Several decades ago, a group of professors developed the Efficient Markets Hypothesis ("EMH"). While its validity, or at least the degree of its validity, is a widely debated topic in today's financial circles, it continues to form the basis for many current general investment strategies. In short, EMH suggests that the financial markets are made up of thousands of investors, analysts, money managers and others, constantly pouring over information regarding the valuation of individual stocks. As this information is digested and assimilated by hoards of educated and intelligent people, their collective efforts result in ongoing valuations and resulting stock prices that are essentially efficient, making it very difficult for anyone to achieve extraordinary returns over any measurable period of time. From a practical standpoint, EMH makes empirical sense to us. The more people that follow a particular stock, and buy or sell the stock based on their conclusions, the better chance those collective conclusions reflect fair value, at least over reasonable periods of time.
From our viewpoint, if the basis of EMH is in fact accurate, then it stands to reason that any potential opportunities for extraordinary returns in the equity markets could only exist in situations where the premise(s) of the theory are not present. In other words, what if there are stocks that are not widely followed by the masses, and therefore may exhibit valuations that are not fairly or efficiently reflected in their prices? This assumption is the basis of our approach, as we attempt to discover companies that may in fact possess fundamental values that the market has not recognized.
While we believe that these opportunities do in fact exist among many under followed micro and small cap companies, we do not believe that extreme valuation discounts in individual stocks are likely to last for measurable periods of time. If a company is able to consistently perform in a positive manner over several concurrent quarters, its price will eventually reflect that performance, regardless of its lack of following, in part, because that performance is likely to ultimately attract the attention it originally lacked. As a result, we think our challenge is to try to find these undiscovered small companies at or near the front end of the inflection point where they begin to perform extraordinarily or their relative opportunity somehow becomes substantially bigger than it had previously been.
Oddly enough, there don't seem to be a lot of commonalities among the more successful companies we have written in the past. Some of them were high growth so-called "new economy" stocks, while others were "brick and mortar", earnings stories. Some were engaged in large well-established industries, while others operated in niche businesses for which there were no standard industry classifications and perhaps no relevant comparable companies. Some of these companies were relatively new issuers that had gone public within the past few years of our initial coverage, while others, had been public for several years, and in some cases in business for decades. Again, the only common thread among some of the best companies we have followed was the fact that that no one else seemed to like them when we first started writing them.
As we mentioned we often try to find issues that we think possess some sort of catalyst that will drive the company?s performance and in turn its stock value. These sorts of variables can come about as a result of a number of things. For example, sometimes, companies can simply reach a critical mass in their operating models where perhaps a proponderance of their costs are fixed in nature, and beyond some level of business, a greater percentage of each dollar of revenue becomes earnings. In other instances, companies can simply find themselves in the middle of environmental changes that bode particularly well for their businesses. A good example of this might be companies involved in developing security technologies prior to the bombing of the World Trade Center in September of 2001. A good portion of our research is dedicated to trying recognize the changes in the political, legislative and economic environment(s) that might create watershed opportunities for relevant companies affected by those changes, and then trying to identify those particular entities.
We have seen micro cap companies with great ideas fail because of bad managers, and we have seen small companies with mediocre or even precarious opportunities thrive because of quality managers. Needless to say, we typically spend considerable amounts of time talking to and visiting with the management of the companies we follow. We look for managers with considerable business aptitudes both inside and outside of the company?s relevant industry. We also look for managers that understand the limits of the contributions they can make to the company, and express a willingness to add others when the company outgrows their talents. An entrepreneurial manager may be a $10 million revenue company?s greatest asset, however, as the company?s growth accelerates beyond $10 million he/she may become its greatest weakness. In our view, management may be the single biggest factor regarding the success or failure of most companies, and it is especially true with respect to micro cap and small cap issuers.
Small companies always seem to need money. They are often undercapitalized, and their balance sheets are typically illiquid. We try to ascertain the liquidity risks associated with the individual balance sheets of each company we follow. In some instances, our assessments are driven by what we believe the issuers? abilities are to raise additional capital. This can sometimes be a bit subjective because it often comes down to both the company?s opportunities and the ability of those opportunities to support a financing, as well as management?s ties to the investment community and their ability to leverage those ties into financing transactions. We would like to think that over the years we have developed some insights into these issues.
