As a big Buffett fan the following statement the great investor made to Businessweek in 1999 was forever burned into my memory:
"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."
Yes, Buffett said he could make 50% a year if he had a portfolio of a million dollars.
To me that meant that the best place for a small investor like me to look must be in the places where the big money can’t go. I should focus on small companies. As a small investor I should have a big advantage because I can find companies the big boys aren’t interested in.
But it is easier said than done.
What I’ve subsequently found in the years since hearing this from Buffett is that:
1) It takes a huge amount of time to sift through hundreds and hundreds of little companies looking for great bargains. The bargains exist, but it takes a lot of time to find them.
2) I’m not nearly as smart as I hoped that I was. What I think is a good idea isn’t always necessarily so.
In response to these two challenges, what I’ve done (rather than give up on finding small cap bargains) is to try and piggyback on the work of smarter investors who also fish in the small cap pool.
That way I still get the advantage of investing in the small cap sector where there is more opportunity for undervaluation, but also have the benefit of looking at only the best ideas of better investors.
[b]One Place to Look Is in Billionaire Phillip Frost’s Portfolio
Last month I started looking more closely at the portfolio of Dr. Phillip Frost. I became familiar with Frost through another investment that I have and became very interested in his investment portfolio.
Frost is a billionaire. He has made his billions by taking small companies and making them big. Frost started out by building Key Pharmaceuticals which he sold in 1986 and pocketed $100 million. Then he founded IVAX and as CEO built that company to the point where it was sold for $7.4 billion in 2006 to TEVA Pharmaceuticals (TEVA).
He knows how to find something small and turn it into something big.
Frost now has an investment portfolio made up of very small cap companies. There aren’t many other investors looking in this space that have the track record of Frost and I welcome the chance to borrow from him.
Many of the stocks in Frost’s portfolio have had fantastic runs and I’d like to participate in some of that.
That brings me to IZEA Inc (IZEA) which Frost owns almost 10% of.
Normally investing in a young high growth company like IZEA likely wouldn’t be for me. Investing in these types of young companies is undoubtedly very risky (please read the risk section at the end of my article).
Frost’s involvement however changes the risk profile for me considerably.
Frost being involved doesn’t take the risk away, but it does greatly increase the risk/reward relationship for me.
First of all, Frost is a proven investor and if IZEA has made it through his due diligence screening then that is encouraging. The man is a billionaire and he isn’t going to be wasting time with second rate ideas.
Secondly, the biggest challenge for young growth companies is access to capital. Having a billionaire behind as a major owner your stock can see you through capital crunches. It will be in his best interest to protect the value of the shares he owns and he can provide financial support at critical times.
This doesn’t guarantee success by any stretch, and I still view IZEA as quite risky.
But it does bring the risk profile (for me) down to a level where I could find room in a diversified portfolio for a situation like this.
What Does IZEA Do?
IZEA has a pretty cool business and certainly one that even I can understand.
IZEA has found an interesting niche where it operates as a middleman.
IZEA creates marketplaces where an advertiser can find a celebrity or other influencer to promote their product. The celebrity of influencer will tweet, blog or use other forms of social media to promote the company’s product to the influencer’s followers.
The advertiser will obviously pay the influencer a fee for this, and IZEA takes a cut of that fee for acting as middleman.
Advertising through social media obviously has huge potential. IZEA has the advantage of being the first mover in creating a marketplace for advertisers to link up with influencers.
IZEA’s network covers 170 countries, over 750,000 influencers and has established a critical mass that can’t easily be replicated.
There is great benefit to being an early entrant to a new and powerful trend.
Operating In A High Growth Industry
I’ve always tried to stick to investing in companies that have tangible assets or predictable cash flows that I feel I can value with a reasonable degree of precision.
Investing in IVEA is totally different than that.
It is hard to predict accurately where this company is going to go. This is a young company with an eye on big things but many challenges ahead of it.
One thing that is pretty easy to predict is that the business IZEA is operating in has years of growth ahead of it. The harder part is predicting how much of that growth IZEA will participate in.
Paid social advertising is still in its early innings.
While 75% of advertisers now say they use paid social advertising the percentage of their budgets directed to it are growing every year. According the Nielsen 2013 paid social media advertising report 64% of advertisers were increasing their social media advertising budgets in 2013.
That same report showed that while 75% of advertisers are already using social media advertising most of them have been doing so for less than three years with 20% having only been active for less than one year.
This reminds me of the early years of Amazon.com (AMZN) where it seemed obvious that internet shopping was going to be big, but pulling the trigger on early stage unproven companies was scary for many of us.
To me, the fascinating part of this growing business is how a company like IZEA can slip in and grab a big market share while the social media platform providers like Facebook (FB) or Twitter (TWTR) sit back and don’t participate.
This social media advertising is taking place on the Facebook and Twitter platforms, yet it is IZEA that has moved in and established a critical scale in creating a marketplace.
Why Facebook or Twitter doesn’t play the role that IZEA does and profit from it is puzzling to me.
It leads me to believe that at some point Facebook or Twitter or LinkedIn would be interested in acquiring IZEA to simplify the process of providing this marketplace.
Why go through the trouble of building something from scratch if you can just buy it.
IZEA – The Financials
What makes investing in a company like IZEA tricky and risky is that analysis of the current financial statements doesn’t reveal much about the future valuation of the company.
IZEA is likely either going to be a huge winner or it isn’t. There isn’t much in the current financials that can tell me which outcome is more likely.
If I’m looking at buying an oil and gas company I can take a look at its cash flow, booked reserves and asset portfolio to help me see what the company might be worth today and how much it can grow over the next decade.
The readily available financial filings can help me paint a valuation picture for an oil and gas company (with me providing me own assumptions on commodity prices).
For IZEA determining valuation and predicting the future is much more complicated.
Here is what I know about IZEA:
- IZEA itself has been growing very rapidly.
- IZEA is operating in a business that is certain to get much larger over the next ten years.
The trends in this industry puts the wind at IZEA’s back. Being a small company creates challenges as it will be difficult to fend off competition.
Revenue growth and margin expansion for IZEA over the past four years has been consistent and quite rapid.
This is a company that is focused on growth and gaining critical mass rather than on near term cash flows.
Revenue over the past four years has been:
2012 - $5 million
2011 - $4.3 million
2010 - $3.8 million
2009 - $2.8 million
In percentage terms that growth is:
2012 – 16%
2011 – 13%
2010 – 35%
Importantly not only have revenues been growing but so have gross margins:
2012 – 57%
2011 – 55%
2010 – 52%
2009 – 52%
Despite IZEA’s small size the company has managed to create a bit of a “moat” around its business. The marketplace that IZEA has founded has as mentioned earlier 750,000 participants and is the place that advertisers know where to go.
I think it would be much easier for a Twitter or a Facebook to go ahead and acquire IZEA than it would be for them to spend the time to try and build something similar from scratch.
As the slide above shows, acquisitions in the social media space have been commonplace and could be the logical end result for IZEA.
I believe IZEA is an instance where the next five years likely offer a binary set of outcomes. An investment at current prices is likely to either work out incredibly well, or not so much.
This is a bit like venture capital investing where valuation work is a bit of a lost cause.
This isn’t a situation where you buy a company trading at $5 because you think it is worth $7.50. This is a situation where if all the cards line up right you have a company that five years from now is worth multiples of the current share price. If the cards don’t line up right, you are likely going to be sitting on a loss.
I’ve Had Success Piggybacking Before
I like the IZEA story, but I don’t like my ability to pick winners in high growth industries.
What I have had some pretty good success with is picking good investors to borrow ideas from.
My most obvious recent examples come from the portfolio of the Fairholme Fund’s Bruce Berkowitz.
Back in 2011 the financial media was making Berkowitz out to have lost his stock picking ability. I thought the opposite and invested in his favorite holding at that time AIG (AIG).
That worked out extremely well.
I also bought into the preferred shares of Fannie Mae and Freddie Mac earlier this year after Berkowitz revealed a large stake and both of those investments have had terrific runs.
In this case the piggyback would be on the back of Dr. Frost who clearly likes what he sees in IZEA.
As I showed in the article that I linked about Frost earlier he has had some huge success with small cap growth stocks this year, and the fact that he made himself a billionaire by growing companies adds to his credibility.
I’m very intrigued by his interest in IZEA as he clearly sees some long term potential.
For me an investment in IZEA (because of my own limitations) would be as much a bet on Frost’s ability (and financial presence) as it is a bet on the IZEA company itself.
The Risks Here Are Very Rea
I can’t overstate the fact that exposing money to small companies in emerging industries is risky business.
I don’t yet own IZEA but if I decide to it will involve a very small investment and one that I go into with my eyes open. There are risks here and they involve:
- Potential threats from much larger competitors who could take IZEA’s business if they wanted to spend the money to do so.
- IZEA has a small balance sheet and limited cash flows which create the risk of dilution or running out of capital.
- This will be a very volatile stock.
IZEA is a high risk, high reward situation. I like the business, I like IZEA’s foothold in the marketplace and I like the presence of Frost. It will be interesting to see where this company and stock are in five years.