Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Talking to management is one of the most important things I do as a microcap investor.
Talking to management is one of the most important things I do as a microcap investor. Some investors disagree and say that public filings, press releases, and other surface due diligence give them all the information they need. Their argument against talking to management is that management won’t give you an honest assessment because they are more or less paid advocates for the company. They say, the facts are in the filings, so no reason to talk to management. Let these investors think this way, because they are wrong. You really think that talking to the person that leads the company won’t give you additional insight? In almost every circumstance you will gain an edge by talking to management. In fact, one of my rules before buying a position is to talk to management. This is a hard topic to discuss in writing, so I’ll do my best to hit on some of the broader points.
“To achieve superior results, you have to have an edge in either information or analysis, or both.” — Howard Marks
A big fallacy is when people believe talking to management is about acquiring insider information. This certainly isn’t true. Joseph P. Kennedy, the father of President John F. Kennedy, made a large fortune in the stock market a well as real estate. In 1934, President Roosevelt would appoint Joseph Kennedy to be the very first chairman of the Securities and Exchange Commission. Thomas Phelps, author of 100 to 1 In The Stock Market, asked Joseph Kennedy if he regarded insider information as a major problem or hazard for investors. His response, “If I had all the money that has been lost on inside information I’d really be rich.” I whole-heartedly agree with this. The management teams that tell you too much are almost always the ones that do too little. Such information rarely is true in the first place. It is a red flag when a management team crosses the line, and it’s never that type of information that I’m looking to collect. When I talk to management, I’m looking for their help to answer questions I have after conducting surface due diligence.
The smaller the company the more you are betting on management. I’ve always felt the best illustration of a small company is that of the human body.
The management team is the head/brain and the product-service is the body.
Think about how many extremely gifted people you’ve known that never lived up to their potential because of bad decision-making. All of their gifts and talent wasted. Similarly, it doesn’t matter how great a company’s product or service is if the management doesn’t make the right decisions. It doesn’t matter that a technology is 10x better than the competition. It doesn’t matter that a company has $10 billion of gold, silver, and copper buried in the ground. If the management team makes the wrong decisions marketing/selling the technology, or the mining company uses the wrong financing mechanism to fund its project, shareholders will lose money. If the head is deaf, dumb, and blind, the body is useless.
The key to microcap investing is finding great companies before the next investor. You can’t just wait around and watch the company perform (or not) for a few years before investing. You need to find them early. You can analyze with hindsight but you get paid for foresight. You need to talk to management and really drill down on their strategy so you know what assumptions to use to build out your model. Through discussion you also find out how the CEO thinks and problem solves. Maybe most important you can develop a report card, and see if the management are doers or talkers. When evaluating small emerging companies like microcaps, talking to management is crucial. It has saved me and made me more money than anything else.
Why Are Some MicroCap Management Teams Hard To Access?
You will find some resistance when trying to access management. Some microcap management teams are hard to reach, don’t respond to phone calls, and run their companies like private companies. So why is this? It is true that some management teams just don’t care about communicating with investors, but I’ve found the main culprit is the following: Management teams are solicited by all sorts of service providers (Investor Relations, Investment Banks, Consultants, Attorneys, etc) on a daily basis trying to sell them services. Don’t believe me? Just ask a CEO. In fact, I would say this is the biggest reason microcap management teams are hard to get a hold of. At a certain point they just shut down and tune out the capital markets because all they’ve known it to be is a bunch of snake oil salesmen. Investors often times are also thrown out via baby thrown out with the bathwater.
What this means is it sometimes takes persistence. In every case, always be nice. No one responds to anyone that is annoying and rude. I believe a lot of investors, even experienced ones, contact management with a “chip” on their shoulder, like they are above management. Their tone reflects it and they wonder why they have issues getting through to management. Always be nice. Always be respectful.
I’ll give you a real life example. A few years ago I finished my surface due diligence into Where Food Comes From (WFCF). I called and emailed the CEO, John Saunders. I got no reply. A couple weeks later, I did the same thing, this time in an even nicer tone. It took a month, but I finally spoke to him. I broke the ice with the call, but it wasn’t exactly easy from there on out to communicate with John. He still had his wall up. Here is a story I shared in our members forum about traveling to meet John at WFCF headquarters:
I first met John Saunders in early 2012 in Castle Rock, CO when the stock was $0.40. The company was 16 years old, and my bet was it would take 4 more years for it to be an overnight success. When I sat down with John he didn’t trust me at all, in fact he didn’t trust anyone from the capital markets side. When I sat down with him in his office he asked the first question, and it was, “Are you here because you want my job?” It was such a distrusting question to ask, but one I had to respect because he was the one that went through hell and back. He just like many other microcap CEO’s trusted the wrong people in the microcap space. A few years earlier he went public too soon, was undercapitalized, and was left to die. He was thrown into the deep end of a pool without knowing how to swim. It’s why so many microcaps that start out microcaps don’t succeed. They are set up to fail. It’s also why most microcap success stories are also turn around stories. It is very rare when a microcap company turns itself around and does so without diluting shareholders. This is a common theme in microcap successes. Because John had done this, I already knew he was a winner, so I responded, “No John, I wouldn’t be here if I thought I could do your job”. I then told him what I tell every CEO I meet with. That I wasn’t there to sell him anything, I would never have my hand out, and that I had just bought 1% of his company in the open market and was looking for a reason to buy more. My only motivation was my A account, so I was completely aligned with him. At that point, his wall was officially broken down, and we dove into the business.
How Do You Access Management?
We already wrote an article on this [HERE]
When I was just getting started as a microcap investor in my early 20’s, the thought of talking to management was very intimidating. I was a bit lucky though because I had a mentor who showed me how to communicate with management. This mentor was an established and wealthy investor, so of course management was going to respect an investor that had the potential to buy hundreds of thousands or millions of dollars worth of their stock. We would do a lot of management calls together. In the beginning he would take the lead, and every so often I would interject with my shaky nervous voice to ask a few questions. But after several calls, my mentor encouraged me to lead the calls, and I gained more and more confidence. Just like most things in life, practice makes perfect. Don’t let fear stop you from picking up the phone.
Combat Fear With Preparation
If a CEO is going to give you 30-60 minutes of his or her time, you need to respect that. I’ve found that management teams are very cordial, polite, and responsive to investors that do their homework. I do as much work as possible before getting on the phone with management. If the company has been around a long time, I like to read the last five years of annual reports to really get a sense of the history of the company. I read through the annual reports from top to bottom starting with the oldest report, and work my way to the present. I first focus on management’s discussion and analysis of the business to see how/if their strategy changed through the years. This also helps link strategy shifts with possible financial shifts. If three years ago, the company knowingly shifted the product mix, which led to lower gross margins, it’s good to know this before diving into the financials. As you do this, take notes and write down any questions that pop up. These types of questions are good ones for your call with management because it shows you did your homework.
I want to know as much as I can about management. Their successes will be in their public bio/resume. Their failures will be on the Internet. Google search the officers in the management team to find out all you can about them. A lot of things in the microcap space are counter-intuitive. Most investors view a “Great Background” as one where the microcap executive had successful mid-upper level roles at large notable companies. The problem with this is microcaps are not large companies. Most microcap companies operate on small budgets, thus needing more of an entrepreneurial mindset by management. I’ve seen many microcaps fail under the leadership of individuals with great backgrounds running large companies. In general, I would much rather see an executive who’s shown entrepreneurial success, starting and growing small companies. With that said, success doesn’t come from the same cookie cutter background. It comes in all shapes, sizes, and backgrounds. When I talk with management I like to explore why they made the decisions they did in the past. Success is determined by execution, and a lot of times the past can only tell us so much about the future.
Don’t Be Turned Off By Failure
I like to see success and failure in a CEO and management team’s background. I’m not turned off by failure, in fact most of my successful investments were betting on CEO’s who’ve first failed. In the case of failure, the question is, did they learn from it? If so, a failure can be the best thing, since they will not make those same mistakes again. Like I said earlier in this writeup, most microcap success stories were first turn around stories. It’s just the nature of the microcap space. A company is brought public too soon and undercapitalized, and after a year or so the stock craters. Now the management team needs to figure it out. MicroCapClub had an invite only (investor and company) conference earlier this year. We invited 13 of the best microcap companies we could find along with the top 70 microcap investors and put them in a room together to see what would happen. The interesting thing was almost all of the companies that presented were turnaround stories. Some were on bankruptcy’s doorstep just a few short years earlier. For example, BioSyent (RX.V) was at $0.06 in 2010, now it’s at $11 (180-bagger). XPEL Technologies (XPLT) was at $0.06 in 2012, now it’s at $3.00 (50-bagger). Where Food Comes From (WFCF) was at $0.10 in 2011, now it’s at $2.80 (28-bagger). Just think if you found them that early and had The Conviction To Hold these stocks. These management teams learned the hard lessons when they were turning around these companies. Now they are thriving. The key was they turned their companies around with minimal dilution to shareholders. If a management team did right by shareholders in the worst of times, it’s a good sign they will do right by shareholders in the best of times.
The First Call
On most initial calls with companies, management goes through their most recent investor presentation. Some of the very small microcaps don’t even have an investor presentation, so be prepared for either case. Have a good list of questions ready and try to put them in an order that makes sense for the conversation. Very rarely does a call go exactly as planned, but it’s good to at least approach the meeting with a plan. Lastly, have fun. I like to joke around a little bit on calls where appropriate to lighten the mood a bit. I’ve found management teams appreciate this as well.
Not everyone can beat the market since collectively they are the market. Think about that. To outperform you need to think differently. Microcap investing is one of the few arenas where the small retail investor actually has an edge. The edge is that “smarter”, larger investors can’t even invest in these companies. Due to illiquidity, they literally have to wait for the stocks to go higher and be more liquid before they can buy. The other part of the edge is access. I fell in love with the microcap space because even a small investor like me can gain access to management. Most investors don’t even try to access management. This is crazy to me. Howard Mark’s tells this short story of an efficient market believing finance professor who takes a walk with a student:
“Isn’t that a $10 bill lying on the ground?” asks the student
“No, it can’t be a $10 bill,” answers the professor. “If it were, someone would have picked it up by now.”
The professor walks away, and the student picks it up and has a beer.
The ability to access management is a gift. It’s a $10 bill laying on the ground. Pick it up.
You like this article? Read Part 2: The Art of Interviewing Management
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
Dilution is the subtle erosion of ownership. This hidden, persistent addition of new supply of shares leaves shareholders with less and less of the company’s value. Dilution, like inflation, is a silent killer of returns.