MI 05: Tim Stabosz (Activist Investor) Describes How he Turned a Small Gift into a Small Fortune

Check out our new episode with Tim Stabosz, activist investor. He describes how he went from investing a small amount of money he received as a gift, to trying to over-throw public company CEO’s. His story is Warren Buffetesque yet remains largely untold because he plays mainly in the small cap space.

Activists Association: www.activistsassociation.com

We Discuss:

  • How he turned a nominal amount of money into a small fortune through investing
  • Mounting an activist campaign on a corporate board
  • CEO compensation
  • His Campaign against P&F Industries, and Scott’s Liquid Gold
  • Value Investing
  • A stock that he likes
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MI 04: Maj Soueidan Founder of Geo Investing Talks Activist Investors, Pump and Dumps, and Stocks He Likes

Check out our new episode with Maj Soueidan founder of Geo Investing. He has been investing in micro caps for over two decades. His firm rose to fame by calling out a number of fraudulent companies. “You need someone to hold your hand if you want to invest in China” says Soueidan. Him and his team do some of the best research on the market for micro caps both domestic and abroad.

www.geoinvesting.com

We Discuss:

  • His first investment
  • Shorts and pump and dumps
  • Fraudulent Chinese companies
  • Activist Investors
  • NV5 Holdings
  • His firm Geo Investing

I even drop some facts about the market and chat about a turn around story that I have been following, Scotts Liquid Gold.

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MI 03: Jacob Ma-Weaver on Biotech and Running a Long/Short Fund

Today on Micro Cap Investing we have Jacob Ma-Weaver, founder of Cable Car Capital. He runs a concentrated absolute return strategy at his firm. He is always insightful and entertaining.

We Discuss:

  • His road to founding Cable Car capital
  • How he searches for stocks both big and micro
  • His favorite idea in the Biotech sector
  • What he thinks about when constructing his portfolio
  • I even share an idea of my own, George Risk Industries, and talk micro cap facts
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MI 02: Nate Tobik From Oddball Stocks, Discussing Ideas and the Grey Market

Today on the show we have Nate Tobik, author of the well-regarded blog Oddball Stocks and President of Complete Bank data. Tobik’s blog is one of the most popular on the web about micro cap stocks. Tobik is a deep value investor.

We Discuss:

  • How he got started
  • How he finds stocks in the Grey Market
  • Two of his favorite ideas
  • Benefits of nano cap stocks
  • Information advantages
  • Why he likes the bank sector
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MI 01: Welcome to the First Ever Micro Cap Investing Podcast with Guest Chris Lahiji!

In this podcast I interview Chris Lahiji, President of LD Micro. LD Micro hosts two of the most popular micro cap conferences every year. Chris was one of the youngest ever money mangers on Wall Street and was a fixture on Fox News as a teenager. He has been investing in micro caps for over a decade and he stopped by the show to tell us what he has learned.

www.ldmicro.com

We Discuss:

  • One of his favorite current investment ideas
  • How he got his start
  • How he does due diligence
  • What he thinks about the market currently
  • Who he predicts will win the NCAA tournament

 

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The Advantages of Investing in Micro Cap Stocks

Many overlook the potential opportunity that micro caps provide because many do not have an effective means of investing in them. At Tarsier Capital Management our goal is to provide that opportunity. The risks associated with these small stocks have been exaggerated and too many everyday investors are missing an important source of diversification and return. In this paper, I discuss the advantages of micro cap stocks, why these advantages exist, and the risks.

A micro cap stock is generally defined as a company whose market capitalization is under $500 million. There are over 20,000 publicly traded companies and over 60% of those are micro caps. While they make up the vast majority of publicly traded companies, micro caps make up under 3% of total market value. Another way to look at it is that Apple is over 1.5 times larger than all micro cap companies put together. These small companies are often family businesses; the entire micro cap segment is over 26% owner operator controlled.

The Advantages
The big advantages of investing in micro cap stocks are portfolio diversification and increased returns. These stocks can reduce overall risk in a portfolio of assets. In addition, micro caps significantly outperform the broader market. From June 30, 1926 to November 30, 2013, the smallest decile of U.S. stocks returned 12.91% annually, while the largest decile returned 9.37%. In addition, a study by Acuitas Investments revealed an average alpha of almost 3% from active management of micro caps, 3 times that of large cap managers1. Alpha refers to the ability of active stock pickers to find hidden gems that outperform the market.

Micro Caps have a low correlation with the S&P 500, meaning that their prices do not move in close tandem with large cap stocks. On top of that, in a down market when most stock prices are falling, the correlation with larger stocks goes down further. The up-market correlation between 1992 and 2010 was 56%, and the down-market correlation was 34%. I have found that many small companies have a small investor base. That base does not sell off when the market goes down because they know the value of their stock. Over 26% of the stock in these companies is family owned and they are the least likely to sell off. Micro caps are not highly reliant on international markets to sell their products, which also reduces risk, especially since the dollar is and has historically been strong. Lastly, micro caps are more focused and sometimes only have a few products. They do not spend money diversifying their business and they are often less exposed to operational risk.

With rate hikes looming in 2015, an important consideration is how micro cap stocks will react. In the 12 months following the last six federal funds interest rate hikes, the Russell 2000 (small stock index) averaged a 15.6% return. I believe that as the economy improves on its own in 2015 without the help of the Fed, it will instill faith in the capital markets and investors will move into the micro cap space. As the segment gains demand, valuations will increase.

Micro Caps have returned on average over 3% more than the broader market since 1926. During that time risk has come down considerably too. Regulation, including Sarbanes Oxley, has weeded out many risky companies.

So many micro cap companies are not closely followed, which makes it easier to find hidden gems. If you are willing to spend the time looking, you can find stocks that offer impressive risk adjusted returns. It is possible to find forgotten companies that trade at a deep discount, value stocks. Another option is seeking companies that are growing quickly and have not yet been discovered, growth stocks. In addition, Micro caps have more growth potential than their larger counter parts. It is easier to compound earnings of a small business than that of a more mature business. A $20 million contract is meaningless to Amazon, for example, but could double earnings for a micro cap.

In the investing business, where knowledge is king, the micro cap space is the most inefficient and the easiest place to gain an information advantage. With thorough due diligence you can find information before other investors. It is also easier to access management of smaller companies for conversations. This access provides a significant advantage to those who use it.

It is not a well-kept secret that smaller stocks outperform larger stocks on a risk adjusted basis. It just gets harder to invest in them as you have more money. For the institutional investors, such as mutual funds and endowments, it becomes nearly impossible. In a 1999 interview with BusinessWeek, Warren Buffet was quoted speaking about the advantages of investing in small stocks. “If I was running $1 million today, or $10 million for that matter, I’d be fully invested. Anyone who says that size does not hurt investment performance is selling. The highest rates of return I’ve ever achieved were in the 1950s. I killed the Dow. You ought to see the numbers. But I was investing peanuts then. It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”

Why These Advantages Exist

The fact that micro cap stocks outperform larger companies on a risk-adjusted basis has come to be known as The Micro Cap Effect. In addition to outperforming the broader market by over 3% on an annual basis, micro caps have outperformed large cap stocks on a 20-year rolling basis in 59 out of 69 periods. There are many factors that go into causing this effect including, Wall Street neglect by analysts and institutions, liquidity premiums, better owner manager alignment, more mergers and acquisitions, and growth opportunities.

Large institutional investors ignore micro cap stocks because they have too much capital to allocate. If a mutual fund, for instance, has $1 billion to invest, it can’t put a meaningful amount of capital to work in micro cap stocks without negatively impacting the supply and demand dynamics that determine prices. Wall Street analysts ignore micro caps because their largest clients, institutions, ignore them. These large institutions control over two-thirds of the money. The job of Wall Street analysts is to put out research that will drive trading activity at their bank. When the banks execute a trade, they take a commission. This commission comes in the price they charge to execute the trade and the difference in the bid and ask price of the stock. There is a lot more commission to be had on a large cap stock that trades millions of shares a day than a micro cap that trades thousands. Since banks lack a financial incentive to do the work, interested investors must read the SEC filings because Wall Street does not publish many reports. Over 40% of micro cap stocks are not covered at all. The absence of attention distorts risk verse return characteristics. In a study titled, “ The Neglected And Small Firm Effects” Professors Arbel and Strebel proved that the lower the concentration of analyst coverage, the higher the returns2.

Micro cap stocks are not as liquid as their larger counterparts. They do not trade as many shares per day. A study by Roger Ibbotson, indicated that an average annual return premium of 5.34% exists for the least liquid stocks3. That is the difference between the least liquid and most liquid stocks between 1972 and 2011. What this means is that it may take a week instead of one trade to buy in or sell out of a position, depending on the size. This lack of liquidity is a major concern for larger players. It keeps institutions out and keeps prices down.

Having management and shareholder interests aligned is key to strong performance. As mentioned before in the micro cap space management owns more than 26% of their companies. Management acts in shareholders’ best interests because they are major shareholders themselves and want the stock price to increase as much or more than outside investors do. Having this extra incentive is what ensures that management is doing everything they can to protect and grow your investment. In contrast, small cap stocks between $500 million and $3 billion in market capitalization, have less than 16% insider ownership and large caps, over $10 billion, have less than 7%.

Largely due to their small size, micro caps have a high potential for rapid growth and a larger chance of being acquired. Over 50% of mergers and acquisitions occurred at the micro cap level between 1993 and 2013. Another reason for this is that many micro caps are pure-play companies, which are easier to purchase and integrate. Generally companies are acquired at a significant premium to their stock price.

I also believe that exaggerated risks deter many individual investors from the smallest stocks. When combined with the neglect from institutions, the lack of demand creates lower valuations for micro caps and hence higher returns. If earnings are constant and you pay less, then your return increases, since return = earnings/price.

A Chicago PhD student, Rolf Banz, first noted The Micro Cap Effect in 19784. Others followed with further studies. Then came the emergence of institutions seeking to capitalize on these findings. Mutual funds formed that were focused on micro caps but as the funds grew assets under management so grew the companies that these funds invested in. Many micro funds now hold companies as large as $2 billion or more. Not many true micro cap mutual funds exist and those that do mostly invest in the most liquid stocks, which Ibbotson proved have the worst returns. The main problem that I have with exchange traded funds (ETF) in the micro cap space is that they invest too broadly. ETFs seek to mirror the return of an entire index of stocks. The problem is that only 15% of the U.S micro cap stocks are even profitable. I prefer to invest in the profitable 15% as opposed to the increased risk of pre-revenue or struggling businesses. Private investments in public equities or PIPE deals offer enough liquidity for institutions to invest in micro caps. Larger players often partake in these deals, but again they are generally focused on unprofitable businesses that need money.

Risks
When contemplating an investment it is always recommended to thoroughly study the risks in addition to the advantages. I believe that most investors would find the risks associated with micro caps to be much more palatable than expected. Common risks associated with this segment include volatility, illiquidity, and fraud.

While still significant, volatility in the segment has come down over time. Micro cap stocks have the same standard deviation of returns as small caps. Many investors have exposure to small cap stocks, which have lower returns. Price swings can also be mitigated. The most liquid micro caps are the stocks held by institutions. These stocks are the first to get sold off when concern about the market rises. Portfolio managers get rid of the micro caps that they own, creating a down swing in price. These are also the stocks that can get pumped up the most. My advice for micro cap investors who are trying to avoid volatility is to avoid the most liquid stocks. It is the least liquid stocks that perform the best over time and that and hold their value in a down market.

Illiquidity is a blessing and a curse. It keeps the big players out and it protects the existence of The Micro Cap Effect, but it can also make entering and exiting a position difficult. If you have a significant amount invested and want to pull your money out quickly, it will likely negatively impact the price. Those who are patient and who do not mind sometimes waiting a week to make an orderly exit are rewarded generously for the lack of liquidity. The greatest risk is that in a recession bid ask spreads can widen dramatically and stocks can go days without trading.

Liquidity vs size copy

Because the micro cap space is less regulated you have to be mindful of pump-and-dumps and companies with no business model. These stocks can largely be avoided by investing in only profitable businesses. If you do thorough due diligence avoiding these companies should not be a problem. If the company does not communicate with investors then it is a red flag.

The last risk is more distant. The size of the micro cap space is contracting. There is not enough incentive for good small companies to go public. Larger companies acquire some micro caps and others grow into small caps, but they are not being replaced by new initial public offerings. This trend could begin to diminish the returns of micro caps over time.

Conclusion
Investments must be balanced with risk tolerances, but everyone’s portfolio would benefit from having a concentration of some of the least liquid stocks. That being said it is too much risk for many to tolerate to have all their assets in micro cap stocks. Everyday investors are overexposed to large cap stocks and would receive diversification benefits and higher return potential by adding micro cap investments. These small companies are domestically focused and provide a lifeline to the American economy. They also prosper the most from the strength of the dollar.

Always consider the risks and be willing to hold positions over a full economic cycle to realize benefits. There are pockets of micro cap under-performance but over time they outperform larger cap investments. To invest in micro caps you must do your own homework or find a manager who is willing to keep his assets under management low. To exploit the structural advantages in the micro cap space you must be small. At Tarsier Capital Management we manage two micro cap strategies capped at $10 million and $5 million. Assets are managed in separate client accounts. We are here to help improve your returns please contact us with further questions.


Contact Information

Fred Rockwell

info@tarsiercm.com

202-256-9707

References

1.) Dennis Jensen, Acuitas Investment, Shrinking Risk Budgets and Smart Beta – Using Microcap and International Small Cap to Improve Returns, 2013

http://acuitasinvestments.com/insights/Acuitas_SmartBeta.pdf

2.) Avner Arbel and Paul Strebel, The Neglected And Small Firm Effects, 1982

3.) Ibbotson and Associates, (2010)” Liquidity as an investment style.” Working paper.

http://www.ibbotson.com/US/documents/MethodologyDocuments/ResearchPapers/LiquidityAsAnInvestmentStyle.pdf

4.) Rolf Banz, The Relationship Between Return and Market Value of Common Stocks, 1980

http://www.business.unr.edu/faculty/liuc/files/BADM742/Banz_sizeeffect_1980.pdf

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Lessons On Investing In a Turnaround, Scott’s Liquid Gold

I have been closely following the story of Scott’s Liquid Gold (SLGD), which became profitable for the first time in a decade in the middle of 2013. The company manufactures and sells wood polish and air fresheners and they have distribution rights to dry shampoo and other products. What makes the story interesting is that the company has been profitable since Q2 2013 but it is still dirt cheap. The stock still trades slightly above book value. The sale leaseback of the companies facilities in February of 2013, which netted $9.5M, aided the come back. Detractors like to point out that SLGD is losing some of its distribution rights to the quickly growing dry shampoo business. Still further is the sordid battle between the company and activist investor Tim Stabosz. I plan on waiting a little longer before deciding whether to invest, but I will be waiting anxiously. Investing in a turn around story generally ends in one of two ways, big win or big loss. Getting in is a difficult thing to time. I recommend caution.

The Pros of SGLD

The Company’s valuation is attractive and its balance sheet is clean. SLGD has a P/E ratio of 6.8x TTM and trades slightly below 4.0x EV/EBITDA TTM. The company has no debt and $4.4M in cash. Its business segments have been improving top and bottom line. The market cap is ~$10.7M and TBV is ~$8.6M.

After freeing up cash from the sale leaseback the company was able to make some improvements. It paid down all debt and put a bigger emphasis on its products and marketing. In Q4 2013 the company introduced it’s Floor Restore product. The company also hired a new head of marketing, who has an impressive background at other major CPG companies. These moves helped to revitalize the legacy Liquid Gold brand, which saw sales decline from nearly $10 million in 1998 to under $5 million in 2012. Household products are manufactured in house and make up only 27% of sales and grew by ~18% in the last twelve months. The business operates at a loss, but margins are improving as sales grow. A complicating factor is that overhead is allocated 50-50 over both segments, which I doubt is a fair split. Household goods had a $600K operating loss. If sales improve this business could turn quickly as margins are high, ~47% and growing, by ~5% in the last 12 months.

Skin and hair care makes up 73% of the companies revenues. The company has two owned brands Alpha Hydrox and Neoteric Diabetic. Alpha Hydrox is the larger brand with products that include face creams, body lotions, and foot creams.  Like its name implies Noeteric Diabetic’s skin products are made for diabetics. Like the rest of the business these brands struggled over the past decade, but are now a main target for the company to revitalize. These products suffered mainly due to neglect and a lack of new products.

SLGD distributes Montagne Jeunesse face masques, and Batiste dry shampoo. The Company recently renewed its contract with Montagne Jeunesse through September 15, 2017. The one stipulation is that SLGD brings in at least $4.5 million in face mask sales annually, which seems doable because they are currently doing more sales than that and the business is growing. The companies distribution rights to the dry shampoo lapsed at the end of 2014 but a new deal was recently made. This is where the future becomes a question mark. SLGD retained the right to distribute Batiste to specialty retailers but lost the right to mass retailers. The deal lasts through 2016. The impact of this new deal will be what makes or breaks the company. The company does not break out sales which further clouds the picture. We do know that the dry shampoo market in the U.S. is growing, it is a relatively new product here and sales growth is up between 50-100% in the TTM. Some believe that the company can be profitable under these new terms but I think it is hard to know.

SLGD IS copy

The Products

wood copyTouch of scent copyfloor copydry copyface copy

The Cons: All That Shimmers Isn’t Gold, Says Tim Stabosz

Company management is suspect, the impact of losing part of the dry shampoo business could be worse than expected, and the company could lose further product distribution rights in years to come. If SLGD can not turn a profit you can expect for management to just let the company bleed out. Activist investor Tim Stabosz has been vocal in critiquing the company’s management, which may have scared some investors away. I agree that management has not acted in the shareholders best interests.

Stabosz wanted the CEO, who is also majority shareholder ~26%, fired and the businesses sold. He accused the board of being spineless yes men. At one point he even offered to buy out all of the boards shares at $.50 or let them have his shares for the same price. I can understand his frustration. The company could have been sold at an attractive price before Stabosz got involved. The CEO turned the offer down. He then proceeded to drive the company into the ground, with only one year of profitability over the next 14 years. The whole time he was earning ~$500K in salary. Would he have been fired if he did not own the lion share and have the board in his pocket? Absolutely!!  Stabosz has since sold his entire stake. His involvement has been pretty entertaining. My favorite quote from Stabosz is below.

  • Mr. Goldstein lives in a bubble, thriving on the high regard in which he is held by his employees and the community-at-large, and is operating the company primarily for the sake of “image” and “pride,” as a de facto not-for-profit institution, for which he is awarded a generous “sinecure.”

Read Some of Stabosz’s letters in filings on the SEC’s EDGAR website at the following two links:

http://www.sec.gov/Archives/edgar/data/88000/000116289311000004/slgd13d1.txt

http://www.sec.gov/Archives/edgar/data/88000/000116289311000004/slgdltr.txt

My other concern is that SLGD will lose all distribution rights to dry shampoo. The owners Church and Dwight are handling the mass retailers now because that is easier logistically. It would definitely make sense that they are slowly taking control of their entire business. I have seen other examples of this happening in the space before.

Recommendation:

There could be big opportunity here because the stock is so cheap, but I am going to wait. My projections of dry shampoo’s impact on net income has a wide range. It might be profitable and it might not. I do not think the company’s break-up value means anything because management will let it bleed money forever.

In a turn around or a company that just turns profitable a lot of the pop in the stock comes after the second quarter of profitability. In this case another big milestone is Q1 2015 when we see how the business reacts to losing the distribution rights. Stay tuned.

Warning: Like many of the other stocks that I write about on here this stock is illiquid.

In related news Horizon Lines, HRZL, had its first profitable quarter in a long time. It made ~$10M last quarter in net income, which is not bad for a $27M market cap company. Yes, I said only $27M market cap. Beware there is a lot of hair on this one, namely debt, lots of debt. In addition, TSRI is finally making a comeback after the recession, this one is not as messy.

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George Risk Industries Is Not Such A Big Risk After All.

Background: George Risk Industries (RSKIA) designs and manufactures, burglar alarm components and systems, pool alarms, computer keyboards, push button switches, and water sensors. Security alarm products make up ~85% of revenues and are sold through distributors. It is not an exciting business, but the company is good at what they do. They have been able to carve out a niche by taking custom orders that larger competitors shy away from. Management asserts that the company competes well on price and from my scratch the surface investigation that seems accurate. The company is 58% insider owned, with the commanding number of shares held by the mother daughter combination who serve as board member and CEO, respectively. RSKIA has a market cap of ~$39M. This is a good investment for a personal account because of the companies size and trading volume.

Thesis: Between its earnings power and the value of its assets the company deserves a higher stock price. The company remained profitable through the recession and has been growing steadily since. I see an upside of +45% with a limited downside. The stock price is supported by a +$24M cash and marketable securities balance. The rub is that management is not very shareholder friendly. They are sitting on top of a mountain of excess capital that should be returned to shareholders. Continue reading

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Growth Will Drive Past Next Year Consensus Expectations.

Summary: (Full report click here: EXA Corp Report)

  • Competitive advantages in simulation software, market leader position in auto space.
  • My consumer survey results suggest rapid company growth and high barriers to entry.
  • Fuel economy regulations will continue to spur demand for Exa Corporation products into the foreseeable future.
  • Attractive entry point, trades at 2.2x EV/Sales.

Business Description: Exa Corporation (EXA) competes in the digital simulation space, where it is a leader within fluid simulation, working with ground transportation customers (96% of 2014 Sales). Engineers use EXA’s software to simulate, for example, how changes to a car’s dimensions will impact fuel economy and interior noise. PowerFLOW is EXA’s core product. The alternative to using simulation is building physical prototypes and testing them in wind tunnels. The company earns its revenue by licensing software (~85% of Sales) and by performing consulting projects for clients (~15% of Sales). Customers of fixed cost projects are generally converted to licensed software users once they understand the technology. Customers are sticky and the business is steady and predictable. EXA showed sales growth even through the recession in 2008 and 2009.

The stock has traded down from ~$16 to $10.89 after management’s decision last year to invest a higher percentage of revenue in the necessary infrastructure for growth. The company’s stock is thinly traded, contributing to the pullback. The sales force was doubled over 18 months ago. In the six months ending July 30 versus the same period last year, R&D went from 35.1% to 36.7% of revenue, G&A from 20.6% to 22.2% of revenue, and S&M from 17.1% to 17.7% of revenue. These higher costs have pressured the bottom line. This has shaken out some near-sighted investors, but has created an attractive entry point. Continue reading

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LogMeIn is Running Out of Levers to Pull to Drive Growth

I have been following this company for awhile and I think it is time to SELL – To Read Full Report Click Here: LOGM SELL

LogMeIn, Inc. Time To Sell

 Concept:

  • LOGM growth is driven by business model changes, new products, and aggressive sales and marketing spending. This has masked that the majority of the company’s services have mature or flat growth.
  • Risks related to competition are not fully reflected in stock price. Large players have established brand names and deep pockets, and free substitutes are easy to find.
  • Customers are upset and leaving because of the abrupt forced migration, price increases, and poor customer service.
  • On a P/Sales basis, the company is trading above its average premium to mature tech companies and its peers. In addition, I predict 2015 sales coming in below consensus estimates.
  • LOGM does not deserve a similar multiple to growth software-as-a-service companies, which often trade above 5x sales. LOGM is a broken growth story and sum-of-the-parts analysis justifies a lower price.

Continue reading

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