During the past six weeks I have traveled extensively to meet with our companies and attend several conferences on both coasts and in middle America. (True confessions: I did manage to squeeze in some mountain biking with my son in Colorado). The trip was therapeutic on several fronts. Sitting in my office and talking on the phone with management and following the news just doesn’t cut it. Getting out of the office and kicking the tires to ascertain that we are on track with our investments is essential. Prior to this trip, I was admittedly feeling down about the lack of progress (stock prices) with our companies. The small-cap world has been left behind; while the larger firms have strengthened in 2012. What I discovered in my travels was enlightening as well as encouraging.
Several times a year I meet up with investment professionals specializing in the analysis and purchase of small companies. We meet at conferences that often host 40+ companies with their CEO/CFOs presenting and available for 1×1 meetings. This fall, I discovered several things from my brethren — We are all in pretty much the same predicament regardless of our holdings, and business is better than reflected in the stock prices. We agreed that across the board, small companies are grossly undervalued – lagging large companies by unprecedented margins. How this can be interpreted is that our small gems have a lot of room for a positive run. One of my highlights was spending a cocktail hour with the “guru” (to remain unnamed) in the small-cap arena. He has been in the industry for 50+ years (grandfather several times over) and has often been quoted in major financial publications for insights into smaller companies. Allow me to share his quick analysis of this time period in the small-cap space:
1. There is no trust; therefore no money pouring into small companies.
2. Business is better than reflected in stock prices.
3. We are now in the midst of one of the largest valuation gaps (difference between a company’s market capitalization and it’s revenue/profit potential) in his lifetime. He mentioned that he wanted to retire several years ago but decided not to leave on a downward note. We ended our discussion noting that we are both very optimistic and, although uncertain as to the timing, agreed that our patience will be rewarded. As it turns out – we own several of the same companies.
Many of you recently noticed a first-hand account of our patience. We started buying Pioneer Behavioral Health (PHC) in 2003, which later merged into Acadia Healthcare (ACHC) in 2011. We just sold one-half of the position for approximately six- times what we originally paid. This took nine years with a tremendous amount of ups and downs! I am confident that we own more companies that will perform similarly, however, the timing cannot be predicted. As for Emerald Dairy, our small Chinese company – It is a very successful business in China but the shares are not trading in the U.S. presently. I am working with an American citizen and investment professional (a major EMDY shareholder) who is working closely with EMDY’s board. We are working on a solution that will hopefully be beneficial for all parties. We will hang in there for the time.
Just to reiterate….
We seek out undervalued businesses that are neglected by the majority of analysts and left on the back burners of the investment community. One of the unconventional metrics that we utilize before investing in a business is the number of analysts keeping track of a prospect – the lower the number the better for us. In the final analysis, a company’s growth potential is crucial and an undervalued stock’s most reliable precursor for an eventual price jump is simply revenue and earnings momentum. Like ACHC, when the analysts jump in, we begin to unload.
We believe that inefficient markets provide a comparatively bigger potential for returns. This combined with the fact that there exists an imperfect distribution of information for many smaller sized companies, gives us the fodder to create unique opportunities for investing. However, going against the grain is clearly not for everyone (and it may not help you in your social life), but to make the really large money in investing, you have to have the guts to make the bets that everyone else is afraid to make.
There are two eminently reasonable ways to stop the off-kilter spinning top that Wall Street has become:
1. Starve the Beast 2. Allow only human beings to trade
OK, I realize that the genie is out of the bottle, so the second one is simply not going to happen. This leaves #1.
As discussed in previous letters, market volatility has increased due to institutional day trading, program trading, high frequency trading, and…..trading for the sake of trading. Partly as a result of this hijacking of investing (and the source for much of the difficulty we have as small-cap money managers), many investors have increasingly eschewed the equity markets in favor of bonds, CDs, gold coins and other non-equity investments.
Not that long ago, markets were dominated by individual investors. In the 1960s, 23% of transactions were conducted by institutions. Those markets were considerably less volatile, and were characterized by positions held for long-term growth. Today the bulk of transactions (80%) are institutional which are explosive in nature and for the most part, incredibly short-term. Oh, how I yearn for the old days!
A little headline irony from the 10/2/12 issue of the Wall St. Journal –
RAPID FIRE TRADERS’ BIG FEAR: THEMSELVES
Nice to know that these knuckleheads are waking up to the fact of the damage and the dangerous scenarios they’ve created. Does anyone remember the August 1, $440 million loss by Knight Capital in just 40 minutes. They now want – REGULATION! Starve the Beast!
You do not know another entirely till you have…… divided an inheritance with him.
Money is made in the dark, not in the light of day. Rejoice in the gloom and fear and consider adding to your investment.
Health Corner – Avoiding Back Injury… Approximately 8 years ago I had back surgery, but it’s been yoga that has contributed to my back pain and related issues being greatly resolved. Yoga poses and stretching have become essential parts of my daily routine. I diligently work on my core and the hips to support the back. I’ve learned that loose hips can not only help you on the dance floor but will keep you safer in the gym, too. According to a recent study in 2012, hip mobility can be improved through stretching. In just 6 weeks, men who completed a stretching program improved their range of motion by 50%! Guys who cannot rotate their hips often twist their lower backs. Here’s my method for keeping loose:
I lie on my back. I bend one knee so my foot is flat on the floor, placing the ankle of the other foot on top of the knee and do the following: I push down on my thigh of the crossed leg until I feel some separation and next, I grab my thigh from behind of the bent knee and draw it toward me, while keeping the ankle of the other leg on top of my knee. I simultaneously pull the knee toward me while pushing away the crossed leg/hip with my inside arm. Then I switch sides and repeat the stretch. In addition, while on all fours, I arch and round my back for several minutes. This keeps the hips in alignment. Rarely a day goes by that I do not perform these, especially before heading to the golf course.