The Small-Cap Investing Handbook Part Seven & Eight: Lessons From Value Investors

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small cap equities, 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 equities magazine Hidden Value Stocks.

To find out more, head over to www.hiddenvaluestocks.com.

For the other parts of this small cap equities Investing Guide series please follow the links below:

Small cap, the studies say one thing but there’s nothing better than the practical experience. The Hidden Value Stocks newsletter is devoted to the practical experience of managers, fundamental analysis and their views on small-cap investing. Before Hidden Value Stocks came into existence, ValueWalk had been publishing a weekly interview with small, value orientated hedge funds. These funds use a variety of different strategies and some even try to copy the partnership strategy used by Warren Buffett at the beginning of his career.

These discussions brought forward some highly valuable insights, which can help small-cap investors refine their process. So, for this part of the series I’ve gathered together some of the best quotes on value investing, portfolio management and fundamental analysis. Most of these funds are Small cap equities focused.

Small Cap Equities – Cable Car Capital’s Jacob Ma-Weaver

I have a probabilistic approach to valuation. Typically, I will value a business separately under several potential scenarios, which reflect specific outcomes rather than generic bear/bull situations. The goal is not to compare the market price to an artificial expected value computed using subjective probabilities, which I think is often inappropriate given the lack of any information about the underlying distribution. Instead, I’m trying to identify situations where the valuation in even the most negative state of the world remains acceptable, but an alternative scenario is what I think will actually be most likely to happen, based upon my research.

I always like to begin my analysis with the potential downside, and from that standpoint the valuation exercise often starts with the balance sheet. In many situations, I find it helpful to compute a net asset value or liquidation value before assessing the ongoing business. Importantly, this requires understanding the whole capital structure and the rights and priority of other claims relative to the particular security I’m interested in. Even though that is usually common equity, I want the context of the entire enterprise first.

For ongoing earnings streams, I try to estimate the earnings power of the business 3-5 years into the future. By earnings power, I mean the eventual capability of the business to generate recurring free cash flow (or one of its proxies for convenience, which depending on the company and its capital structure could be EPS or some variation on operating income). That can be a straightforward calculation, or it may involve some hypothesizing about how profitability could evolve in different states of the world.

I compute the present and potential future value of the business using justified multiples as shorthand for a full discounted cash flow analysis. This part is subjective, but the multiple I’m willing to pay is a function of the company’s growth prospects, return on capital, and predictability, as well as the general market environment. I’m looking to earn significantly more than the discount rate while allowing myself some margin of safety. If the calculations need to be terribly exact to support an investment thesis, the business is likely close to fairly valued, and there’s more risk of loss than I would usually be willing to accept.

Ben Strubel Of Strubel Investment Management on Small cap equities

You know you hear a lot about these famous investors that say you should concentrate your bets on your best ideas, but you never really hear the other side of the story. Many people have tried it and haven’t been successful?

I know some people personally who have tried it and failed. There was no reason to believe that they wouldn’t have been successful to start with, but a concentrated portfolio cost them a substantial amount of money. That’s the side you don’t hear about. You only hear the success stories. So we tend to use equal weightings.

In some cases, we will underweight positions if they are a bit more risky or if there are questions about the business. I’ll admit this is a bit strange for a value investor, most tend to rebalance but I’ve had success using this method, so I’m going to stick with it. I think it also helps enforce buy and sell decisions. Because I’m fully invested if I want to add a stock I have to sell something first. I need to be sure that I want to make the trade-off, so it helps with discipline.

That said, we do own multiple stocks in the same industry, which could be considered a form of overweighting, other than that it’s equal weighting.

Christian Olesen, Olesen Value on Small cap equities

Obviously, we look at a wide range of factors. It’s not something you can easily put into a neat formula, but I would say in general, especially compared to other value investors, we tend to avoid companies with weak balance sheets. We never invest in companies below investment grade, obviously many aren’t rated, but we don’t invest below that level of credit quality. We usually don’t invest in the equity securities of a company — with very rare exceptions. I think that companies with weak balance sheets make up the single largest quality of value traps out there. Besides the balance sheet, we tend to place a lot of emphasis on shareholder friendliness, more so than most value investors. I think a lot of investors underestimate how much value a board of directors, that’s not friendly to shareholders, can erase over time. We do get involved in activist situations once in a while; we have a couple of these situations going on right now.

Other than that, we focus on companies where we feel we can understand the business and predict the future of the enterprise with a reasonable degree of accuracy and accurately value the company. We tend to focus more on the higher quality companies than some value investors. I think that business quality is underrated by investors, even by value investors. We do make some exceptions to the rule, but most of our investments are pretty decent quality companies.

Overall, we look for something that really offers good value. I often like to buy something that, even though it’s never going to happen, I would be ok owning the company indefinitely. We do focus quite a lot on downside protection, and that I think has been the key to our success, especially during the second half of last year.

Put simply, we look for investments

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