A niche hedge fund strategy is investing in microcap stocks. It is a niche strategy because it is not scalable in the way that other hedge fund strategies are. There can be limited liquidity in funds and in the securities they invest in. There is also a pronounced cycle of relative performance of micro-capitalisation stocks versus the rest of the market. THFJ turned to an acknowledged leader in the field, Ian Ellis of MicroCapital LLC of Southport Connecticut to find out where we are in that cycle.

Ian, what has been happening in your area of investment recently?

Well we have been through the typical shape of relative performance for the strategy in the last few years. What is different this time is the incidence of extremely low valuation we saw at the market lows. At the beginning of 2007 the market was demanding 8x EBITDA for a growth portfolio of microcap stocks. That valuation was okay for the time, but we haven’t seen it since!

At 6 and then 5x EBITDA I thought we had attractive valuations for the good growth companies we prefer in our universe. But they got lower yet. We saw 4x EBITDA multiples in the later part of 2008, and earlier this year you could buy good businesses with reasonable margins and no financing problems at a price representing less than two year’s cash flow. Think about it – you hold a stock for two years and in the time the company’s cash flow has been equivalent to the price you paid. It was a bargain that couldn’t last and it didn’t. Microcap stocks have rebounded better than the market this year, and we have been able to ride that outperformance.

And what are the attractions just now of investing in the microcap area?

It’s the combination of two things – the sentiment towards microcap and the way companies have adapted to the new economic environment.

I spend a lot of time visiting companies, and I’m very bullish from seeing them. Company managements have got a real focus on costs, and businesses have gone back to their core competency. I’ve seen founders come back into businesses they had passed onto professional managers. This has improved companies financially as well as strategically. There has been a massive agency/principal problem in the corporate world of the US, and getting the owners back in is a good response to that. Stock options are low on the list of priorities and that is appropriate in my way of thinking.

America has sobered up over the last year, and feels like a good place to be.

So what is the sentiment towards microcap?

Despite the clear turnaround of a multi-year cycle which is positive for microcap there is no euphoria. I guess institutional investors have been concentrating on other things because there is still low interest from that quarter. The institutional investor part of the buy-side is as dysfunctional as the banking community from my recent experience. I couldn’t get a single institutional investor meeting in Chicago when I was there. There is no interest. Thankfully entrepreneurial America can still recognise value when they see it, and I have six new individual investors who are all credible seasoned business people.

You have taken an interest in smaller companies for many years, and been running MicroCapital since 2000. What has changed to keep you interested?

There have been a couple of developments which I’d say are likely to change microcap investing for the better. The first is that the SEC removed the requirement for $75m of independently held capital last year. It used to be a limitation on owner/managers to give up that much of the value of their company on quotation, but that has gone now. Listing is an effective way for companies to raise money quickly.

So the primary market has opened up, and issues can be directly registered rather than be underwritten. The securities companies can issue are not restricted in the way they were before. Now buyers can trade the stock on day of purchase – this is really important for the buy-side. Those deals are going very well, and deal flow is good for fund managers in smaller cap.

The second interesting development is the phenomenon of Chinese companies.
Is this off-shoring by small US companies?

No it’s something else. A lot of Chinese companies reversed into small US shell companies before the bear market set in. So there are a slew of Chinese companies in all kinds of different businesses, some service industry, some manufacturing, with US stockmarket listings. They present an opportunity like we saw a generation ago in the United States.

In the US many successful quoted companies grew through taking a business concept from a local or regional level to a national business. Whether it was Safety Kleen or Krispy Kreme or Macdonalds, or even the professionalisation of the waste management business. It was about buying out a small local competitor, replicating a business model in a new territory, sometimes franchising, sometimes adding a new regional subsidiary, and using stock as a takeover currency – all the classic ingredients for expanding. The same thing is the opportunity for Chinese companies. They may be regional leaders for their industry, but they have the chance to take the business model nationally within China. I see it as exporting the commercialisation of mom and pop businesses. This investment theme made the careers of several stock-pickers in the United States, and it remains very powerful now it can be applied in China.

Have there been any other changes within microcap investing?

I see a return to investing in growth. For some years listed company investing seemed to be too much about leveraging steady businesses to drive returns to investors. The lack of availability of finance has changed the climate. Investors will have to find companies with organic growth, where returns can come from real engineering rather than financial engineering. This is a very healthy re-orientation, and one with which the more recently trained investment analysts are unfamiliar. Forecasting top-line growth is something that I have asked younger potential employees about, and they have had no experience doing it – they have never needed to.

So your experience through several cycles and insight into growth investing may have its moment in the sun?

I’m hoping so, yes.

Thank you, Ian.