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Alluvial Up 12.1% In Q1 On Small Cap Picks

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.

The Small-Cap Investing Handbook Part Two: The Small-Cap Premium

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

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.


The Small-Cap Investing Handbook Part Two: The Small-Cap Premium

Evidence of a small-cap premium first appeared in 1980 when a study titled “The Relationship Between Return And Market Value Of Common Stocks” was first published. Since publication, this study has formed the basis of a number of other academic studies that have tried to prove the existence of the small-cap premium.

Today investors are increasingly asking if this study remains relevant considering how the markets have developed since the late 70s. Not only has information on small caps become more widely disseminated but trading in these instruments is now easier than ever.

According to research conducted by Aswath Damodaran professor of corporate finance and valuation at the Stern School of Business at New York University, while a small-cap premium may have existed between 1928 and 1979 when the above study was published in 1980, it seems all of the excess small-cap returns evaporated.

Professor Ken French’s data library (on small-cap stocks) shows between 1926 and 1980, small-cap stocks earned on average of 7.18% more than the market each year. Immediately after 1980, the small-cap stock premium appears to have disappeared.

Between 1981 and 2014, small-cap stocks earned on average 0.18% less than the market each year. The dissemination of information certainly has something to do with this trend so do wider macroeconomic variables. For example, small caps outperformed large caps by more than 40% in 2002, after the dot-com bubble burst and by 60% in 1967. The best year on record for small-cap stocks was outperformance of 80% towards the end of the second war. The periods between these outlier events have been dominated by underperformance or moderate outperformance of 10% or less.

small-cap investing small-cap premium
small-cap premium

Still, even though Ken French’s data shows the small-cap premium is not a regular occurrence, it does demonstrate that it exists.

Further evidence of the small-cap premium can be found in a study titled “The Disappearing Size Effect” although this particular study finds that any small-cap premium disappears for companies with a market capitalization of over $5 million.

“During the period 1963–1981, we find an annualized return difference between small and large firms over 13% compared to a negative 2% return differential since 1982. Removal of the smallest firms (less than $5 million market value) eliminates any statistically significant size effect during the sample period using a regression framework.”

The studies appear to question the existence of the small-cap premium, but they fail to answer one fundamental question: what happens if you remove the junk?

Watch your junk

Small caps are naturally risky, and the majority of them flame out, but famous small-cap investors such as Peter Lynch and Warren Buffett made a name for themselves by buying the best small caps and ignoring the junk. With this in mind, a paper by Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, And Lasse H. Pedersen published in 2015 tried to answer this key question.

The researchers find that the existing criticisms of the small-cap premium do hold true in most cases. The size factor, a weak historical record of performance in the US, and even more inadequate record internationally “makes the size effect marginally significant at best.” The authors also acknowledge that long periods of poor performance, the difficulty of investing in micro-cap stocks and the concentration of small returns in January make the small-cap premiums existence difficult to justify.

Nonetheless, the paper goes on to note that the majority of the studies on the topic of the small-cap premium so far “load strongly and consistently negative on a large variety of “quality” factors.”

As determined in the paper Quality Minus Junk, following from the Gordon Growth Model, quality stocks are safe, profitable, growing, and have high payout ratio and outperform junk stocks over the long term.

Stocks with very poor quality (i.e., “junk”) are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality. By controlling for junk, the authors of this small-cap study find that a robust size premium is present in all time periods, with no reliably detectable differences across time from July 1957 to December 2012.

Bluetower Q1 Letter

Blue Tower Asset Management  is off to a slower start in 2017 but had a monster 2016 with an impressive 35% return. Check out our exclusive interview with the PM on some of the hedge fund’s favorite small caps.

Also see Livermore Partners up 85% in 2016 (also profiled here)

The Global Value strategy returned -2.90% gross (-3.14% net) for Q1 2017. Our performance this quarter was somewhat weak primarily due to three factors: 1) relative weakness in US small-cap equities, 2) a sentiment-driven sell off in EZCORP’s stock, 3) a general meltdown in the subprime auto lending sector. In this letter, I will give updates on EZCORP’s business and our investments in auto lending.

Blue Tower Asset Management

Blue Tower Asset Management – Relative Weakness in small-caps

Smaller companies had a rougher start to the year than the overall market. The Russell 2000, an index of smaller companies that (as of the most recent reconstitution) have market capitalizations between $3.9 billion and $133 million, had a return of 2.47% in Q1 relative to 6.07% for the S&P 500. If I were to speculate on the origin of the relative weakness of small cap stocks, I believe it is the result of the tremendous post-election rally that small cap stocks had after the election. This post-election bump in small caps was largely due to the belief that US corporate tax reform would be forthcoming (Trump campaigned on lowering the corporate tax rate to 15%). Small companies in the US pay a higher effective tax rate than large caps stocks, with the average for the Russell 2000 and the S&P500 being 30.6% and 25.8% respectively1. As hopes for a rapid tax reform process dim, Russell 2000 stocks have pulled back. Due to the Blue Tower Global Value strategy historically being invested mostly in US small cap stocks, the Russell 2000 has been the most correlated of the major indices to the strategy.


EZCORP (EZPW) was the largest detractor to our performance in Q1 2017 with a performance impact of -4.5%. EZCORP has gone through significant changes since we first invested. Late last year, they sold Grupo Finmart, their Mexican government employee payday lending service. The company recently had their annual shareholder meeting in Austin, TX where the company’s leadership discussed the growth in pawn loans outstanding and other aspects of the business. Over the past year, the company has grown loans in the US faster than either of their two major competitors. They are also undergoing a major hiring push and switching their workforce towards being fulltime only and phasing out many part time roles. They explained that they believe that fulltime employees will give the company less turnover which will allow them to gain more experience and create a better customer experience.

The creation of a new point of sale system for EZPW is a major initiative for the company. EZPW is developing the new system in-house with a software development team in Austin and has already invested $3 million into the project. This system will use the individual history of each borrower to determine the relative likelihood that the borrower will repay their pawn loan. For individuals who are more likely to pay back the loan, EZPW can give a larger loan and therefore boost the balance upon which they are collecting interest. For those who are less likely to pay back their loans, EZPW can give a smaller loan and thereby lower the cost of their merchandise and boost their gross margin. The point of sale software will provide store staff with a minimum and maximum loan amount for each item used as collateral allowing them to still make adjustments based on their judgement. If well implemented, such a system could give it a significant advantage over other pawn chains.

The company is also doing a major refurbishment of their stores due to significant deferred maintenance. For example, the company mentioned during the annual meeting that one store had pot holes in its parking lot. This reinvestment should improve the experience for customers and borrowers as well as increase the morale of employees.

Blue Tower Asset Management

Charlie Munger once said in response to a question about the power of incentives: ‘I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.’ The incentive structure of any company’s management is important towards understanding their behavior, and this is certainly true for EZCORP.

It’s important to note that several of the senior executives at the company left far larger corporations to work at EZCORP. For example, Stuart Grimshaw, the Executive Chairman, was previously the CEO of the Bank of Queensland, an Australian bank with a market capitalization of $3.5 Billion US Dollars. For them to leave larger companies, they must have seen an opportunity to make more money off of their EZPW equity.
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