Category Archives: Investment Philosophy

More Thoughts on Small Cap Investing

On October 4, 2010, I wrote a post entitled Small Stock Investing: The Path to Riches?, which outlined some of the differences between investing in small caps and large caps.

The post considered the idea that there is more opportunity in small caps. Upon reflection, perhaps it would have been better to make the distinction between micro-caps and large-caps, as micro-caps – stocks with market capitalizations less than $250-300 million – are more the area of the market I was writing about.

I have a few more thoughts on this thread.

I don’t think there is as much opportunity in this area as there was when Buffett was operating his partnership. There were no value-oriented hedge funds scouring the market with computer screens, so the market was less efficient. In 1963, there were 284 candidates for the CFA. In 2007 there were nearly 100,000 CFA charter holders.

Munger has made the point that the Great Depression so shell shocked equity investors that it caused a lasting multiple compression that created a period of opportunity for early value investors. Using Munger’s metaphor, now, when you run your Geiger counter looking for mispriced micro-caps, it may not click. The practical implication here is that to operate in this sector – given the potential paucity of candidates – you may find yourself reaching for companies of questionable quality.

A point that was made in the prior post – but that deserves re-emphasis – is that Buffett was an exceptionally gifted investor. He was the only student to get an A+ in Ben Graham’s investment class and is widely acknowledged as the best investor of his generation, if not all time. The point is that investing in micro-caps can be tricky. These companies don’t typically have the resilience of large caps and the lack of information that contributes to their mispricing may make it difficult to determine their intrinsic value.

For what it’s worth – and it may say more about me as an investor than the risks of micro-cap investing – I have lost more money in this area than in investing in large caps. Perhaps it would be prudent to “cut your teeth” in large or mid caps and prove to yourself that you know what you’re doing before seeking opportunity in micro-caps.

A case in point of the challenges of micro-cap investing is the example of Paul Sonkin. Sonkin is a hedge fund manager who specializes in micro and nano-cap investing (market caps under $50 million). Bruce Greenwald has looked at Sonkin’s trades and concluded that his initial positions were only minimally profitable and that the majority of Sonkin’s returns came from buying more stock as the price declined below his original purchase price. This means that Sonkin had to have a high degree of confidence in his valuations to be able to buy more stock as the priced declined. This could be a recipe for disaster if you didn’t know what you were doing.

Finally, a couple thoughts regarding Buffett.

First, Buffett points out in his partnership letters that he had a built-in hedge when investing in under-valued micro-caps. If he established a position and the stock went up, he made money. If the stock price stayed low, or declined further, Buffett could keep buying and eventually acquire a controlling interest in the business. He could then unlock the value in the business by changing management. Very few investors are in a position to utilize this hedge.

Second, Buffett did not put all his eggs in one basket. He made three types of investment in the partnership: 1) undervalued securities (what he called “generals”), 2) workouts, and 3) control situations.

I am not trying to discourage investing in micro-caps, but rather trying to point out some of the challenges so that, if you decide to do so, you will maximize your odds of success.

Small Stock Investing: The Path to Riches?

Some years ago, Buffett created a stir of sorts when he stated that if he were investing $1 million today he could generate annual returns of 50%. I wrote about it in an earlier post.

In an interview with blogger Jacob Wolinsky, value investor Whitney Tilson was asked if Buffett’s investment style had changed as a result of his different circumstances at Berkshire and if he would be a net-net investor if he was managing less cash. Here’s Tilson’s answer:

Yes, that is absolutely true. He has been asked this question many times and responded that if he were to be managing very little money he would be looking in the nooks and crannies looking for extreme temporary mispricings. If you know where to look, you can sometimes find extreme temporarily mispriced stocks. However these stocks are usually small and it is hard to put much money into them. Not in a million years would Buffett own Kraft if he was managing $10 million.

Recently on The Corner of Berkshire & Fairfax Message Board, an excellent investing forum run by value investor and investment manager Sanjeev Parsad, the question was asked “What percentage of your portfolio is in Fairfax Financial?” The level of discussion on the board is quite high and it’s clear many of the members are capable investors.

For those who are not familiar with the company, Fairfax is an insurance company with outstanding investing capabilities that has compounded book value at a rate of 25% over the past twenty-four years under the leadership of Pre Watsa. Fairfax is often compared to an earlier stage Berkshire Hathaway. Many members of the forum have a material investment in Fairfax.

One member, rick_v, criticized having a large investment in Fairfax because, in his view, it is easy to find cheaper micro-caps with greater opportunity. In response, another member, coc, defended investing in Fairfax and challenged the idea that it is easy to find micro-cap investments that will outperform the market.

I thought the exchange crystallized some of the important decisions investors face when defining their own investment process and philosophy. The exchange also provides some food for thought to those who, inspired by Buffett’s remark, choose to seek opportunity in micro-caps.

Here’s rick_v

I truly hope that all you guys mentioning stakes of 20-30%+ in Fairfax are either passive investors or older in age.

I think its a shame for a young or professional value investor to have such a large percentage of their portfolio in a stock like Fairfax. Afterall, even if Fairfax doubles in a few years that is not how you are going to generate alpha or get rich for that matter…

As a young or professional value investor you should be studying Fairfax and Buffet’s performance to identify your own value plays. Thats where the alpha will come from.

It is very easy with permanent capital to find securities which will outperform the market when you are looking in the 0-250m range. This range is not looked at by Prem, Buffet, and most of the other major value investors anymore due to their size. As such it represents where I see most of the opportunity for up and coming value investors.

Just my thoughts…

Here’s coc’s response:

I’m surprised you all let this go. I’d like to comment on two things, both of which I consider nonsense.

1. It is “very easy” to find securities that will outperform the market.

2. Holding Fairfax is inferior to running around finding these “very easy” securities.

I think investors vastly underestimate how good Warren Buffett was at his job back in the 1950’s and 1960’s when he was buying these niche securities. He’s even better now, but obviously runs so much capital that his returns are lower. There seems to be this “Buffett envy” going on in value investing circles whereby investors feel the need to look for little cigar butts similar to what Warren used to – largely influenced by his talks to students and his biography.

And yet, I have seen precious few investors who have successfully done it. Beyond the platitude that smaller areas of the market are “inefficient,” there are considerable risks. You are usually investing in second rate businesses that destroy value, or at least are not really building any. Often these businesses are run by inexperienced managers and have little advantage over their competitors. Thus, the business risks you assume are big ones, although most investors think a cheap valuation makes up for it. Sometimes, but not always.

Take for an example Dempster Mill Mftg – a well known Buffett investment way back when. If you think through the situation, there was a good probability that the investment was not a wise one. It took heroic efforts by a new manager to keep Dempster from going under, and even then, it was not an absolute home run. Yet, most Buffetteers admire these types of investments Warren used to make.

But what was Warren’s largest partnership investment? American Express, a well known company then and now, not a micro-cap dishwasher manufacturer. He also had a successful investment in Disney, and one in GEICO, again two companies that were well known. What was probably his best stock investment at Berkshire? The Washington Post, not exactly “unknown.”

Yet we’re told that he made all of his great returns back then because he could look small. Well, as with everything in life, the answer is yes and no. I think there is a great myth that you need to look where no-one else is looking and be creative in the investment process. That you should get points for creativity or something. But the very same people propagating this myth are students of Charlie Munger, who once wrote to Wesco shareholders that “We try to profit more from always remembering the obvious then grasping the esoteric.”

Let’s talk about a few more of Warren’s home runs. Petrochina, one of the largest companies on the planet. Freddie Mac, one of the largest companies on the planet. Coca-Cola, the most well-known brand on the planet. BYD, one of China’s most well-known and well-respected companies. These are investments where, for the first 5-10 years, he made 25%+ compound annual returns. Who are these people not getting rich by consistently generating 25% compound returns? Where is this stock market where 25% annual returns don’t generate “alpha”? Why do small investors need to run around looking at micro-caps?

***

Let’s also look at some other legendary investors. What sort of returns did they achieve and what were they buying? Lou Simpson – 20%+ type returns buying very well known companies. Rick Guerin – 25% type returns investing in a pretty broad range of securities small and large. Ruane, Cunniff – 15% over 40 years investing in large stocks. Eddie Lampert at ESL – you would probably know of almost every company he ever invested in – 30% CAGR for a 15-20 year period. Glenn Greenberg at Chieftain – did 25% for about 20 years, again you’d probably recognize almost every stock he owned.

These guys are legends, they’re all rich, and they invested in a huge range of securities.

Who do we know of that was investing in small securities that no one has heard of? Here’s two: Schloss and Graham. Did either of them do 50% compounded? Hell no. They’re hall-of-famers with 15-20% returns. Do I need to bring up Charlie’s returns? What has he bought over time?

So I dispute this notion that investors are somehow doing themselves a disservice by sticking with companies they know well and that others know well. Well-known companies are often just as mispriced as small ones. “To a man with a hammer, everything looks like a nail,” says Munger. Yet the Buffetteers seem to only admire one tool for finding cheap stocks (size constraints), when myopia, ignorance, and a host of other biases are just as powerful in creating misvalued securities.

To wrap this up a little, I’m not saying there aren’t lots of small mispriced stocks. Buffett did very well with them, and there are probably others doing great, too. But recognize two things: 1. Huge CAGR’s are really, really hard. 2. You can do extremely well investing in larger companies, great companies, and well-known companies, without a lot of the risks of investing in broken-down nags. This is well proven.

So if you rationally evaluate Fairfax and come to the conclusion that you’re going to get 15-20%+ CAGR (eminently reasonable given the fact that they are a relatively small player in a gigantic global insurance market and are run by one of the smarter investment teams on the planet), don’t worry about how much “alpha” you’re not generating by looking elsewhere. Was it a mistake to invest in Berkshire when it had a billion dollar market cap and was well known? I repeat, there are no points for creativity. Don’t forget it takes a unique cast of mind to just sit on some great companies and compound at high rates with no taxes, professional investor or not.

I’m probably not going to convert anyone who believes strongly that they have to be looking in the dirty alleys for cheap stocks, but if you’re on the fence, hopefully this is food for thought.

Here’s a link to the thread if you want to read more.

My own opinion is that there is no reason to limit yourself to certain investments based on market capitalization, just like it doesn’t make sense to make a false distinction between value and growth. You can get rich investing in either. For example, today large caps offer unusually strong risk-adjusted returns.

In investing, what really matters is how much cash you get back and when for the cash you invest and how certain you are of the outcome. I do think it’s fairly obvious that Buffett would be more active in small and micro caps if he were investing far less money, although not to the exclusion of investing in large caps. He would simply have greater options.

Sound Advice from John Train

John Train offers the following sound wisdom in his fine book The New Money Masters (p. 248-249):

…trying to achive great wealth – that is, far more than you need – is in fact irrational.  You have to give up too much getting there, and having done it, you’re often worse off than before.  Midas is ruined by the gold he craves.

Our nature, says Shakesspeare, is subdued to what it works in, like the dyer’s hand, and in pursuing great wealth you become a money person. You see the world through dollar-sign binoculars.

Then, the exaggeration of any principle becomes its undoing, as the excess of a stimulant becomes a poison …

The rational approach is to trust in a sufficiency of wealth as a byproduct of useful life.  Happy are those who find fulfillment in their families, their work, and their civic duties, and hope for the best.

Value Investing Works

Before adopting a particular investing approach, it makes sense to ask if the approach has been successful over time. There is clear evidence that a value oriented approach will outperform over time. Buffett wrote about this outperformance in his 1984 article “The Superinvestors of Graham-and-Doddsville”.

I took a quick look at the performance of six prominent value equity funds vs. the Vanguard Index 500. The data compares the funds’ 10 year annualized returns and the data is through 7/15/2009. The data is from Morningstar. It is instructive to remember that most actively managed funds underperform the S&P 500.

Longleaf Partners: 1.32%
Dodge & Cox: 3.16%
Weitz Value: 2.50%
FPA Capital: 6.36%
Third Avenue Value: 5.83%
Sequoia Fund: 2.63%
Average: 3.63%

Vanguard 500 Index: -2.29%

Average Outperformance: 5.92%

These value oriented managers have added significant outperformance over the past decade in spite of the very challenging conditions.

Introduction

In the introduction to his acclaimed book A History of the American People, historian Paul Johnson writes about his motivation for writing the book, which, given its more than a thousand pages, was a huge undertaking. As an adult, he became fascinated with American history, which he had not studied in school, and wanted to acquire a deep and lasting understanding of the subject. So he, “Determined … to write a history of it, knowing that to produce a book is the only way to study a subject systematically, purposefully, and retentively.”

In similar fashion, I’m writing this blog to sharpen and deepen my understanding of value investing. It is widely understood that putting your thoughts into writing is an effective way to clarify your thinking. Often, it is not until you try to write about a topic that you realize you have some more work to do in understanding it.

What’s in it for you? I hope to share some ideas and insights that will make you a better investor. I spend a lot of time studying the subject and reading a lot of material so I hope to find some valuable nuggets and insights to share with my readers.

Becoming a successful investor is a journey that takes many years and there are always new lessons to learn. It is important to develop a sound philosophy and investment process that is based on what has worked over a long period of time and that has a solid intellectual underpinning. It is for this reason that the writings and speeches of Warren Buffett will be a major source of ideas for this blog. What he has to say is worth carefully studying.

Fortunately, Buffett, like his mentor, Benjamin Graham, has been very generous in sharing his ideas. Buffett has also been clear on what a student of investing should focus on. In his 1996 Chairman’s letter to Berkshire Hathaway shareholders, Buffett wrote that, “In our view, though, investment students need only two well-taught courses – How to Value a Business, and How to Think About Market Prices.” These two subjects will be emphasized in this blog. I will also draw on the work of other successful value investors and teachers including Benjamin Graham, Charlie Munger, Seth Klarman, Joel Greenblatt, Eddie Lampert, Mason Hawkins, Lou Simpson, Bruce Greenwald, Walter Schloss, Tom Gayner, Bruce Berkowitz, David Einhorn and many others.