Thinking Big About Small Companies
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Q3 Letter Excerpt: The Monte Sol Investment Process Summarized

November 8th, 2012 | Posted by Torin in Uncategorized

The goal is to generate the greatest returns possible within the constraint of a portfolio that poses no more than a remote risk of losing money in the long-term. This concept sounds obvious but it is one that many investors gradually forget. Over time most investors drift toward one end of the spectrum or the other: either they chase returns so aggressively that they become blind to the risks they are assuming, or they fixate so intensely on risk that they settle for sub-par returns. Neither of these approaches is optimal, and both should be rejected except by gamblers and retirees. A skilled investor with a small capital base should aim for extraordinary returns paired with minimal loss probabilities.

Return

Warren Buffett once said that if he were managing a million dollars, he could return 50% per year. Stock markets have become much more competitive since Mr. Buffett made that statement, but the premise—that enterprising investors with small sums of capital can massively outperform the markets—is still true.

The goal is to invest in stocks that can triple in value in three years, or quintuple in five. Very rarely does a stock appreciate so much for so long unless the underlying company itself is also growing its profits at a high rate. This investing reality limits the search for candidates primarily to the ranks of fast-growing companies. Unfortunately, growth companies are the shiny objects of the investment world. They attract great interest from many parties and they are rarely undervalued. To find an exceptional combination of growth and value, one must be creative and look where others do not, pursue companies most people have never heard of, undertake extensive research on companies that few major investment firms have ever examined, and hunt for companies that have no history of growth but which may stand at growth’s doorstep.

Growth is the first trait a candidate must exhibit, but others matter as well: high profit margins or returns on capital, capable managers, and recent stock purchases by corporate insiders. These traits signal that a company may be a great investment, but not that it is one. Each trait is only a hypothesis. A growing revenue base hypothesizes an industry or niche with beneficial long-term trends. Attractive profit margins hypothesize a competitive advantage. The assertion that a company’s managers are capable hypothesizes a future ability to seize opportunities that competitors do not. Insider stock purchases hypothesize an executive suite whose interests are aligned with those of the investors in the company.

Good research is an attempt to disprove these hypotheses. Are the attractive revenues and margins truly indicative of a positive long-term trend, or are they short-lived aberrations? Do the managers have demonstrable histories of sound decision making, or do they just talk a good game? Are the insiders buying stock because they are compelled by its investment merits, or are their purchases a calculated attempt to inflate the stock price? Do the CEO and board members come to work to stake their fortunes and reputations on the endeavor at hand, or to draw a salary?

If all of these questions can be answered positively, then the company’s shares are probably a wise investment so long as the price is low enough to generate the magnitude of return that we seek. If valuation is sufficiently attractive, buy. If not, add the company to the watch list and hope that its share price falls. Turning down very good investments in order to wait for great ones is a painful but necessary step in achieving the returns we aim for.

Risk

Return is one side of the coin; risk is the other. One cannot invest wisely without giving each side its due consideration. The most fundamental risk assessment is the analysis of the company’s financial assets and obligations, and its ability to meet them. No hard and fast rules suffice in this analysis; it is based on subjective judgment. Some companies that appear risky are not, and some companies that appear safe are in fact quite risky, as investors were reminded in 2008 and 2009. If a reasonable scenario can be constructed in which a company will be unable to meet its obligations, then that company may be unfit for investment no matter how great the potential return.

Another core principle of risk management philosophy is private market value. The stock market values of companies fluctuate wildly, but the prices paid by private buyers usually hew closely to true economic value. As such, they provide a very helpful baseline for valuation, especially when a company has multiple potential suitors. Accumulating data about precedent transactions from the industry in question enables the formation of a well-educated estimate of what a private buyer would pay today for the business in question. Buying a company’s shares at a large discount to that value goes a long way towards putting a floor on the risk in the transaction.

This method of analysis is particularly applicable to small companies. There are few parties in the world—if any—that can gather the capital necessary to buy a company as large as, say, Microsoft. Consequently Microsoft’s private market value, if it could be determined, may not be relevant to the price of its stock. But the world is full of interested parties with the resources to buy any small cap company. Therefore, knowing what your investment companies would realistically sell for in a negotiated transaction—as opposed to what the flighty stock market has decided they are worth today—is essential when making the final investment decision. Not every investment is going to end with a sale of the company, but small, fast-growing, well-run companies have a way of becoming M&A targets.

Understanding the devotion of the board and management team is another important step in understanding the risk of an investment. A CEO who has staked his or her net worth and professional reputation on the success of a single company is likely to work inhuman hours and endure great travail in order to attain success. This is no guarantee that things will play out favorably—a management team can fail no matter how extraordinary its efforts—but investing in a company whose management is ‘all in’ minimizes the risk of the managers looting the company or settling for ‘good enough’.

Combine these core risk management principles with some diversification. The optimal number of investments is between five and fifteen; few enough to allow for ample concentration, but not so few that a failed investment or two will do more damage than can be offset by gains from the remaining holdings. The shamans of academic finance would not consider this portfolio diversified, and indeed it is more concentrated than 99% of institutional investment portfolios, but in this model capital is not deployed into a single business—it is deployed into a collection of businesses, whose profits come from an array of minimally correlated industries, customer bases, and geographic regions.

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