My life in Value

Mikro Kap philosophy

Although early readers (thank you) likely already have a good feel for it, I still wanted to do something different for this article and answer the question;

What's your investing philosophy? 

The aim of answering this question is twofold. Firstly, I wanted to give some reasoning for why I don't cater to the current investing dogma in value investors' circles and what I value and am looking for instead. Secondly, I want to have this thing “set in stone” with the hope of coming back to this article 10 years from now and seeing how my framework wasn't optimal for me, and how much I have learned since.

As there are many roads to Rome, there are lots of ways to beat the market. That's the name of the game, that is the puzzle. Finding what you're good at, and what suits you, and keep learning from there.

With this out of the way, here are the main pillars of a strategy that I've built around myself:

First, let's start with an obvious one. As the name of my Substack itself suggests I like illiquidity, I like micro-caps.

1. Illiquidity

What always struck me about Buffett wasn't the moat concept or his „transition“ from buying cheap cigar-butts to buying wonderful businesses at a fair price.

These words stood out:

„I found some strange things when I was 20 years old. I went through Moody’s Bank and Finance Manual, about 1,000 pages. I went through it twice.“

“I went through the Moody’s Manuals page by page. Ten thousand pages in the Moody’s Industrial, Transportation, Banks and Finance Manuals—twice. I actually looked at every business—although I didn’t look very hard at some.”

„There are 1,700 or 1,800 of America’s companies that I’m generally familiar with”

Now ask yourself: Do you know somebody who's been put in this amount of „investing work“ over longer periods of time? Who the hell is willing to do that? No one.

Most analysts, investment funds, or retail investors are lazy. Only the ones curious and willing to constantly search for opportunities outperform.

And while I'm not claiming I am familiar with thousands of companies or anything along those lines, I am prepared to put in more effort than your typical investor. Going from A-Z, constantly turning over rocks, and reading regulatory filings of all kinds has become a habit of mine.

I do believe that he who turns over the most rocks wins. (believe it is a Peter Lynch quote)

This brings me to the point of illiquidity. If you really are willing to do all that work, common sense tells me that it would be wise to do it in the pockets of the market where there’s less competition. The real appeal of illiquidity is taking the road less traveled. Where others aren't and where you're on your own. Forcing you to do your own research and think independently.

Although most value investors like to think that markets are inefficient all the time and that they can just buy a P/E of 10 and call it a day, the truth is markets are getting more and more efficient by the year. The industry keeps growing and the players are becoming more sophisticated.

My view is that at this moment, the analytical edge in large caps has gotten almost completely competed away. The only option left is hoping for a broader market crash so all stocks can get cheap(er) or taking advantage of an emotional/behavioral edge that arises every few years ($META comes to mind or $BABA when JPM called it uninvestable).

However, my opinion is that this kind of strategy is unnecessarily hard and I dislike attempting to be the smartest guy in the room. Hundreds of billions of dollars are involved in this kind of strategy, with unlimited budgets for research. Competing against hundreds of analysts that have already looked at the stock you're analyzing before you, and are in regular contact with the management or industry experts. And them thinking you are wrong should at least cause you to pause and reassess your bullish/bearish stance on the stock.

I'm confident that my hundred-fiftieth analysis of Microsoft likely won't give me a superior insight or generate meaningful alpha. Finding companies that institutions can't or won't buy just might.

The lack of institutions in your pond can also give you a good foundation for your future investing journey. You'll stop biasing yourself with third-party analyses or 2-hour YouTube videos doing a Costco DCF and will finally be forced to put your knowledge to work and become a master of your craft.

Pattern recognition is a powerful force.

After all, this was one of the very reasons I started this newsletter. To see what was my thinking at the time, what I missed, and what I did well. Micro-caps are the fastest way to continue learning and evolving as an investor.

Here are some ways to go outside of Wall Street and find illiquidity that I frequently use:

• low free-float adjusted market-cap

I prefer market caps of below 100M. However, a 350M company like $RCS.MI, which is 75% owned by three shareholders will also do the trick.

• low share-turnover, the lower the better

Probably the best metric out there to indicate illiquidity. I especially like stocks that are in the single-digit range or those that aren't traded every day.

• low average-trading volume, the lower the better

Don't want to see this number in millions.

• low beta

It is not a must but it does show that the company's stock is not impacted by flows or with what the market is doing instead, it trades independently and is driven less by trading and more by fundamentals.

• not many mentions on Twitter

I prefer to be the first person who found the stock. If there's a seeking alpha article I won't buy it. If 3 big accounts wrote it up on Substack I probably won't buy it. The same goes for VIC and other similar investment communities. The less something is talked about the better.

However, I do sometimes get ideas from Twitter, but these are the ideas that are not discussed heavily there, and „the real research“ hasn't been done yet.

Yahoo Finance’s stock profile with no news underneath is a good sign, but Simply Wall Street saying it is cheap in its same-template articles makes me pause. Ticker not being mentioned on Twitter since 2020 is very good news.

• low institutional ownership, the lower the better

I don't like to see institutions owning the stock that I am interested in. It often indicates that it is either liquid enough for them to buy it or that some kind of discovery process has already taken place and there's not much alpha left in my analysis.

• no analyst' reports

• high insider ownership

Especially in the micro-cap land, most institutions want to feel like they have a say in the direction of that business so they likely won't buy the stock if there are controlling insiders involved who don't give them full attention.

• no earnings calls and investor presentations

The less easily accessible data the better. Most investors don't have the attention span to read a 150-page 10K and prefer visual investor presentations instead. Also, if it's on the Quartr app, it's not unfollowed (a great tool for those hunting in the more liquid space though).

• secondary stock exchanges

Pink sheets listed on the OTC, AIM, or a Polish nano-cap on the NewConnect are more attractive than index constitutes on NYSE/LSE or WSE as most institutions aren't allowed to own them.

• ugly investor relations site

• no ticker on Google/Yahoo finance

• filings not in English(for global stocks)

• wrong data on Koyfin/Tikr/Quicksfs

• screens can't catch it

I should emphasize that these (and everything else in this article) are just guidelines and not set-in-stone rules. It’s not black and white. $VNO, my best-performing stock this year didn't pass any of these tests. How about that?

(P.S. When I'm buying disgust I'm willing to consider liquid names)

Now that we've defined the typical hunting ground, let's see what I want to find there.

2. Downside first

Another investing maxim that I follow is buying things well beats buying good things. While most investors preach assessing the business quality first and doing the valuation work later, I don't.

If the stock is above 15x normalized FCF it won't pass my initial quick diligence. I'm not in the business of predicting future growth rates but in the business where value screams at me.

Although I don't think that there are no good investments at higher multiples I do believe that by going „cheap only“ puts you in a position where odds are tilted in your favor. I like to set high hurdles and I'm scared of the multiple compression. Moreover, it’s difficult to predict where the business is headed in this uncertain world (at least for me) and I wouldn't be comfortable concentrating into a position that purely depends on my future projections. IMO, it's way easier to handicap my returns if the earning power is already here and not in the distant future.

However, I do buy growth when it's free (like in the $BHU.SI case for example)

Most of the stocks I buy trade at between 5-10 times normalized earnings or/and have a significant margin of safety with their assets, cash on the balance sheet, or high durable dividend yield.

This way I'm getting what Buffett calls one-foot hurdles. With „hope“that they offer good returns in a base-case scenario or great returns when multiple expansion, growth plans, or some other catalysts come to fruition.

Another beautiful thing about buying downside protection is that even if my thesis isn't correct I often find myself not losing money on the stock as it is both cheap and neglected enough and there's nobody left to sell it.

Once I've determined that there's value, I need to see if it is really a value trap or if the discount really doesn't make any sense.

3. I'm a shareholder

…and want to be treated as one.

IMO the main difference between value and a value trap is a catalyst or capital allocation. Impactful catalysts can be harder to find before others which is why I mostly rely on capital allocation. Capital allocation ensures that the market will someday agree with my valuation work.

Cheap companies where the management doesn't return money to shareholders tend to remain cheap. No one cares that XYZ Japanese net net has 80% of its market cap in cash on its balance sheet. This cash is not and likely will never be in your pocket if the current management has a history of hoarding cash and being overly conservative with the balance sheet, always preparing for the rainy day. BUT. If the same XYZ company communicates to the market that it's going to pay half its cash in dividend, then all of a sudden, you have a setup where you're going to get a 40% dividend and this thing will likely re-rate accordingly.

Also, if the wonderful business you're looking at trades at 8x earnings but all it does is diworsify by making dumb acquisitions and reinvesting all its cash flow at very low ROIC year over year instead of buying back the stock or paying a dividend then you're probably end up with a value-trap.

All else (risk) being equal, all everybody wants from their investments is to get cash. You shouldn't care if it comes from you successfully trading Nvidia's momentum or from a Zimbabwean cement producer paying you dividends. In my strategy, capital allocation is one thing that ensures that the normalized earnings I estimated going forward will actually end up in my pocket or that they are going to be successfully reinvested in more cash.

It's tough for me to imagine a setup where a company is paying a double-digit dividend on a 50% payout ratio, with durable earning power that is not going to make you money. Yes, I'm simplifying.

Positive changes in capital allocation I like even more. Those often lead to a multiple re-rate. (check my Nisshin write-up!)

There are multiple ways you can check if the management is aligned with you as a shareholder but the two of them I frequently use are insider ownership and history check.

I prefer management with significant skin in the game who is going to lose money if I lose money and make money if I make money. Besides that, checking their history as allocators also helps out. I prefer management that can handle pain and make tough but opportunistic decisions with their capital (simple example: buybacks when the stock is dirt-cheap and the terminal value is growing).

However, a CEO doesn't have to be an Outsider for capital allocation to make sense. The ones that have a history of doing one thing will work just fine. For example. if the CEO clearly states and has paid 50% of the company's profits as a dividend for a decade+ and the stock is now trading for 5x earnings going forward, it's going to be tough for you not to make 10%+ a year on this setup. Simplifying again, but you get the message.

4. Confidence

The last pillar is a non-negotiable one. It involves a lot of qualitative work and is very much situation dependent so it might be tougher to explain than the previous three.

Confidence means sticking to what you know. Firmly defining what Buffett would call the „circle of competence.“

I want to be certain. I want to be certain that the business is simple enough for me to understand the few important KPIs that will impact the company's and my thesis' success. I want to be certain that my work of converting GAAP to normalized earnings is sound and that, I'm indeed paying 30 dollars for something that is worth 40-60 dollars. And I mean conservatively 40-60 dollars, with a high hurdle rate.

I need to have confidence in the downside protection. I need to be certain that the business is predictable enough and its earning power is durable and won't evaporate in a year from now. I need to understand what its durability is based on. I want to be certain that there will be no changes/innovation/competition in the industry that will impact the company's position in that industry and its ability to generate the cash flow that I estimated going forward.

In short, the most important part of my analysis is making sure that it is sound, that I can confidently say I have an edge over other market participants, and that the odds are in my favor.

My research stops when I conclude that a lot has to go wrong for this investment not to work out.

Conclusion:

To conclude, I like to fish in markets where people cannot fish, will not fish, or aren’t fishing, even though the fish are fat.

My framework is not a complicated one and doesn't involve inflexible rules. I don't use a 30-point checklist. However, I do value obscure and cheap above other things. Currently, these are the pillars that suit me and that I believe will help me succeed going forward.

But I'm sure these will change in the future. As they have in the past.

My only hope is that I remain curious and willing to do the work.

If you're interested in learning more about how I apply this philosophy, please visit my previous Substack articles and Twitter posts. Thank you for reading!