Microcaps: Should You Fear Controlled Companies?

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Jul 28, 2013
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One of my favorite value investing blogs, Oddball Stocks, recently did a post called “Why Micro Caps”? It’s a good post. And a good question. I don’t look at big cap stocks any more than I look at micro caps. How odd is this?

Let’s quantify. I don’t have exact figures in front of me – but I’m pretty sure I can ballpark this. I would put the median market cap in the U.S. at around $150 million or so. In my experience – and this depends what databases you are screening in – if you use a dividing line of a $100 million market cap, you’ll find most public companies in the U.S. will be above that line. You’ll get more non-microcaps than microcaps in your sample if you define a microcap as a stock under $100 million. If you define it as a stock under $200 million in market cap, you’ll tend to get more microcaps than non-microcaps. Therefore, the median is probably somewhere in between.

I’m talking very roughly here. I run actual screens – I don’t test for what the median market cap in a database is. But, in my experience, whether I screen for quality or cheapness or years of history or any other quirky metric I can think of – I tend to find that about half the companies in that screen have a market cap under $200 million. Maybe more than half.

For a lot of investors, $200 million sounds like a small company. A market cap of $100 million certainly does. And yet, in the U.S., that’s a “normal” market cap. It’s pretty average.

That means the vast majority of most people’s time is spent thinking about a small minority of publicly traded companies.

For me, big cap value investing is either taking advantage of:

· Negative headlines (stock specific fear)

· Cheap markets (country specific fear)

Fear is perhaps too strong a word. Sometimes it’s more like malaise. Or fatigue. But it’s often a matter of being greedy when others are fearful – or interested when others are bored.

When I’ve bought big cap stocks – like in early 2009 – they’ve tended to fit that mold. When I’ve bought a basket of stocks – even if they were microcaps – like in Japan, they fit the country specific category. Japan’s stocks had done badly for decades. Then there was a natural disaster. Then there was a nuclear disaster. I bought after those events.

Even then, I bought microcaps.


I actually started by looking at pretty big Japanese companies. Especially exporters. Most – with the exception of something like Nintendo – didn’t interest me. They were not as cheap as small, domestically oriented Japanese companies. They were complex. And their management was at least as difficult to understand. What I could understand – like capital allocation – I didn’t like.

This also tends to be true for me in Europe. Given a choice between large or small French companies – I’d buy the small ones. This is true regardless of price. Having spent some time looking at large and small French companies, I have zero preference for the large. I’m sure there are some wonderful large French companies. But there’s no reason for me to pay a premium for them. I like the management of the small companies at least as much. Much of what I don’t like about French business is as much an issue – I actually think a bigger issue – in their largest corporations.

Is this true in the United States?

I’m not sure. My biggest concern from a management perspective in the U.S. is always the same. I’m worried about short-sightedness and a focus on what Wall Street wants. In theory, this is less of an issue at small companies than large companies.

However, there are reasons a small company’s management might not care about shareholders. The result would be equally bad. Ideally, I want management to be focused on increasing value longer term for shareholders. If they don’t care about shareholder value at all, that’s bad. And if they care about the short-term too much – as many American CEOs do – that’s bad too.

Overwhelmingly, this has lead me to prefer situations where there is a controlling shareholder. Even when I have mentioned larger American companies – DreamWorks (DWA), Berkshire, Carnival, John Wiley (JW.A), even Barnes & Noble – they have controlling shareholders.

Barnes & Noble may be a clear example where a controlling shareholder can be a bad thing. The proxy fight was a big part of my investment thesis. Riggio’s victory – and decision to stick with the Nook, since reversed – were what made me sell that investment.

These are some of the negatives people list about microcaps. Management can screw you. To be honest, my view is that management can always screw you. A CEO who can push through dilutive mergers etc. – whether that means they are using soft powers of persuasion with a board or actual votes they control in a shareholder meeting – is the greatest threat to you as a shareholder.

When you look at cases like Time Warner and AOL, Hewlett-Packard (HPQ), Yahoo (YHOO), Dell (DELL), etc. I find it hard to say that being a big or small stock – having a controlling shareholder or not – is what determines the harm a board can do.

In my experience, there are really 4 factors that determine how you will be treated by management:

· Worldview

· Honor

· Shame

· Laws

All managers – like all people – have certain worldviews. They are sometime upfront about them. If you invest with Jeff Bezos and expect quick profits and instead get losses – that’s your fault, not his. He’s been very upfront about how Amazon (AMZN) is run.

Many microcaps are not run with optimal leverage. They sometimes have debt when they buy things. They often pay this down. Families frequently prefer to operate at around an even net debt/net cash position.

Honor is integrity. I mean this in the personal sense. How someone behaves when they aren’t sure if someone else is looking. Some CEOs like to get paid a lot, but don’t like to take money when the company does poorly. They want options. You may not agree with that approach. But it may fit their sense of honor. I can’t think of many extreme examples of honor and candor – they usually go together. But I can think of a few. I know of one microcap CEO who warned his shareholders that he was worried the company’s stock price was getting too high and new shareholders would be disappointed even if the company executed well. In big caps, Warren Buffett is the classic example.

Shame is probably the most effective regulator of management mistreatment of shareholders. This is why I try to avoid countries perceived to have high corruption. A corrupt manager in a society with low corruption is ashamed. Anyone who participates – or even has knowledge – of such corruption is conflicted. They know they are doing wrong. And they know they can’t just claim everyone else does it, it’s normal. In less corrupt societies, corruption is shameful. It actually eats away at you.

In corrupt societies, not so much. You may be more concerned with jail time. This doesn’t sound like a big issue – but it actually is. It’s a huge issue with the folks on the periphery of any corruption – lawyers, accountants, people who come across fraud when checking what seems to be a data entry error. How do they react?

In China – a corrupt country – there were several major accounting scandals. There have been accounting scandals in societies perceived as less corrupt like the U.S. and even Japan.

That’s not the problem. Bad people can do bad things anywhere. The problem is how some of that fraud was carried out in China.

The egregious part of these frauds was that – for several years – the accountants had not independently verified bank account of the company with the actual banks.

I mentioned my Mom was part of the top management of a family controlled company – a couple brothers owned 90% of this company – when I was growing up. There were no outside shareholders in this company. Only employees and executives owned stock. The auditor was not a big accounting firm.

They always verified the accounts with the bank – they never allowed communication from the company directly. You couldn’t have the bank mail a document to the company and then have the company mail it to the bank.

Why did they do this?

They weren’t better people than auditors in other countries. They weren’t under a lot more scrutiny. In fact, for most of the history of this company, the audits weren’t even being used by outside parties. At times, banks were using them.

These were habits. They were things that could be broken – maybe would be broken with enough incentive – but they were clearly creating a line between normal procedure and this is something shameful for me to do.

I always worry about this in countries where foreigners are the main investors in the companies. It seems a lot easier to defend mistreatment of shareholders when they aren’t local.

To reiterate, I don’t avoid countries with high corruption because I’m worried about management. I actually avoid countries with high corruption because I’m worried that folks on the outside – employees who come across evidence of this corruption, lawyers, accountants, bankers, etc. – are less likely to react in a way that imposes a heavy social cost on any misconduct.

You can be corrupt in any country. You can only be corrupt with a clear conscience in a society that is less likely to treat corruption as something truly shameful.

Laws are the last defense. I think they – I’m speaking mostly from my experience in the U.S. here – may help with board behavior. When I say laws, I mostly mean getting sued. Don’t confuse laws with justice. In almost all cases I can think of, the laws probably encouraged a good process – never a good outcome. Cynically, you could say laws ensure a show of process not equitable treatment.

But a show of process at least requires people to go through some steps. They at least have to justify things to others. And – most importantly – to themselves.

When you treat someone badly, you must convince yourself that it’s okay to do so. That you’re not really such a bad person. You may be taking a bad action. But it’s necessary. You may be taking a bribe – but everyone does that. You may be paying the CEO way too much – but look at that compensation comparison with peers.

This is the last point I’ll make. Conduct is relatively moral. It’s not absolutely moral. With very rare exceptions, people don’t set out to be good. They set out to be good enough.

This depends a lot on your perspective. Personally, I feel shareholders are too quick to condemn management as people. They believe them to be immoral when generally they are behaving much as anyone in that situation might.

The problem is situational. You are a shareholder – you want your dividends. You don’t want the company piling up cash for no reason.

The CEO of a microcap company sees it differently. Maybe he owns stock. Maybe he cares (a little) about you, his shareholders. But he also cares a great deal about the survival of his business. He probably does not want to fire people when there is a slight downturn. He may have – you’ll have to investigate this – lived through times when the company was in constant contact with bankers and survival didn’t seem so assured.

I mentioned Carnival earlier in this article. Carnival – before it went public – was not an investment grade company. It was often very short of funds. It relied a lot on customer deposits. This history is never entirely absent from the mind of folks – like the Chairman of the company today – who were with the company back then.

If you read a book by Richard Branson, you know how close he came to ruin because of his company’s early borrowing. Logic won’t erase memory.

It is easier for shareholders to forget that management has a lot of different desires – a lot of different fears. They probably want to be the best in their industry, they probably want to keep their job, they definitely don’t want to fire people, etc.

Some of these desires conflict with yours. For example, the best way not to fire people is to grow unit volume. Virtually every company – regardless of what they actually say – really does, deep down want to grow unit volume every year. They would like to do more business. They would even give up a smidge of profit (unconsciously perhaps) and accept a lower return on your investment if it meant they could always be increasing the workforce – always be having some room for upward mobility – and always providing a bit of job security.

A shrinking company lacks that.

The math for shareholders is different. I’ve often looked at a company and what it was doing and decided that it frankly wouldn’t matter to my investment if they grew or paid out a dividend or bought back stock.

It matters to the company. Just like it matters whether they have a few years’ worth of free cash flow piled up.

Managers – like investors – are as lazy as they can afford to be. They will try to do as little hard decision making and make themselves as safe as possible. That means they will give in to habits and inertia.

In my experience, the best way for investors to deal with this is to use past actions – not future projections – as their guide. To me, the character of management is the sum total of their past actions.

This is as true in microcaps as in big caps. If you are looking at a microcap with a controlling shareholder – as I often am – it’s way more important. That’s because management at a major American company is only going to last something like 5 years. By the time you have much of a record to go on, that guy will be gone. And the board generally doesn’t warn you who will replace him.

That’s why I’ve not found that management at microcaps is worse than at big caps. It’s just more concentrated. A very bad manager at a very small company can do terrible things. At a large company, unless they are engage in a lot of M&A – especially issuing shares – they simply have less ability to alter the existing institutional inertia. Big companies turn slowly. So they’re pilots matter less.

Managers matter more at small companies – for better or worse.

Talk to Geoff