My Approach to Small Caps

I generally break small caps down into two categories.

1.      Value

2.      Quality

Value

I generally think of value companies as companies whose per share intrinsic value is growing below their Cost of Capital. With value, the emphasis is on returning cash to shareholders rather than investing in future .

I tend to hold value stocks for shorter holding periods. Generally, the underlying business performance tends to not keep track with the overall market or deteriorate. Either value is unlocked quickly, and cash is returned to shareholders, or value is destroyed.

Companies undergoing orderly liquidations, in the process of selling a business division, selling property or land holdings can often be attractive value opportunities.

Value companies tend to earn lower returns on invested capital and reinvestment usually destroys shareholder value.

The above is an example of two hypothetical companies that would fall into the Value categories. They both have the same initial NOPAT, cost of capital and both earn poor returns on incremental capital—below their cost of capital. In scenario 1, an aggressive reinvestment policy is pursued despite being a poor capital allocation decision. In scenario 2, there is no reinvestment. Free Cash Flow is distributed to shareholders when it becomes available. Despite the terminal value being higher in Scenario 1, the overall value of Scenario 2 is greater.

A value stock where management engages in empire building and continued reinvestment into poorly though out projects and initiatives is unownable to me.

Quality

I generally think of quality companies as companies whose per share intrinsic value is growing faster than my Cost of Capital. With quality, the emphasis is on reinvestment.

I look for high incremental returns and some form of competitive advantage. A company that has poor incremental returns will not make an attractive long-term investment. A company that has attractive incremental returns, but no competitive advantage will have these high returns eroded by competitors who enter the industry. I am perfectly content to invest in companies that produce zero or even negative cumulative Free Cash Flow for the duration of my holding period, provided the incremental returns are sufficiently high and in excess of the Cost of Capital

In addition to looking at rates of return, reinvestment runway is an important consideration. Provided the company can maintain sufficiently high rates of return and avoid reversion to the mean, the more a company can reinvest, the better the returns will be.

Because these companies tend to be younger and on the smaller side, insider ownership is of critical importance. I am looking for companies that are going to create value over the longer term. Examining compensation metrics is also important. Compensation that is not necessarily tied to value creation (revenue growth) or metrics that are easily gameable (Adjusted EDITDA) are usually red flags.

With value stocks, I look for quick price appreciation or pay out (tender offer, special dividend, liquidation) and then sell. Quality stocks are different because there is often underlying intrinsic value appreciation. I tend to be IRR driven when holding Quality stocks. If I purchase a quality stock and it has a quick price appreciation, I am more inclined to sell. If the price declines or trades sideways for an extended period of time, it gives cause to re-examine and potentially buy.

There is a small subsection of companies that, over the long term, will be responsible for virtually all of the overall stock markets gains. It is bordering on impossible for an investor to consistently find these companies but in the exceedingly rare circumstance where a company has highly invested and aligned management team with history of value creation, secular tailwinds, is continually beating expectations and gaining market share, it is permissible to become slightly less valuation sensitive and not sell even when a DCF model suggests it can be the correct action to take.

Conclusion

Value stocks can be thought of as past their prime. Their intrinsic value is likely to decline over time. What matters is what can be extracted from the company before the company’s terminal value goes to zero.

Quality stocks can be thought of as growing into their prime. Their intrinsic value will grow over time. Reinvestment above their cost of capital is what determines their intrinsic value. What matters is how much can be reinvested and at what rate of return.