Large asset managers are forced to ignore firms under a certain market cap due to liquidity issues.
However, this means there is potential for sizable returns in firms with less liquidity, as there is less institutional competition or research around these names. Today’s fund is able to navigate in this investing space and ignore the misleading signals of as-reported accounting.
In addition to examining the portfolio, we’re including a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.
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Friday Uniform Portfolio Analytics
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“We do these things not because they are easy, but because they are hard.”
– John F. Kennedy
In the twentieth century, two places remained unexplored by mankind. The vastness of unexplored space was the first, and it captivated the imagination of physicists, astronauts, and policymakers during the Space Race. The other place was not above our heads, but deep beneath our feet.
In 1960, the Italian bathyscaphe Trieste made the first manned journey to plumb the depths of the Challenger Deep, the deepest section of the world’s oceans, at the bottom of the Marianas Trench. Explorers had been plotting the sea floor for the past century using submarines, but this was the latest mission of its kind.
To send two men to the pitch blackness and crushing pressure of Challenger Deep required overcoming specific engineering challenges past the capabilities of normal submarines, which would be crushed. However, this challenge paid off for the explorers Jacques Piccard and Don Walsh, who answered the question if life could exist in such hostile conditions.
Upon spotting a strange, but very living fish, the men shook hands at negative 35,000 ft to celebrate their discovery.
In the investing world, there is a Challenger Deep few explorers will dive to. Due to the difficulty of the required research, it turns off most institutional investors from the possible discoveries. Last week, we talked about the firm Wasatch Microcap, a firm whose due diligence with microcap firms unlock sizable investor wealth.
However, there is another reason research is sparse within the microcap universe: the limited liquidity of microcap names. For firms worth $1 billion or more, liquidity is a small concern for investors. And yet, as market capitalization drops down to $500 million or $50 million and below, liquidity becomes a serious barrier for large funds.
If a large institutional investor with a one-billion-dollar fund would like to invest in a stock, they would likely want to allocate a position of at least 0.5% of their portfolio, or the stock’s moves would have barely any effect on the fund. However, 0.5% of a one billion fund is five million dollars, or 10% of a $50 million microcap firm.
If the fund were to build a 10% position, firstly it would take them some time to build it. As importantly, it would lead to a bunch of legal red tape they’d have to deal with too.
Once your ownership position goes above 4.99%, you’d need to file a 13-D, or a 13-G if you promise never to engage with management. You have to disclose your position to the world and have new rules in how and when you can trade the position.
A fund wouldn’t jump through these hoops unless the team really thought the company had exceptionally massive upside. And that’s assuming the fund is even allowed to buy these types of names.
These serious liquidity concerns mean institutional investors stay at arm’s length from microcap firms due to their very nature. Furthermore, without institutional investor interest, there is no analyst coverage from investment banks. The ability to make a profit selling research becomes limited if your clients don’t need the research because they’re not buying these stocks.
This means these names remain hidden for most, except for the select few researchers who make it their mission to make the next great discovery. One fund willing to make the plunge is Alluvial Capital, and its portfolio manager David Waters.
David Waters has been writing the blog OTC Adventures for over eight and a half years, predating the existence of Alluvial Capital. Starting as an individual investor, his proven track record of expertise in the microcap space led to him getting capital to build a fund around his strategy.
Waters has been pushing for the democratization of information in the microcap space, to lead individual investors to the massive opportunities in the space and away from portfolio torpedoes.
We agree with Waters that investors need to have the research to get access to this space. It’s just too massive of an opportunity. We don’t want investors to miss out on the opportunity.
So we have created a service geared around highlighting these undiscovered microcap stocks that are primed for tremendous upside. We’ve also gone out of our way to identify companies who could be practicing fraud, to protect our readers’ capital.
We just launched this service, and because we want to start to shine the light on the world of microcaps and help people finally unlock the value in this market of MASSIVE upside, we’re making a special offer.
This service is called Microcap Confidential. While we’re biased (we did take the time to create the product and shoot this video afterall…) we highly recommend you take the time to learn about the service.
And you need to do it today. Because our charter offer is closing today. Today is the last day you can get access to this research for half-off its normal price, as one of our early subscribers.
We have put together a video discussing the power of identifying microcaps that have significant upside when we pull together all the tools we have in our framework that you read about every day here, including:
– Uniform Accounting
– Credit analysis
– Management compensation and communication analysis
– And deep fundamental research
Click here to take your first step in the microcap world.
By the way, if you listened to the full video…we tell you our favorite stock to buy in the microcap world right now, and we also tell you one company that is aggressively and regularly promoting itself in the news and through press releases to try to take advantage of speculators in the midst of the pandemic, that we think it is essential you do not buy.
As we mentioned above, today’s fund, Alluvial Capital, is focused on the unexplored waters of microcap investing. The fund can take advantage of these opportunities because it is still small relative to big institutional investors, with $40 million in client capital.
And we can take a look at Alluvial Capital’s equity portfolio, using its most recent investor letter, to provide a window into the firm’s investment mindset when it comes to microcap investing. We’re showing a summarized and abbreviated analysis of how we work with institutional investors to analyze their portfolios.
While these names may appear to be mediocre investments using as-reported metrics, these securities are, in truth, stronger names once Uniform Accounting metrics are reviewed.
See for yourself below.
Using as-reported accounting, investors would think Alluvial Capital was buying anything other than high quality businesses that could have sustainable upside.
On an as-reported basis, many of these companies are poor performers with returns just above the cost of capital, and the average as-reported return on assets (ROA) is right around 9%.
In reality, the average company in the portfolio displays a Uniform ROA above corporate averages, at 14%.
Once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see these are the kind of high-quality microcap names that earn Alluvial Capital a sizable return.
Once the distortions from as-reported accounting are removed, we can see that Rand Worldwide (RWWI) doesn’t have a below corporate average return of 9%, but a sizable ROA of 27%.
Similarly, BredBand2 i Skandinavien (BRE2:CHE) ROA is really 30%, not at 10%. While as-reported metrics are portraying the company as a firm in line with competitors, Uniform Accounting shows the company’s true robust operations.
Crawford United (CRAW.A) is another great example of as-reported metrics mis-representing the company’s profitability. Crawford United doesn’t have a 12% ROA, it is actually at 21%.
If Alluvial Capital were focused on as-reported metrics, it would never pick most of these companies because they look like anything but successful companies in the microcap space.
Normally, we also focus on EPS expectations when breaking down a fund’s portfolio. However, Alluvial Capital is taking advantage of the liquidity barrier we mentioned earlier. These are firms without forecasts for EPS growth, as institutional research rarely covers these names. By investing in firms before the market catches on, Alluvial is able to springboard their returns.
In conclusion, Alluvial Capital has focused on firms with strong underlying fundamentals, discovered through due diligence in the space. To be successful in the microcap universe requires independent research, and with the power of UAFRS, we can see how much Alluvial Capital has done to position themselves for success.
SUMMARY and Intred S.p.A. Tearsheet
As the Alluvial Capital’s second largest individual stock holding, we’re highlighting Intred S.p.A.’s tearsheet today.
As our Uniform Accounting tearsheet for Intred S.p.A. (BIT:ITD) highlights, Intred’s Uniform P/E trades at 26.3x, which is above average valuation levels and historical average levels.
High P/Es require high EPS growth to sustain them. In the case of Intred, the company has recently shown a 27% Uniform EPS growth.
Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.
We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Intred’s Wall Street analyst-driven forecast is a Uniform EPS growth of 1% in 2020 and decline immaterially in 2021.
Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Intred’s EUR 8 stock price. These are often referred to as market embedded expectations.
The company needs to have Uniform earnings grow by 7% each year over the next three years in order to justify current price levels. What Wall Street analysts expect for Intred’s earnings growth is below what the current stock market valuation requires in 2020 and 2021.
Furthermore, the company’s earning power is 1x the corporate average. Also, cash flows are also 2x higher than its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low credit and dividend risk.
To conclude, Intred’s Uniform earnings growth is above peer averages in 2020. However, the company is trading far below average peer valuations.
Joel Litman & Rob Spivey
Chief Investment Strategist &
Director of Research
at Valens Research