europe I suspect it will be when the current ECB commitment expires at the end of 2017 and isn’t renewed, thanks to German pressure due to U.S. tariff threats, struggling savers & insurance companies and “enough” inflation. In fact, Eurozone inflation is now surging. Japan I think can never stop printing (its ratio of debt to GDP is too high) but will eventually crash the yen into oblivion (we’ve been short yen since late 2012) and with that its bonds will crash too. (I discuss Japan more extensively in the last paragraph of this letter.) The borrow cost for BNDX is just 1.6% a year (plus the yield) and as I see around 5% potential downside to this position (vs. our basis, plus the cost of carry) vs. at least 30% (unlevered) upside, I think it’s a terrific place to sit and wait for the inevitable denouement.


Ticker and other info removed for non subs or one stock – this stock and 3 more small cap tickers below for subscribers

We continue to own XXXXXXXXXXX maker XXXXXXXXXXXXXXXXXXXXXX which in March reported a somewhat disappointing FY 2017 Q1 (its seasonally weakest quarter) with revenue down 6% year over year and a small operating loss ($6X,000) vs. $23X,000 in operating income a year ago. However, the company did generate almost $5XX,000 in free cash flow and seems to have turned its international division around nicely, with solid growth from its XXXXX  acquisition. More importantly, XXXXX has hired an investment bank to “explore strategic alternatives”—in other words it has put itself up for sale (and also paid out a .70/share special dividend in February). Thanks to its 53% gross margin and potential for large SG&A eliminations if it weren’t an independent public company, I think XXXXX should be sell-able to a strategic buyer at a significant premium to the current price; for example, an enterprise value of 1.25x 2016 revenue would be roughly $12.65/share (net of the cash paid in the February special dividend), while a “worst case” scenario of 1x revenue would still be around $10/share.

Stanphyl Capital Letter continues below – skip to end to see small cap discussion

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The Small-Cap Investing Handbook Part Three: Size Matters

This is part three of a ten-part series on small-cap investing and the small-cap premium.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small-cap investing magazine Hidden Value Stocks.

  1.  Handbook Part One: Introduction
  2.  Handbook Part Two: The Premium

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.


small-cap premium The Small-Cap Investing Handbook Part Three: Size Matters – small-cap premium

As covered in parts one and two of this series, there has been some debate as to whether or not the small-cap premium (whereby small-cap stocks outperform their larger peers) still exists. Some studies appear to show that this effect has disappeared but a paper entitled “Size Matters If You Watch Your Junk” by Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, And Lasse H. Pedersen published in 2015 confirms that the small-cap premium does still exist for high-quality companies.


Small caps are known to be high-risk investments, which is why no one expects every single small-cap to outperform. With this being the case, a study looking at the performance of high-quality small caps may be the best way of trying to understand whether or not the small-cap premium does still exist.

The authors of the paper separate the good companies from the “junk” by using several simple measures of “quality” which they described in an earlier paper. These measures are:

“Profitability (margins, free cash flow, profits per unit of book value, etc)

The 5-year growth rate in profits (again using a broad range of measures of earnings)

“Safety”, which is based on both the volatility of the stock, the volatility of the underlying profits, and the amount of leverage

How much profit is returned to shareholders rather than retained or spent, with higher payout ratios signifying higher “quality”

Separating small caps according to these factors produces some astonishing results. The authors found that around one-third of the smallest companies in the sample fall in the bottom of the rankings when it comes to things like profitability, sales growth, and earnings volatility. Overall, the typical small-cap company has far worse fundamentals than the average company in the broader stock market universe with a less than 10% of the small caps considered between 2010 and 2012 actually meeting high-quality standards. As the chart below shows, most of the firms with the worst fundamentals are small.


In comparison, around 40% of the largest firms in the top quintile of all publicly traded shares are of high quality according to the study.

These findings go a long way to explaining why the small-cap premium has been difficult to find in academic studies which do not compensate for quality. The final findings of “Size Matters If You Control Your Junk” should settle the argument once and for all. The alpha (risk-adjusted annual return) to a strategy of buying small stocks and shorting large ones, ignoring quality, is 1.7%/year (t-stat of 1.23). This becomes 5.9%/year (t-stat of 4.89) controlling for quality. It’s hard to argue with those numbers.

Quality investing shouldn’t be confined to just small-caps. Research has shown that most stocks return nothing over their lifetime, which is bad news for investors who believe they can replicate Warren Buffett’s success by using an extremely concentrated portfolio.

The figures supporting this conclusion come from research by Arizona State University finance professor Hendrik Bessembinder, who studied the returns of 26,000 equities over the period of 1926 to 2015. He found 96% of stocks achieved nothing.

During this period, $31.8 trillion of wealth was created but just 4% of equities. Of the total, Apple Inc. accounted for about 2% of wealth creation between 1926 and 2015. ExxonMobil Corp. accounted for 3% of the wealth created.

This isn’t just a lesson for small-cap investors. It is a warning for investors across the board if you want to outperform then quality matters.

What’s more, if you’re willing to take on the extra work and dig deeper to find the market highest quality small caps, then there is evidence to support the conclusion that small caps will outperform the market over time. However, the small-cap universe as a whole should not be counted on to outperform the rest of the market.

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