AUGUST CLIENT LETTER: THE SMALL-CAP MARKET OF 2016; “I’D RATHER EAT ROCKS THAN BUY STOCKS”; THE NARROWS
What follows is a section from the “Thoughts & Analysis” portion of my monthly letter to investors at T11 Capital. The Small-Cap Market of 2016 Since 2014, small-cap investors have been treated to a sideways market, with a 27% peak to valley drawdown thrown in for good measure. The pricing environment for small company shares paired up with a near chronic pessimism that has incrementally advanced since the 2009 bottom has led to a trading environment that is tremendously illiquid and severely mispriced in certain areas. In small-cap investing, there will always be pockets of mispricing as the market simply is not efficient enough to correctly price thousands of companies with scant or nonexistent analyst coverage. This simple phenomenon leads to the opportunities that become available to investors over time to profit from these blatant inefficiencies in the marketplace. In 2016, however, the simple phenomenon of mispricing has taken on a new slant. Securities pricing is being graded by difficulty. The more difficult the situation, the more likely it is that the company will be mispriced. Companies that release relevant, easy to digest information regarding products or partnerships that are recognizable to investors are properly rewarded through premiums in share price. However, situations that are opaque, difficult or those possessing variability in outcomes are largely ignored. This leaves special situation/event driven investors reliant upon their analysis to be correct more than ever because the market simply won't assign a premium based on expectations of success, but on success coming to fruition in a tangible, recognizable way. In some ways, the public equity market for companies with market caps under $500 million has become similar to private equity or venture capital in 2016. Value is taking longer to realize in an environment that is not necessarily liquid but rewards tangible results over time. Gone are the days of blanket adjustments up in the price of shares based on a sector or general market movement. Companies are being left behind in favor of tangible performers with tangible products and partnerships. This leaves the special situation/event driven investor in a position that demands a mentality in step with the times. Managers have a relatively simple decision to make: 1. Conform to the current market cycle, seeking out opportunities that the market sees as relevant. Essentially becoming a growth investor rather than a value investor. 2. Adjust your mentality to fall more in line with that of a private equity or venture capital investor that is dealing in the public markets. Very simply put, assuming that you disagree with the first choice, deciding that maintaining an edge in the markets is...
MADE A U-TURN ON RELY: THE REASON WE ARE ALL OUT
In what is an unusually swift u-turn for the portfolios, I exited our position in RELY during the month of August, resulting in a roughly 1% hit to overall performance, after initiating the position in July. With every position that is established within the portfolios, there are certain fundamental elements that should remain intact or on track in order for us to remain in an investment. Every situation is different, making the list of fundamental faux pas vary among our investments. In the case of RELY, the CEO Craig Bouchard was a key element in the overall strategy, as it was abundantly clear that the first acquisition made was the first in a series of acquisitions, with subsequent acquisitions being what would drive profitability going forward. In order for their strategy to be successful, the presence of an excellent asset allocator was of obvious importance. Mr. Bouchard struck me as an excellent asset allocator, understanding the various nuances of rolling up several companies in an effort to create a highly profitable entity with significant tax attributes. So when it was revealed during August that Mr. Bouchard had resigned his position, it struck me as both extremely surprising and a sign of trouble in a highly leveraged company that simply cannot handle trouble in the slightest given their current debt load. Perhaps more than any other company in the portfolios, RELY was CEO dependent in order to see their mission through. The fact that they switched out quarterbacks in the 2nd quarter during a game that they seemed to be winning is an oddity at best and a sign of a failed initial acquisition at worst. Oddities in leveraged situations, especially in the volatile field of raw materials, are best left to the daredevils among us, of which I don't count myself as one. Further, admitting that the first acquisition was ill-advised, which is essentially what Bouchard resigning or more than likely, being fired, points to, means that the company has a very long road ahead in terms of righting that initial wrong. A process that I am not necessarily interested in being part of due to the leverage involved. Lastly, it should be noted, that among value/special situation/event driven managers, I consider myself to be especially cognizant of risk. One of the worst habits of your typical, garden variety value manager is the belief that a value stock becomes that much more valuable when it moves lower. The tendency among the traditional investment community is to see greater value in the name instead of question their own thesis. My initial reaction whenever a position goes against us, especially right...