Lessons Learned after Two Years of Managing a MicroCap Fund

Neil Cataldi Blog, Educational 8 Comments

I launched Blueprint Capital Management with my partner, Jason Revland, in October of 2012. He wrote a post one year ago highlighting a series of lessons we had learned during our first year post launching the strategy. Our strategy approach is to build a concentrated, long-only portfolio of high-conviction microcap companies that over a full market cycle deliver annualized returns exceeding 15%, with a low correlation (50% or better) vs. the broad equity market. Our philosophy embraces a disciplined, multi-step investment process including direct access to management blended with our own research. Finding “edge” in the investment management business is very difficult, but we believe our approach offers this to our investors by focusing exclusively on the highly inefficient microcap equity universe. Information, quite simply, is king, and our process is purpose-built to uncover and exploit it through direct management communication, company site visits, and thorough industry and competitor channel checks. There are many nuances that play a critical role in our process, whether they are fundamental to the company and their business model, or perhaps more specific to the short-term trading dynamic of each individual security. In last year’s post, we discussed partnership, peer networks, red and green flags one should look for. This year, I thought it would be valuable to highlight and discuss the benefits and pitfalls of some of these investing nuances.

Elevated social media activity

Microcap investors often witness the impact Seeking Alpha, Twitter, independent blogs and other investment websites can have on small and sometimes illiquid stocks. Their impact can be dramatic, and seem more pronounced than ever, as the dissemination of opinions and research has become far more decentralized, and is no longer the singular domain of investment banks and their sell-side research analysts. As an example, we followed a company, Digital Ally (DGLY), for over 12 months waiting for management to show signs of execution. This waiting period was challenging for us, with frequent execution delays combined with the stock being fairly illiquid and in general decline. Over our holding period, the company was pumped several times on social media resulting in brief periods of extreme volume. This can often be fortuitous and desirable liquidity that enables opportunity to add or exit positions, as well as cause outsized moves in the share price. You may have even made 200%+ in one day if you were lucky! That is not a typo. The result was a series of momentum traders getting involved, pushing a low float stock up, touting it to their peers on Twitter, message board forums, etc only to sell on a quick flip as everyone else was pouring in.

TAKEAWAY: If you’re lucky enough to be in a position that is obviously being pumped hard via social media, and there is no corresponding fundamental development to support the move, our experience suggests that you take the win, and move to the sidelines, with possible re-entry once volume and behavior normalizes. Especially with lower float names, it is akin to a game of musical chairs, where the eventual selloff leads to hard and fast selling. Our mandate is to be long term investors, but that horizon does not preclude us from being cognizant of the short-term changes in risk-reward dynamics. The “pump” does not warrant a fundamental change in the valuation, and is largely a technical event from our perspective. These new buyers have a much shorter term horizon than you do, along with a potentially higher cost basis. They seek out and crave momentum and volume, and are often quick to move on once the action subsides. You’ll likely get a chance to buy back your position cheaper than where you sold it, when the music stops and the short term money exits, sometimes in reckless fashion.

Lumpy business model

Microcaps are more often subjected to the pitfalls of a lumpy business model, more so than larger companies. By “lumpy”, I mean 1) large contracts or customer wins resulting in abnormal/inconsistent quarter to quarter results or 2) seasonality causing one or two quarters to be materially different than others. It can be a struggle forecasting this type of business model, and often frustrating for microcap investors. As a result, valuations may not reach the premium they may deserve, and short-term volatility can cause more pain than seems tolerable. Microcap equities are inefficient to begin with. Any dynamic that breeds skepticism or uncertainty can disproportionately impact valuation.

We’ve followed a company called Xplore Technologies (XPLR) for nearly two years, which has historically produced very lumpy quarterly results, but the overall annual trajectory has been on track. The company is currently undergoing an important expansion of their available product suite. As they expand their addressable market, industry and customer base, we expect results should soon transition to being more consistent, and less lumpy. Detecting this type of business model evolution can be interesting to watch and can produce very positive investment results. We believe this evolution is currently under way for Xplore, though investors have yet to fully embrace this new paradigm. The valuation framework should improve substantially when lumpiness transitions to higher normalized quarterly results with multiple revenue streams coming into the mix.

TAKEAWAY: Seek out companies with consistent business models. Those that are lumpy become even more of a “show me” story and execution fundamentally can be unpredictable at times. If a company is transitioning from a lumpy business to one that has more consistency, investment returns can be even more dramatic. Persistent lumpiness should be considered within your overall risk-reward calculation, as it will mostly likely drive higher volatility quarter to quarter.

Information Blackout

Consistency is key, and it encompasses earnings results (revenue, EPS, margins), methods of communication (conference calls, IR activities) as well as management track record of success. Companies that issue guidance, but then stop doing so typically pay a penalty. Issuing forward-looking guidance is not always appropriate, depending on the company or industry, but a change in the routine established is deemed inconsistent and is often perceived as a negative. Another example would be conference calls. Companies that are not transparent and openly communicating at least once per quarter with their investor base often have a harder time establishing a solid investor base than companies who consistently host calls every quarter.

We begin building a relationship with management long before we ever purchase any stock. This relationship and communication consistency is a very important component to our investment philosophy and process. When communication patterns change, we can often identify red flags more quickly.

Example. Charles & Colvard (CTHR). In late 2013, the company hired a new CFO and subsequently stopped talking to investors after the calendar year ended. Companies often are more careful communicating after a quarter has just ended and prior to reporting their results, but in this case, it was a significant change in style. Additionally, the company missed their historical earnings release date and ultimately reported a few days before the SEC mandated deadline. The stock suffered disproportionately during this time as investors had no choice other than to speculate on reasons behind the change in communication. The conflict for an investor in this situation is challenging. You may have strong conviction on a company, but are then forced to digest unforeseen variables. Human nature may drive an investor who is already biased in owning the shares to make excuses for management or the situation at hand. In reality, the uncertainty is what you need to be ahead of because uncertainty directly influences share price. Call this a lesson learned for the future, and Charles & Colvard has spent the better part of 2014 trying to build back shareholder support.

TAKEAWAY: If you lose your “edge” for any number of reasons, follow your discipline and reassess the position. When you identify elements that have changed, try to acknowledge the significance of such change and take immediate action. Trust your instinct. A high level of conviction should not turn to doubt easily and when it does, that means something.

Conference Calls

The quarterly earnings conference call is a critically important part of the investment process. It provides important information and color on the business, and is an opportunity for you, as a shareholder, to interact with management in a public forum. Listening very closely to what management has to say, information updates/changes, the number of participants and questions relative to previous calls, and the tone of the conversation and questions being asked are all key variables to consider. Passion, enthusiasm, frustration, caution, disappointment are all valuable and real emotions that can be detected from audio speech, none of which translate very accurately when reading text transcripts. We have experienced many situations where companies disclose material changes to their business pipeline, strategic relationships, and this lays the groundwork for additional follow up questions, whether live or during subsequent calls. Connecting the dots on those details and timeline of activities can result in immense value. Sometimes management announces new relationships or contracts during conference calls, without putting this information in a formal press release, as they may be constrained by legal or competitive reasons.

For example, Mandalay Digital (MNDL) held their quarterly call this past August. They had previously launched their mobile advertising enabling software on a single Android phone through a trial period with Verizon. When the call began, they kicked it off with revealing a multi-year agreement with Verizon that would include deployment of their software across the entire Android line up. This was an extraordinary and surprising development. The company later provided formal financial guidance reflecting the value of this relationship. The stock closed at $3.50 on the day of the call. Six trading days later it closed at $5.85, a gain of ~65%, a majority of which came in the days that followed and not immediately after the call

TAKEAWAY: While this example is uncommon, it proves that inefficiencies do exist and identifying them by listening to conference calls can deliver outstanding returns. Conference calls can be very valuable for many reasons, as opportunities big and small commonly present themselves. The subtleties of dialogue and information are where the most knowledgeable investors derive their edge. You can excel at this too by building relationships with management and thoroughly knowing the company story.

The Giant Contract

The coveted Big Brother relationship is one we seek out as such partnerships provide credibility and validity to a service or product offering. If a Fortune 500 company is willing to take business risk in relying on a small company for something strategically important, as well as the risk associated with the product, it goes a long way towards vetting a story. We’ve seen this play out many times in different iterations, and the most important takeaway is that it does not always mean a growth inflection point is about to unfold.

For example, Bridgeline Digital (BLIN) signed a strategic partnership with UPS, as well as the UPS Stores, a few years ago. Both UPS relationships were internally awarded independent of each other and validated two large and separate growth opportunities for the company. Unfortunately, they were not a precursor to what might have seemed like exponential growth. While the relationships are still in place and working to this day, they are not driving the interest which seemed plausible at the time of announcements. In this case, the UPS agreement validated their technology but there may not have been a true alignment of interest to drive material incremental business. The UPS Store opportunity validated the company’s attractive SaaS offering, but it did not move the needle for their prospects and equally as important, did not help shorten the already long sales cycle.

TAKEAWAY: The Fortune 500 relationship undoubtedly de-risks a service or product on some level. It can validate a company and provide a roadmap to an inflection in topline growth and earnings. However, the relationship does not mean immediate sales and in many cases, as it can take a long time for the impact to be felt, especially when dealing with very large corporations. We often see companies have very large increases in valuation around such announcements only to give back some, if not all, during the ramp period. Keep this in mind as expectations are critical to watch in situations where there is a significant time gap between relationship announcement and realized revenue/earnings.

Management: Track Record and Promotional Behavior

We are often asked how we source our ideas. The answer is simple, meet management teams. We try to perform at least three management calls per week, resulting in a steady flow of new stories, and companies we are monitoring. Getting to know management and hearing their story is essential as the team is critical to investment success, or “betting on the jockey”. A great product in the hands of bad management is a recipe for disappointment. Determining the strength of your management team is extremely important and often starts with understanding their pedigree and background experience. Micro caps run the gamut in this sense as you come across start up entrepreneurs with little experience to those that have already managed and sold billion dollar companies. While previous demonstrated success is very easy to spot because it is often touted and can be easily validated, the lack thereof is often skillfully hidden and quickly glossed over. Simple Google searches that include the name of a person in question and past companies often yield interesting results. There are a lot of characters in micro caps. It’s also important to screen management names with the SEC/FINRA databases to ensure they have a clean record.

Track record is fairly black and white. Promotion behavior is not. This aspect of communication is very important though. CEO’s that promote themselves with BIG forecasts are a problem. As investors, we prefer reasonable and measurable expectations that can be met or exceeded over time. If management can consistently deliver on this premise, the company is likely to grow at a healthy clip and investors will remain content and stick with them over time. When they set high bars, there is a greater chance of disappointment and thus an obstacle for momentum in share price/valuation. Regaining investor attention and confidence can take a long time, once management has destroyed its credibility.

For example, we spoke with a software company in June of this year, whose software could translate website text into speech. I immediately felt the company would either be something really big or a complete implosion. They seemed to be on the verge of several inflection points with a compelling product, but yet remained mostly unknown to the Street. The first red flag was on a slide in their investor presentation labeled “Projected Five Year Revenue Vertical Split & Growth.” This slide essentially guided five year revenue growth from $0 to $78,867,968. Yes, down to the specific dollar! I don’t know many companies that issue one year guidance, let alone five year guidance. There is no benefit to setting expectations at this level, that far out, and no one will take that estimate seriously. We interpreted this as promotional, foolish, and indicative of a lack of experience dealing with serious investors. The second red flag occurred when we researched the management team, via Google. In this case, they both came from a prior failed microcap and the Chairman had state-level charges filed against him alleging fraudulent practices where he engaged in unauthorized trading. That is a BIG red flag and when paired together, one might see why this investment quickly became a pass for us.

TAKEAWAY: Find good management teams that have reputable backgrounds with demonstrated success that can be easily verified. Also, look for teams that set reasonable expectations and do not hype their story, or make ridiculous claims or promises.

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Comments 8

  1. Thanks for the article, Neil. Regarding “Elevated social media activity”, one of the bigger mistakes I’ve made recently is not selling the momentum bump in Pro-Dex a month or two ago. The stock shot up over 80% shortly after the open, and I was totally unprepared for this situation. Several times the float traded that day, and the stock quite quickly re-settled right about where it was before the frenzy.

  2. Thanks for the comments! Glad you all enjoyed it. There are many more nuances to cover. Perhaps we’ll do a follow up at some point in the future!

  3. Thanks Neil. Interesting stuff.

    My takeaway: Much of investing boils down to some simple questions — how much of a premium are you, as an investor, willing to pay for an established competitive advantage? For consistently above average returns on capital, which are generally the result of either above average margins or above average capital turnover? Rarely both. Michael Porter wrote a classic on this subject — “Competitive Advantage.” And yes, while the micro cap market does offer some inefficiencies in this regard, they are more a matter of degree than of totality — microcap stocks are somewhat more inefficient than big cap stocks, but better companies generating consistently better long term results sell at a premium over erratic or poor performers, even in the microcap arena. How much of a premium can you pay for superior, consistent financial performance, and have superior consistent investment results?

    Said another way, how much of a discount is required to achieve above average returns, over the long term, by investing in poorly performing businesses that appear to have a competitive advantage but have not yet proven that?

    There are also tax implications to the latter that must be factored in, except in tax exempt accounts. If you invest in a second rate company, and the stock goes up 60% in a week (or a month), and has not yet proven it has a (protectable or unfair) competitive advantage, what do you do? You sell and incur tax, I think. If you don’t, on average, over time, in a wide variety of markets, a basket of those securities will show poor overall results.

  4. Thank you for your insight Neil. I am definitely in “learning mode” and unfortunately have been for the last 12 years. I appreciate your time and efforts in sharing.

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