Steady Returns in Small Caps
Intrepid Small Cap Value Fund
US > Small-Cap > Value
Oct 26, 2009
Dec 15, 2015
Q: What core beliefs guide your investment philosophy?
A : We are buyers of good businesses at good prices. We are not necessarily looking for businesses that generate high returns on capital but businesses that are generating excess cash after paying for all capital expenses and yet are trading at attractive valuations. It is our belief that businesses that generate excess free cash flows and are fiscally disciplined, in the long run will reward shareholders.
Our philosophy is not only to look at companies based on their rate of return but also look at their capital intensity, the longevity in the business and competitive dynamic, as well as how it all translates into free cash flow and the yields on free cash flow. We are absolute investors so we look at one company at a time.
Q: What kind of small cap companies meet your quality criteria?
A : Conventional wisdom for quality refers to profitability metrics like high margins or high return on capital that a company generates. But our belief is that despite low margins or low return on capital, companies can still be a good business depending on the industry. We view quality more as strength in balance sheet and cash flows. Our belief is that that you can have a business that generates an average rate of return on capital, but generates excess cash flow and it could still be a healthy business to invest in.
If a company has 1% return on capital and we are receiving a 10% free cash flow yield at the time we purchase a stock, we will consider it. We look for high return on equity companies but high returns are not necessary.
A good example is Oil-Dri Corporation of America, which is engaged in developing, manufacturing and marketing sorbent products and is currently the market leader in cat litter. They actually have low return on capital but can generate a lot of cash, their potential free cash flow is around $8 to $10 million and about $100 million market cap. The company also pays 4% dividend and has strong balance sheet and the business has high barriers to entry. The reason why they generate low returns on capital is because the balance sheet is so asset heavy.
They have clay quarries with processing facilities on the East and West coasts, and in fact, it’s very difficult to get a new mining permit for clay. As a result, their coastal facilities allow them to distribute to national retailers and will be difficult to replicate.
The other factor is cat litter is very heavy and expensive to transport so it doesn’t make sense to ship giant boxes and bags of it from China to the U.S.
Q: How does your investment philosophy translate into the fund’s investment strategy?
A : We seek long term capital appreciation. The fund invests at least 80% of assets in common stocks of small capitalization companies. It invests in undervalued common stocks and in internally financed companies generating cash in excess of their business needs, with predictable revenue streams, and in industries with high barriers to entry.
Q: Could you describe your research process with a few examples?
A : Our research process searches for companies where there is disconnect between the market price and the underlying long-term value of a business. We believe that price is not always indicative of value.
We focus on companies that are generally smaller and may be closely held, and that generate their cash needs internally. We prefer businesses that generate meaningful free cash flow, since this is an important characteristic of a good business and usually indicates a solid or improving balance sheet. In addition, free cash flow clearly increases intrinsic value and can be used to pay shareholders via buybacks or dividends. Companies with predictable free cash flow can also be valued with a higher degree of confidence than those with negative or uncertain free cash flow.
We have developed a list of about 300 to 400 names which we don’t own but follow. We would like to buy, but we hold off when the price doesn’t make sense or if we are not familiar with the business we will follow it a little longer until we get to know it. Consequently, the portfolio has around 50 names, though we probably follow nearly 400.
In terms of sector allocation, we do not necessarily focus on any sector. Our higher weightings are the companies with better balance sheets and cash flows and bigger discounts, and the lower weights tend to be companies that have some debt in the balance sheet or higher operating risk in the business than normal for us. Generally, smaller names, even though they may have operating or financial risk, usually will never have both.
Whereas we will not buy a cyclical business with a lot of debt, we will buy a cyclical business without any debt or financial leverage. If we were to buy a company with debt, it would be one with a steady end market or very little operating risk. So, it’s one or the other if you are going to take risk. We rarely have to take both operating and financial risk at the same time.
For instance, our most recent purchase is Weis Markets, Inc., a chain of supermarkets in Pennsylvania. They have 165 stores and all the stores have about 30% to 50% market share. They focus more on efficiency, speed, cleanliness and in selling fresh produce and meat.
Although the company has low operating margins normalized around 3.5%, they have a very strong balance sheet with no debt, $112 million in cash and $850 million of market cap. In other words, that is about $4 a share in cash on a $32 stock. They generate normalized free cash flows around $2.50 to $2.60 a share and that equates to free cash flow yield of around 9-10% for a fairly consistent business.
This was a company that historically has sold around eleven, twelve times EBIT (Earnings before Interest and Taxes) on enterprise value and because of its consistency in earnings has been rewarded with an attractive valuation, but currently it’s selling at around eight times enterprise value to EBIT. So we think it is worth $37 to $39 based on our discounting free cash flow valuation. Again, the stock is trading around $32 so between 17% and 20% is not a huge discount but in this fairly valued market it is attractive and in addition there is a 3.7% dividend.
We prefer these companies that can generate between 15% and 20% gains than companies that surge four to five fold because established companies that are mispriced in the market tend to limit our downside.
Another example would be PetSmart, Inc., a specialty provider of products and services for the lifetime needs of pets. It has a fairly consistent business even though business has been soft recently. Where discretionary retailers have seen their comparable same store sales have declined between 5% and 8%, sales at PetSmart are nearly flat.
It is not a high-growth market but catering to pets for the most part is a consistent business. PetSmart has been growing its stores base around 10% a year for the past several years and this year have pulled it back probably to about 4% and what that does is it gives them focus and allows them to cut back on the high capital expenditures, the inventory growth and the pre-opening expenses but it helps margins and it definitely helps free cash flow.
They have steady free cash flow which will increase as the company slows the expansion and will need lower amount of capital to fund their inventories.
Q: What is your definition of “enterprise value?”
A : For us enterprise value means when buying a business we’re going to buy the market cap of the business and the debt. If we have no debt, it is much more attractive to purchase that business, and if we have cash, that cash can be used to help pay for the acquisition. We view enterprise value as market cap plus debt minus cash.
Q: What is your buy-and-sell discipline?
A : It is a pretty simple buy-and-sell discipline model – buy, when we get at least a 20% discount, sometimes less, and sell it when it reaches our valuation.
We hold companies as long as we need to if it trades at discount to our value. What’s great about a lot of these companies that generate cash with good balance sheets is they pay dividend while you hold them. Dividends are nice but we also like to have some kind of catalyst, which is not always evident when we buy the stock. Sometimes, we do have to hold the small-cap companies for a while and the catalyst will occur but no one notices.
Q: Does the book value multiple plays a significant role while investing in a company?
A : It actually depends. If a company is paying dividends or does buyback stocks it may reduce the book value. We wouldn’t necessarily penalize management just because their book value per share is flat or decreasing because they are returning capital to shareholders. But what is very important to us is how they are allocating their free cash flow and are they creating value when they do reinvest in the business.
We think of a business as a long-term bond. For instance, in a 30-year bond, most of the value is from the reinvestment of the coupon. So that’s exactly how we view a business, most of the value when discounting free cash flows isn’t the first three years of cash flow but is the perpetual discounting of those cash flows and the terminal value of the business.
To us it’s more of a concern about the value of the business not necessarily an accounting statistic of book value, so we’re much more concerned about value creation and growth of the business which can be correlated. There can be rising book value per share and rising intrinsic value per share but it is not always the case.
Q: How do you conduct your portfolio construction?
A : The portfolio team focuses on businesses that we believe are selling below our calculated intrinsic values, or what we believe the underlying business is worth. Our valuations are calculated by discounting free cash flows, asset valuation, and transaction valuation. We focus on established businesses that have strong balance sheets and that generate above-average free cash flows.
We attempt to reduce risk through detailed fundamental analysis, limiting the number of holdings to below 55, and by avoiding businesses that cannot be valued with a high degree of confidence. We focus on absolute results rather than relative results. By doing so, we attempt to think independently and avoid investment fads and sell stocks when they exceed our calculated intrinsic value.
We produce valuations using realistic assumptions and generate our research internally while avoiding external sellside analysis. We invest our own money alongside our clients’ funds and we will not buy for the fund a stock that we would not buy for ourselves.
We typically are not correlated to benchmark indices because we have a concentrated portfolio consisting of our best ideas. We are flexible and do not have limits on how much cash we can hold.
Q: What risks do you perceive in the portfolio and how do you mitigate them?
A : We are very concerned about risk and one of the most interesting facts about our fund is that we have had very good returns by focusing more on risk than return. It is so much easier to consistently generate returns and if you keep risk in mind at all times.
First of all, we view risk as losing money. That is why we are more concerned about the risks to the operating results or the cash flows of a business. Secondly, we like companies with a long operating history because if management does something unconventional with the balance sheet, knowing management will help us better understand the performance of a business and thus control some of the risk.
Individual stock weights are another way to control risk. For us, risk is a three-layer combination of risks to the business, to cash flows and to our valuation.