Lessons Learned After One Year of Managing a MicroCap Fund

I became a full time microcap investor in October 2012, after working on Wall Street for 16 years across research, trading, institutional investment management and client service jobs. Early on in my career, I worked as the sole analyst for a microcap investor who ran his own firm. It was entirely his own money, and he had a lot of it. He accumulated his wealth by taking concentrated positions in companies I had never heard of. His approach involved taking huge positions, getting to know management on a personal level, and then watching his investments like a hawk. At the time, I didn’t appreciate the nuances of his strategy, and eventually moved on to other jobs.

I have always gravitated toward investing in smaller companies. They just seemed more interesting to figure out, and offered more upside per unit of time spent. My evolution brought me to a place where investing full time became a possibility and my wife was fortunately a key supporter of the idea.  I left a good paying job where I could have kept on clipping the coupon, but what nagged at me was the desire for more freedom and to control my own destiny. I’ve been at it for almost a year now, running a portion of our personal wealth, alongside additional client money. My partner in the business, who I have known for more than 10 years, has the same skin in the game, and we share responsibilities equally. Doing this alone would be impossible, and we have been fortunate in our first year of operation.

To the extent anyone is out there thinking about taking a similar leap, this blog post is for you. Go for it. Failure IS an option, because whatever you learn and whoever you meet along the way will provide unforeseen options down the road. I probably waited too long to make the leap.

Lessons learned:

Liquidity is the best friend and the worst enemy of microcap investors. Never underestimate the risk of when you will need liquidity, and conversely don’t overestimate the opportunity to be a liquidity provider, especially when others will not. Position sizing and always having some cash on hand are two ways to mitigate this risk overall, as well as having a medium term investment horizon. There are days when your favorite stock might move down 10% on little volume, which is a good day to be a liquidity provider. We maintain at least 10% cash at all times to take advantage of such opportunities.

Patience is required to let themes play out. There are days when absolutely nothing happens. If you are a trader or like the action of trading, know this ahead of time. Sometimes there is no wind for the sails, or the sniper just lies in wait.  After a six month holding period, we sold one of our positions after growing frustrated with management execution. We then watched it double in the next 4 months. We still don’t know why it doubled. Execution delays are common, and sometimes you need to let out longer rope. Management teams that mis-mange expectations are often bad management teams.

Information is king in microcaps. Figuring out a story first is difficult, but even if you are the second person to come upon actionable information, don’t discount its value, though it does have a sliding scale. You should know where you sit in the information chain. Information can be currency with your peers, and we use it to our advantage all the time, in driving returns for our investors, but also in building relationships with peers and industry contacts.

Conviction is the driver of high returns or financial ruin. Test your conviction via scientific method. i.e., actively try and poke holes in your own thesis. Ask others to evaluate your thinking. Do original research and talk to people who know and use the product or service your company offers. Conviction is maximized when the holes are not found. We have mistaken conviction for idea intoxication in the early stages of information discovery.

Peer networks help drive information, camaraderie, fellowship and hopefully returns. Do your own work, and validate ideas and information that is shared with you. Going it alone sounds noble, but you won’t have any fun in the process. There are great characters in this business, like any other, but especially in microcaps. Better decisions can be made by tapping into people with diverse backgrounds.

Tolerance for pain is required when things go against you. We don’t use stop-losses, which some people do. We accept a wide threshold for being wrong, because we have seen some of our best ideas go down 30% before they double or triple. We believe our home runs will pay for our strike-outs. Thus far that has proven successful. Your entry price is more random than you think, despite your confidence level. Having a position immediately move against you is disheartening and screws with your confidence. This is where conviction comes into play.

Management access is the linchpin of our information advantage, and is virtually impossible to obtain when you travel up the market cap ladder. We will not invest in companies that do not provide access to top-level executives. We try to meet management in person, incurring travel expenses to do so, by attending conferences or going directly to their offices. Travel expenses generally pay for themselves, sometimes in multiples. Nothing can replace looking a human being in the eye and evaluating body language, and meeting people directly goes a long way in building a fruitful relationship. The combination of how they tell you, and what they tell you is a powerful one. We try and speak with management quarterly.

Partnership is the only reason I jumped when I did. It gave me more confidence and I believe it is the key ingredient to our success. We bring different skills and backgrounds to the table. All decisions must be hashed out and debated, sometimes at a stalemate. Decisions that get made are high quality. Sometimes it slows things down, but we both know when to press the other person, and trust factors into this in a big way. There is no room for ego in a partnership model. If you are a lone wolf, it will be harder for sure – you can never leave the screen, your work-life balance and relationships might suffer. Your biases and viewpoints will not be questioned, and you will make faster decisions, to be sure.

Red flags include the need to raise capital and the need to raise capital. Just to hammer home the obvious on shareholder dilution. We recently saw a company get more than cut in half on an equity offering. It went from $5 to $2, in just two days because of the offering. Low insider ownership tells me that management isn’t going to wake up early and stay late, and someone will either eat their lunch or take their lunch money. I have my own money alongside my investors. It really, really hurts when I lose. I take it very personal. I would be embarrassed to offer my services to someone if I didn’t also have my own money at stake. A very high share count is almost a non-starter, which indicates to me that bullets have already been wasted and lots of investor churn will be required to move a stock higher. When someone pitches me an idea, looking at regular and fully diluted shares outstanding is often the very first thing I do. Lastly, we look for management teams that we trust, that we like as human beings and who do what they say they are going to do.

Green flags include high insider ownership, low institutional ownership as we want to lead the pack rather than follow it, clean capital structure (i.e., no warrants or convertible securities), cash on hand that can last in excess of your desired holding period, and/or being cash flow positive, a stable core business combined with a positive catalyst, a management team with a previous record of success.

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