The Rabbit Hole is written by Blas Moros. To support, sign up for the newsletter, become a patron, and/or join The Latticework. Original Design by Thilo Konzok.
Key Takeaways
- Small caps have beaten mid/large cap returns over time
- Successful small cap managers often move "up" into larger market cap companies and this perpetually keeps the small cap space relatively open
- Limited assets under management (AUM) is important
- It takes independent thinking to invest unconventionally well
- Published research is scarce and often biased
- Trading is costlier in the small cap space
- Limiting capital is often the only effective way to remain in the small cap space without overly diversifying from one's highest conviction ideas
- Do not rely on other's conclusions
- A successful status process can be competed away
- Stock price naturally follows value of underlying business given a long enough time horizon
- With management, understand their strategy and how they think about allocating capital
- Extremely important to learn from one's mistakes. They will happen and if learn from them they can be good as long as the process was correct
- Process, acting on conviction more important than results in the long-term. Never fall in love with a stock and look for and learn from mistake
- Investment edge should be able to be easily understood whether analytical, behavioral, technological or some combination
- Understand the risk and exposure of the fund. Being wrong in isolation is the ultimate ostracism
- Contrary opinions are the lifeblood of successful investing
What I got out of it
- Very interesting to get to see how an extremely successful investor thinks about the space he's in and the inherent advantages, disadvantages and difficulties of operating in this space.
Introduction
- Small caps have beaten mid/large cap returns over time
- Successful small cap managers often move "up" into larger market cap companies and this perpetually keeps the small cap space relatively open
- Limited assets under management (AUM) is important
- For investors, a portfolio of small caps only is not recommended
- Bares is a fundamental investor
- It takes independent thinking to invest unconventionally well
Chapter 1 - The Small-Cap Advantage
- Small caps outperform due to inefficiencies of information and tailwind of outperformance
- Funds who tend to do well in the small-cap space tend to grow their AUM and be forced to move up to larger cap companies in order to "move the needle."
- Small cap benchmark - Russell 2000, MSCI 1750, S&P 600, DJ US Small Cap
- These benchmarks comprise about 2/3 of all companies but only 10% of total market cap)
- As companies grow overall, larger markets are now being considered small cap which has been leading to decreasing returns
- Indices becoming more similar as companies are beginning to implement similar strategies
- Definition of what constitutes a small cap is subjective
- Most use Russell 2000 as their benchmark
- Micro caps offer even more potential rewards
- One of the few areas where the individual can beat institutions since these types of companies are not big enough to move institutional investors returns
- Smallest decile returned over 18% annual returns since 1927
- More volatile but definite long-term alpha
- Lack of volume, liquidity an inherent risk
- Smaller companies are much easier to grow than say an Exxon
- These business are often easier to understand as they are smaller and more concentrated
- Should NOT equate volatility with risk
Chapter 2 - Small-Cap Disadvantages
- Published research is scarce and often biased
- Trading is costlier in the small cap space
- Limiting capital is often the only effective way to remain in the small cap space without overly diversifying from one's highest conviction ideas
- Do not rely on other's conclusions
- Must consider the implicit costs (lack of liquidity can lead to implementation shortfall, etc.) along with explicit costs (trading costs, etc.)
- Shouldn't own the small cap index as an investor
- Bares first step in sourcing ideas is using a rudimentary screener but overall it just takes a lot of reading, research and speaking with management
Chapter 3 - Small-Cap Investment Philosophy and Process
- Competitive advantages - informational, analytical and behavioral
- Impossible to differentiate skill from luck over just a few quarters, sometimes even years
- Focus on the investor's investing process over results when new
- A successful status process can be competed away
- Screen - set the max forward P/E and only look at what below maximum
- Be cautious of involving too much emotion. Don't fall in love with a stock
- Any metric tells you little in isolation
- A company's major differentiators are qualitative - management
- Looks at Porter's Five Forces which helps one define the strengths and weaknesses of a business and the industry it's in
- Stock price naturally follows value of underlying business given a long enough time horizon
- Find a business with a competitive advantage but are not yet financially successful - this can be a big winner
- With management, understand their strategy and how they think about allocating capital
- Red flags - inconsistency in implementation and irrationality when trying to explain it
- Should screen companies qualitatively first
- Loyal clients are vital in tough times and attract these clients by serving their needs first and proving your long-term investment edge (limiting AUM)
- Get outsized returns through fewer trades but this means must only invest in high conviction stocks and higher portfolio concentration (fewer holdings)
- Diversification does not equal more stocks. Only the end-market of the companies matter (example - holding 20 different banks does not give you much/any diversification)
- Management and acquisitions makes Free Cash Flow unreliable
- Reasons to sell:
- Company reached its target price
- Another stock seems like a much better opportunity
- One's thesis is wrong
- Extremely important to learn from one's mistakes. They will happen and if learn from them they can be good as long as the process was correct
- Activist investors often lose a company's management's trust
Chapter 4 - Small-Cap Manager Organization
- Hedge funds used to mean long/short but now more about compensation (2 and 20)
- Soft money spent on overpriced research is the same as stealing the client's money
- Research analyst must be genuinely curious, be interested in learning how businesses work and are profitable and be very truthful about their limitations and what they don't know
- Process, acting on conviction more important than results in the long-term
- Never fall in love with a stock and look for and learn from mistakes
- If a fund has a single decision maker, they must have great leadership skills and be able to handle that kind of responsibility
Chapter 5 - The Fund Raising Process
- Proliferation of endowment models helps emerging managers as they provide stability and funding
- Breaks investments down into asset classes of different sizes. Typically include cash, fixed income, real estate, venture capital, private equity, oil/gas, timber, domestic equity, foreign equity and hedge funds
- Use of consulting firms often very helpful and opens many doors
- Use of third-party marketers often advisable if a new firm in order to spread awareness and scale more quickly,
Chapter 6 - Fees, Agency Issues and Other Performance Drags
- Vital to have a frugal manager as that often aligns clients and investor's interests
- Manager and client incentives are often not aligned - higher AUM leads to higher manager fees but often detracts from total returns
- Hard cap on AUM is a great sign as it shows the manager prefers returns over fees
- Management fees and trading costs are the two largest performance drags in institutional small-cap investing
Chapter 7 - Small-Cap managers and the Endowment Model
- People, process, and the investment philosophy of fund should be the client's main focus when choosing new managers
- Small cap inefficiency allows managers more time to research and execute
- Investment edge should be able to be easily understood whether analytical, behavioral, technological or some combination
- Funds tend to perform best early on as their AUM tends to be lower, managers are more motivated, markets are inefficient
- However, due diligence on new funds is difficult as there is little track record and might not even be aware of their existence but should focus on the repeatability of the manager's edge
- A great resource was sent to me on Real Estate Due Diligence, put together by Groundbreaker. It's pretty specific to real estate but definitely some nuggets which are more broadly applicable
- Institutions should try to fund small-cap managers when they are small and in their infancy
- However, small cap managers should try not to accept too much capital too quickly
Chapter 8 - Evaluating Small-Cap Managers
- Due diligence should be structured, detailed, look at new and emerging managers, on site visits
- Repeatability and qualitative factors are key
- Understand the risk and exposure of the fund. Being wrong in isolation is the ultimate ostracism
- Contrary opinions are the lifeblood of successful investing
