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Second Quarter 2017 Letter to Alluvial Fund Partners

Dear Partners,

It is my pleasure to report results for Alluvial Fund, LP’s first six months of existence. While such a period of time is insignificant in the grander scheme, I am nonetheless happy to see the value of our investment grow at a healthy clip out of the gate. For the three months ended June 30, 2017, the value of an investment in Alluvial Fund, LP rose 7.1%, net of full fees. This compares favorably to the S&P 500 Index total return of 3.1% and the Russell 2000 Index total return of 2.5%. Year-to-date, Alluvial Fund, LP has produced a net return of 12.6% compared to 9.3% for the S&P 500 and 5.0% for the Russell 2000. The partnership finished the quarter with $9.3 million in assets.

In launching the partnership, Alluvial has welcomed several new limited partners. I am grateful for the opportunity to manage capital for you, and I will work to the fullest of my abilities to maximize the value of our investment. I am equally grateful to those partners who took a risk on a young, wholly unproven manager back in 2014, when Alluvial was born from a blog I would update in the wee hours in my rowhouse apartment on Pittsburgh’s North Side. It’s been incredibly rewarding to see both our portfolios and the scope of Alluvial’s activities grow.

These quarterly letters are a medium for me to discuss meaningful events at portfolio companies and lay out the investment case for various holdings. From time to time, I may share some general investment related thoughts. However, I tend to leave the pontificating on value investing to others. I enjoy talking about the opportunities I have found much more. With that said, let’s get to it. Alluvial focuses on small companies, illiquid securities, and special situations. Though we maintain this focus, we will purchase larger and more liquid securities when they

With that said, let’s get to it. Alluvial focuses on small companies, illiquid securities, and special situations. Though we maintain this focus, we will purchase larger and more liquid securities when they are especially misprice. We invest globally and are willing to wait years for value to be realized, provided value is accruing at a reasonable rate in the interim. When thinking about Alluvial Fund’s various holdings, I divide them into four informal categories. Many Alluvial holdings do not fit neatly into any of these categories, but the categories do provide me with an analytical framework I use in evaluating possible investments.

See the rest of the letter below:

6 Jun

The Small-Cap Investing Handbook Part Six: Peter’s Principles

This is part six of a ten-part series on our Small-Cap Investing Guide.

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 Small-Cap Investing Guide 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 parts five and six of this series are devoted to Peter Lynch.

Small-Cap Investing Guide Part Six: Peter’s Principles

Why spend so much time on Lynch and his principles? Well, when it comes to real world experience you just can’t beat the experience and record of Lynch.

There have been plenty of other successful small-cap investors throughout history but Lynch is the only investor to be able to have successfully replicated his stock picking success with thousands of equities.

So, here are Peter Lynch’s 21 “Peter’s Principles”, which are intended to sum up the points made in his book, Beating the Street.

Peter Lynch Small-Cap Investing Handbook

Small-Cap Investing Handbook – Peter Lynch’s Principles

Principle #1
When the operas outnumber the football games three to zero, you know there is something wrong with your life.
This point relates specifically to Lynch’s desire to spend more time with his family rather than trying to keep up with all his equities, but the idea behind the principle is simply to remember to make time for what you love in life.

Principle #2
Gentlemen who prefer bonds don’t know what they are missing.

Bonds are inferior to stocks.

Principle #3
Never invest in any idea you can’t illustrate with a crayon.

Buffett has a similar process whereby he avoids what he does not understand. This is the same principle.

Principle #4
You can’t see the future through a rearview mirror.

Past returns are not a guide to future success.

Principle #5
There’s no point paying Yo-Yo Ma to play a radio.

There’s no point paying a bond manager when you can just go and buy the bonds yourself for no annual management fee. The same principle can be used with high costs active funds that closet index.

Principle #6
As long as you’re picking a fund, you might as well pick a good one.

It pays to do your research.

Principle #7
The extravagance of any corporate office is directly proportional to management’s reluctance to reward shareholders.

Excellent companies are thrifty.
Principle #8
When yields on long-term government bonds exceed the dividend yield of the S&P 500 by 6 percent or more, sell your stocks and buy bonds.

This goes against principle two, but it’s offered as a sort of defensive strategy.

Principle #9
Not all common stocks are equally common.

Some companies are very special. Others are junk.

Principle #10
Never look back when you’re driving on the autobahn.

Principle #11
The best stock to buy may be the one you already own.

Principle #12
A sure cure for taking a stock for granted is a big drop in the price.

Nothing brings you back down to earth after a string of winning positions more than a sudden loss.

Principle #13
Never bet on a comeback while they’re playing “Taps”.

(“Taps” is the name of that bugle tune they play at military funerals. In stock terms, it never pays to buy a stock just because its share price has fallen.)

Principle #14
If you like the store, chances are you’ll love the stock.

Successful companies can be spotted before their stock market darlings by watching how many people use the store. Footfall will reveal more about future sales growth than backward looking financials.

Principle #15
When insiders are buying, it’s a good sign – unless they happen to be New England bankers.

(Refers to the management of a number of Texas and New England banks who violated principle #13, continuing to add to their holdings right up until the very end.)

Principle #16
In business, competition is never as healthy as total domination.

A dominating monopoly company will generate much better returns for investors than several smaller companies fighting for market share.

Principle #17
All else being equal, invest in the company with the fewest color photographs in the annual report.

To understand this principle, all you need to do it look at the annual report of Berkshire Hathaway.

Principle #18
When even the analysts are bored, it’s time to start buying.

When analysts get bored by the company’s lack of progress, the company may be boring enough to buy.

Principle #19
Unless you’re a short seller or a poet looking for a wealthy spouse, it never pays to be pessimistic.

Cyclicals can be a great way to make a buck if you buy them at the bottom, so it helps to look for opportunity in depressed stocks, rather than think of all the reasons why a cyclical is going to take losses. Optimism is required.

Principle #20
Corporations, like people, change their names for one of two reasons: either they’ve gotten married, or they’ve been involved in some fiasco that they hope the public will forget.

If it’s the latter, it’s best to stay away.

Principle #21
Whatever the Queen is selling, buy it.

If countries privatize formal state-owned companies, they usually do so on such attractive terms that shareholders are almost guaranteed to make great profits.

Stay tuned for our Small-Cap Investing Guide part VII!

The Small-Cap Investing Handbook Part One: Introduction

This is the first part of what will be a ten part series on small-cap investing.

Throughout this series, I’m going to take a look 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.

 

small-cap investing
small-cap investing

The Small-Cap Investing Handbook Part One: Introduction

Small-capp stocks have a reputation that’s not necessarily good but at the same time, it is not necessarily bad. The majority of the world’s most renowned investors started their early careers by investing in small caps.

The reason why is because the likelihood of the market mispricing securities in the small-cap arena is much higher than with blue chips. Blue-chip stocks tend to be well covered by Wall Street analysts and owned by the largest funds. Small caps, on the other hand, are generally overlooked by Wall Street as it’s not lucrative enough to produce coverage on smaller names.

As a result, some small caps fly completely under the radar of most investors, and it’s here where the largest mispricings exist.

Small-cap investing – Building wealth

Warren Buffett is perhaps the most famous example (barring his tutor Benjamin Graham) of an investor who has used small caps to make a name for himself. In his early days, Warren Buffett made millions for his investors by investing in such names as Dempster Mill and Sanborn Map. Both of these examples were trading at a deep discount to net asset value when Buffett became involved because Wall Street had no idea of how much they were worth. Warren Buffett took the time to do the legwork and was richly rewarded as a result.

Peter Lynch is another investor who made a name for himself in the small-cap arena. Lynch is considered to be one of the greatest money managers of all time and he achieved this accolade by finding small-cap companies that weren’t yet on institutional investors’ radar.

Lynch firmly believed that individual investors had inherent advantages over large institutions because the large firms either wouldn’t or couldn’t invest in smaller cap companies that have yet to receive big attention from analysts or mutual funds.

Still, while Buffett and Lynch have made names for themselves by investing in small caps, investors should be under no illusion that small-cap investing is easy.

It is considered (although as you will see later not entirely factually correct) that because small caps can produce high returns than the market, investing in small caps comes with greater risk. Even though the evidence does not support this statement 100%, it is an important observation.

Unloved small caps can outperform because they fall under the radar of larger investors and research houses. However, because these small caps are not well researched, it is vital that you conduct your own rigorous due diligence. It’s here where most investors trip up.

The 25 Best Personal Finance Books To Read This Year

Both Warren Buffett and Peter Lynch are known for their researching ability. Buffett is known for his love of figures and continual study of company earnings reports, while Lynch was known for his hectic travel schedule to visit company managements when he was running the Fidelity Magellan Fund from 1977 to 1990.

Yes, small caps can outperform the market, but unfortunately, these premium returns don’t come easy.

Can small caps outperform?

The first study that seemed to suggest small caps can outperform appeared in 1980. Titled “The Relationship Between Return And Market Value Of Common Stocks” the study found that smaller firms have higher risk-adjusted returns, on average, than larger enterprises and this ‘size effect’ has been in existence for at least 40 years.

To arrive at this result, the relatively simplistic study broke companies down into market capitalization deciles and found that companies in the lowest decile and the higher returns, after adjusting for conventional risk. Figures showed that the average excess return from holding very small firms long and very large firm short is, on average, 1.52% per month or 19.8% on an annualized basis.

By replicating the above study and extending the sample period through to the end of 2014, Aswath Damodaran professor of corporate finance and valuation at the Stern School of Business at New York University found that this small-cap performance anomaly has continued with companies falling into the lowest decile during the period 1926 to 2014 earning 4.33% more than the market after adjusting for risk.

The 1980 small-cap study has been used again and again as the basis for other academic studies on the topic and by actively managed small-cap funds in marketing materials. But today, there’s a growing debate over whether or not the small-cap premium actually continues to exist or if it has been arbitraged away by those seeking to profit from this market anomaly.

Boyles Fund 4Q16 Letter To Partners – Things that Don’t Make Sense

Here’s the year-end update from Boyles Asset Management, the firm we featured in our October 2016 publication.

Unfortunately, for compliance and regulatory reasons, Boyles have asked us not to publish the firm’s returns for 2016.

Here’s the rest of the Boyles letter (excluding returns) in full.


Quick Portfolio Updates

Creston

Creston, a smaller holding, was bought out by its largest shareholder in November. While we were cautious of this shareholder’s intentions, we had been comforted by the presence of unrelated large shareholders, whom we believed would counter such an offer. That comfort proved to be without merit. The 27% premium to the three-month average share price was much too low in our opinion—representing a valuation of approximately 10x free cash flow (which we believed to be below the firm’s earnings power). We voted against the offer. The total internal rate of return (IRR) since the inception of the idea in 2012 (prior to the Boyles launch) was 7.9%; without the impact of currency, the IRR was 14.4%. The modest outcome was impacted by the severe decline in the British Pound; the modest early outcome of an acquisition the company made; mediocre management which, while changed, was unable to generate organic growth; and as mentioned, the modest exit multiple.

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Stanphyl Capital: January Update

Below is Stanphyl Capital’s January update in full. The firm has got off to a rocky start to the year but is still beating its benchmarks by a wide degree since inception.

Stanphyl Capital: January Update

Friends and Fellow Investors: For January and year to date 2017 the fund was down approximately 3.9% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 1.9% while the Russell 2000 was up approximately 0.4%. Since inception on June 1, 2011 the fund is up approximately 119.2% net while the S&P 500 is up approximately 91.2% and the Russell 2000 is up approximately 73.9%. (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. Although this month we had some great news (and returns) from a couple of our microcap long positions (LTRX and MGCD), the fund’s negative performance was heavily influenced by its short position in Tesla Motors, which was up considerably despite an onslaught of negative fundamental developments. Here are the portfolio specifics… We continue to hold a large short position in the Russell 2000 (via the IWM ETF; short basis: $135.29; January close: $135.23). I think this is a good hedge for our microcap long positions in what I perceive to be a dangerous (expensive and increasingly protectionist) market, and as the companies in the index collectively have no earnings a potential Trump corporate tax cut can’t help them, while valuation (EV to EBITDA) is off the charts:

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Stanphyl Capital: January Update

Below is Stanphyl Capital’s January update in full. The firm has got off to a rocky start to the year but is still beating its benchmarks by a wide degree since inception.

Stanphyl Capital: January Update

Friends and Fellow Investors: For January and year to date 2017 the fund was down approximately 3.9% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 1.9% while the Russell 2000 was up approximately 0.4%. Since inception on June 1, 2011 the fund is up approximately 119.2% net while the S&P 500 is up approximately 91.2% and the Russell 2000 is up approximately 73.9%. (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. Although this month we had some great news (and returns) from a couple of our microcap long positions (LTRX and MGCD), the fund’s negative performance was heavily influenced by its short position in Tesla Motors, which was up considerably despite an onslaught of negative fundamental developments. Here are the portfolio specifics… We continue to hold a large short position in the Russell 2000 (via the IWM ETF; short basis: $135.29; January close: $135.23). I think this is a good hedge for our microcap long positions in what I perceive to be a dangerous (expensive and increasingly protectionist) market, and as the companies in the index collectively have no earnings a potential Trump corporate tax cut can’t help them, while valuation (EV to EBITDA) is off the charts:

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