Forward Guidance
Secrets of Small Cap Value Investing | Kyle Mowery
Mon Feb 19 2024Description
The episode covers various topics related to small cap value investing, including the challenges and opportunities in the market, the importance of qualitative analysis and understanding company fundamentals, generating free cash flow and return on investment, avoiding value traps, engaging with industry professionals, activist short selling strategies, long-short investing, and the role of biofuels and industrial policies in the investment landscape.
Insights
Small cap value investing requires a targeted approach
Small cap value investing focuses on businesses that are significantly mispriced and misunderstood in the Russell 2000 index. Passive investing has been rising, leading to a more momentum-driven small cap market rather than a fundamental one. Small caps as an asset class have low quality boards and management teams, requiring investors to use a targeted approach for success. Active managers in small caps can add value by identifying companies going through inflections or cyclical businesses.
Value factor based on price to book may not be effective in today's market
Value factor in investing can be misleading as cheap stocks may have lower quality and more issues compared to higher priced stocks. Value factor based on price to book may not be effective in today's technology-driven market where book value is less relevant. Using free cash flow instead of price to book can provide a better measure of value over a longer time frame. Finding value in small caps involves looking for businesses with improving numbers, good balance sheets, and high return on invested capital projects over the next one to three years. Investors need domain-specific expertise to navigate through the vast number of companies in the Russell 2000 index for successful stock picking.
Thorough fundamental research is crucial for successful investments
The podcast discusses the process of narrowing down investment opportunities from a broad list of companies to a more manageable number for in-depth analysis. The speaker emphasizes the importance of qualitative deep dives and understanding company fundamentals to generate expected free cash flow and assess risk-return ratios. An example of Ferroglobe is used to illustrate investing during a period of inflection, focusing on factors like balance sheet strength, capital return policy, and market trends.
Investing in companies with strong free cash flow potential
The podcast discusses how companies generate free cash flow and return it to shareholders instead of reinvesting in expansion. Investing in unprofitable businesses with a focus on unit economics and future profitability is highlighted through the example of ACV auctions. ACV auctions disrupts the traditional auto auction industry by using technology for efficient B2B transactions. The focus on unit economics, free cash flow, and future profitability categorizes the discussed investments as value stocks. The use of EBITDA over net income is explained as a way to normalize balance sheets and focus on key financial metrics.
Understanding free cash flow and investments
Companies start with income and then normalize EBITDA by adjusting for factors like capital expenditures. Free cash flow is determined by incoming cash minus capital expenditures. Investments can fail due to changing market conditions, competition, or inaccurate assumptions. Public market investors operate with imperfect information and may face challenges with management transparency. Capital allocation and management incentives can impact company performance and shareholder value.
Thorough fundamental research is key to making informed investment decisions
Analyzing proxy statements is crucial to understand compensation structures and management's motivations in small-cap companies. Thorough fundamental research is key to making informed investment decisions, looking beyond quarterly earnings reports. Publicly available information like Glassdoor reviews can provide insights into a company's culture and management practices. Investing in companies with strong free cash flow potential and volume-based growth strategies can be lucrative. Understanding industry dynamics and focusing on volume rather than price fluctuations can lead to successful investments.
Investment strategies for small cap companies
Pitched Darling ingredients at Invest for Kids charity event, which turned out to be a successful investment in renewable diesel market. Specialize in industrial companies and avoid financial services due to difficulty in gaining a fundamental edge. Focus on small cap companies that are not widely known or covered by mainstream media. Believe that value investing will work again in the future and small caps will benefit from it. Invest across various industries as generalists, understanding the business and product before diving in. Passive investing has led to network effect businesses rising and requires precision in selecting investments undergoing inflection with good earnings and cash returns.
Value investing and avoiding value traps
Investing in companies that return capital to shareholders is a key strategy. Small caps lack deep fundamental research, providing opportunities for success with thorough analysis. Value factor has not been consistently favorable over the years, and structural issues exist, making it challenging to predict its future performance. Large cap value stocks with low PEs can sometimes be value traps due to slow adaptation and lack of innovation. Focusing on companies with good unit economics and customer service can help avoid falling into value traps.
Avoiding value traps and engaging with industry professionals
Avoiding value traps in investing by considering people and culture of the company, not just financial numbers. Importance of understanding industry dynamics and company culture in investment decisions. Engaging with industry professionals, attending trade shows, and talking to former employees for insights on companies. Simplicity in investments but requiring thorough research and understanding of business operations. Balancing long and short investment strategies with a focus on getting paid based on market expectations.
Activist short selling as an investment strategy
Activist short selling is a way to make money by betting on overvalued stocks. Short sellers aim to uncover corporate malfeasance and unethical business practices. Short sellers focus on companies with high fees, potential bankruptcy, or questionable valuations. Short sellers study industries like the recreational vehicle market for cyclical trends and divergent opinions from mainstream projections. Short sellers typically target small-cap companies but also consider larger ones based on their asset allocation strategy.
Long-short investing and macro factors
Investor focuses on a handful of long and short stocks rather than the entire market. Macro factors are considered but less important for long-short investors. US economy is strong while European economy is struggling. Investment in Calumet Specialty Products, a sustainable aviation fuel producer with growth potential.
Chapters
- Small Cap Value Investing
- Value Factor in Investing
- Narrowing Down Investment Opportunities
- Generating Free Cash Flow and Return on Investment
- Understanding Free Cash Flow and Investments
- Thorough Fundamental Research
- Investment Strategies and Small Cap Companies
- Value Investing and Avoiding Value Traps
- Avoiding Value Traps and Engaging with Industry Professionals
- Activist Short Selling and Investment Strategies
- Long-Short Investing and Macro Factors
- Biofuels and Industrial Policies
Small Cap Value Investing
00:00 - 07:10
- Small cap value investing focuses on businesses that are significantly mispriced and misunderstood in the Russell 2000 index.
- Passive investing has been rising, leading to a more momentum-driven small cap market rather than a fundamental one.
- Small caps as an asset class have low quality boards and management teams, requiring investors to use a targeted approach for success.
- Active managers in small caps can add value by identifying companies going through inflections or cyclical businesses.
Value Factor in Investing
06:46 - 13:37
- Value factor in investing can be misleading as cheap stocks may have lower quality and more issues compared to higher priced stocks.
- Value factor based on price to book may not be effective in today's technology-driven market where book value is less relevant.
- Using free cash flow instead of price to book can provide a better measure of value over a longer time frame.
- Finding value in small caps involves looking for businesses with improving numbers, good balance sheets, and high return on invested capital projects over the next one to three years.
- Investors need domain-specific expertise to navigate through the vast number of companies in the Russell 2000 index for successful stock picking.
Narrowing Down Investment Opportunities
13:14 - 20:12
- The podcast discusses the process of narrowing down investment opportunities from a broad list of companies to a more manageable number for in-depth analysis.
- The speaker emphasizes the importance of qualitative deep dives and understanding company fundamentals to generate expected free cash flow and assess risk-return ratios.
- An example of Ferroglobe is used to illustrate investing during a period of inflection, focusing on factors like balance sheet strength, capital return policy, and market trends.
Generating Free Cash Flow and Return on Investment
19:50 - 26:58
- The podcast discusses how companies generate free cash flow and return it to shareholders instead of reinvesting in expansion.
- Investing in unprofitable businesses with a focus on unit economics and future profitability is highlighted through the example of ACV auctions.
- ACV auctions disrupts the traditional auto auction industry by using technology for efficient B2B transactions.
- The focus on unit economics, free cash flow, and future profitability categorizes the discussed investments as value stocks.
- The use of EBITDA over net income is explained as a way to normalize balance sheets and focus on key financial metrics.
Understanding Free Cash Flow and Investments
26:40 - 33:26
- Companies start with income and then normalize EBITDA by adjusting for factors like capital expenditures.
- Free cash flow is determined by incoming cash minus capital expenditures.
- Investments can fail due to changing market conditions, competition, or inaccurate assumptions.
- Public market investors operate with imperfect information and may face challenges with management transparency.
- Capital allocation and management incentives can impact company performance and shareholder value.
Thorough Fundamental Research
33:06 - 40:04
- Analyzing proxy statements is crucial to understand compensation structures and management's motivations in small-cap companies.
- Thorough fundamental research is key to making informed investment decisions, looking beyond quarterly earnings reports.
- Publicly available information like Glassdoor reviews can provide insights into a company's culture and management practices.
- Investing in companies with strong free cash flow potential and volume-based growth strategies can be lucrative.
- Understanding industry dynamics and focusing on volume rather than price fluctuations can lead to successful investments.
Investment Strategies and Small Cap Companies
39:38 - 46:49
- Pitched Darling ingredients at Invest for Kids charity event, which turned out to be a successful investment in renewable diesel market
- Specialize in industrial companies and avoid financial services due to difficulty in gaining a fundamental edge
- Focus on small cap companies that are not widely known or covered by mainstream media
- Believe that value investing will work again in the future and small caps will benefit from it
- Invest across various industries as generalists, understanding the business and product before diving in
- Passive investing has led to network effect businesses rising and requires precision in selecting investments undergoing inflection with good earnings and cash returns
Value Investing and Avoiding Value Traps
46:30 - 53:29
- Investing in companies that return capital to shareholders is a key strategy.
- Small caps lack deep fundamental research, providing opportunities for success with thorough analysis.
- Value factor has not been consistently favorable over the years, and structural issues exist, making it challenging to predict its future performance.
- Large cap value stocks with low PEs can sometimes be value traps due to slow adaptation and lack of innovation.
- Focusing on companies with good unit economics and customer service can help avoid falling into value traps.
Avoiding Value Traps and Engaging with Industry Professionals
53:03 - 59:35
- Avoiding value traps in investing by considering people and culture of the company, not just financial numbers
- Importance of understanding industry dynamics and company culture in investment decisions
- Engaging with industry professionals, attending trade shows, and talking to former employees for insights on companies
- Simplicity in investments but requiring thorough research and understanding of business operations
- Balancing long and short investment strategies with a focus on getting paid based on market expectations
Activist Short Selling and Investment Strategies
59:16 - 1:06:34
- Activist short selling is a way to make money by betting on overvalued stocks.
- Short sellers aim to uncover corporate malfeasance and unethical business practices.
- Short sellers focus on companies with high fees, potential bankruptcy, or questionable valuations.
- Short sellers study industries like the recreational vehicle market for cyclical trends and divergent opinions from mainstream projections.
- Short sellers typically target small-cap companies but also consider larger ones based on their asset allocation strategy.
Long-Short Investing and Macro Factors
1:06:04 - 1:13:18
- Investor focuses on a handful of long and short stocks rather than the entire market
- Macro factors are considered but less important for long-short investors
- US economy is strong while European economy is struggling
- Investment in Calumet Specialty Products, a sustainable aviation fuel producer with growth potential
Biofuels and Industrial Policies
1:12:49 - 1:17:23
- Biofuels are a step towards decarbonizing air transportation, though more expensive to produce.
- American industrial policies like the IRA focus on near-shoring and on-shoring, which can be inflationary.
- Capitalism is seen as a mechanism for economic growth and improving quality of life.
- Grizzly Rock Capital's funds are private, but accredited investors can get more information by contacting them.
- Recommended books for value investing include 'Margin of Safety' by Seth Klarman and works by Greenblatt, Buffet, and Munger.