Value Fund Manager Brian Bares on 'The Small-Cap Advantage'

by: The Manual of Ideas

We are pleased to present an interview with Austin, Texas-based value investor Brian Bares. Bares Capital Management was founded in 2000, initially focusing on investments in micro-cap public companies. The firm launched a small-cap strategy in 2001. Bares has adhered to a disciplined business strategy, limiting the growth of assets under management over time. Bares is the author of the newly published book, "The Small-Cap Advantage: How Top Endowments and Foundations Turn Small Stocks into Big Returns."

The following are the top five holdings of Bares Capital Management, as disclosed in the fund's most recent 13F-HR filing with the SEC:

  • Hallmark Financial (NASDAQ:HALL) ($7.70 per share; MV $154 million), based in Fort Worth, TX, is a property/casualty insurer offering standard and specialty commercial insurance as well as personal insurance in subcategories that have a low-severity, short-tailed risk profile. Each of the company's five business units has its own management team. Roughly 90% of the total premiums produced were retained by Hallmark's insurance subsidiaries. Net premiums written increased 8% from $262 million in 2009 to $282 million in 2010, while revenue increased 7% during the period. Analysts expect Hallmark to lose $0.49 per share in 2011 and earn $0.45 in 2012 (17x P/E). The company trades at 1.0x tangible book value of $151 million.
  • Interactive Intelligence (NASDAQ:ININ) ($35 per share; MV $660 million; EV $580 million), based in Indianapolis, provides software applications that provide customers with a multi-channel communications platform. It is a leader in the contact center market, delivering products on-premise and through the “cloud” using hosted data centers. Target verticals include teleservices, financial services, education, utilities, and healthcare. Operating income surged 62% from $14.4 million in 2009 to $23.4 million in 2010, while revenue rose 27% in the same period. The sell side expects Interactive Intelligence to earn $1.27 per share in 2011 (28x P/E) and $1.39 in 2012 (26x). Interactive Intelligence has a high-return business, with a seven-year average return on equity of 30%.
  • INTL FCStone (NASDAQ:INTL) ($25 per share; MV $450 million), based in Altamonte Springs, FL, provides execution and advisory services in niche commodities, currencies and international securities markets. It acquired FCStone, the fourth-largest independent futures commission merchant in the U.S., for $138 million in stock in 2009. Total assets rose 30% from $1.6 billion at the end of the fiscal year ended September 30, 2009 to $2.0 billion at yearend FY10. The sell side expects INTL FCStone to earn $1.80 per share in FY11 (14x P/E) and $2.35 in 2012 (11x).
  • Travelzoo (NASDAQ:TZOO) ($76 per share; MV $1.3 billion; EV $1.2 billion), based in New York City, has grown to 23+ million email subscribers who receive the company's compilation of the best travel deals. Travelzoo helps travel companies, such as hotels and airlines, fill excess capacity. These companies pay Travelzoo for inclusion in the company's emails. Travelzoo decides which deals get included in its popular weekly Top 20 email. Travelzoo Top 20 subscribers in North America and Europe rose 12% from 16.2 million at the end of 2009 to 18.1 million at yearend 2010. The Street expects Travelzoo to earn $1.64 per share in 2011 (46x P/E), followed by $2.36 (32x) and $2.32 (33x) in each of the next two years, respectively. Travelzoo operates a high-return business, with a seven-year average return on equity of 22%.
  • Winmark (NASDAQ:WINA) ($43 per share; MV $214 million), based in Minneapolis, franchises four retail store concepts that buy, sell, trade and consign merchandise. The brands, which include Plato's Closet and Play It Again Sports, emphasize used merchandise at big discounts from the price of new goods. The company also operates a middle-market equipment leasing business, Winmark Capital, and owns a small-ticket financing business, Wirth Business Credit. Total franchised store locations increased 3% from 877 at the end of 2009 to 903 at yearend 2010. Winmark operates a high-return business, with an average return on equity of 25% over the past seven years.

Our first interview with Brian Bares was published in our August 2009 report and focused on Bares’s investment philosophy. The following interview focuses on some of the topics covered in Bares’s new book.

The Manual of Ideas: Much has happened in the markets since we last interviewed in August 2009. How have rapidly rebounding equity prices affected your ability to find bargains? What are you worried about most today?

Brian Bares: Our investment process is different from that of other managers. We do not screen for low prices in comparison to earnings, cash flow or book value as a starting point for our research. We seek out competitive businesses run by exceptional managers. In this respect, our search for value is qualitative instead of quantitative. Our contention is that the market chronically undervalues exceptional businesses and management teams. Today we are finding more of these than ever before. Prices have risen since we last touched base, but we are finding opportunities where the recognition of exceptional qualitative factors has yet to manifest itself in market prices. In many cases, underlying business value and earnings power has recovered more quickly than market pricing. Our worries today are no different than our worries were in 2009. We are concerned with the economic exposures of our businesses. Because we run concentrated strategies, we attempt to minimize correlation between the drivers of value within our portfolio.

MOI: We recently had the pleasure of reading your newly published book on the small cap value process. You generously provide a blueprint for institutional investment in this part of the equities universe. What differentiates your book, and what is the key message you are hoping to get across?

Bares: There are a few differentiators. First, the book focuses on the opportunities available to small stock investors who cap their asset base. Capping assets is critical for managers who wish to maintain flexibility in the space. Most professional small-cap investors who experience success attract significant asset inflows. This handicaps their potential for sustained outperformance. An increased asset base leaves a manager with two choices — increased diversification within the portfolio, or increased market cap of potential ideas. The first choice crimps potential returns, and the second choice increases competition for investment ideas.

The second differentiator is that the book offers a window into the challenges of growing an institutionally-focused small-cap firm. Institutions and their consultants should be able to come away with a greater understanding of how they can increase performance by investing with small entrepreneurial managers and what extra due diligence may be required before committing capital to these managers.

MOI: The historical outperformance of small caps and their relative illiquidity are well documented. What are some of the less well-known advantages and disadvantages of investing in small cap value?

Bares: One advantage that is misunderstood by the general public is that, despite the proliferation of hedge funds and other professional investors, the space is still inefficient. Successful professionals who operate in small caps tend to attract assets and graduate to mid and large caps, while their unsuccessful peers leave the business. Wall Street firms dependent on investment banking, trading, and other fees shy away from the space for profitability reasons, and their research departments tend to focus on the largest companies. The resulting vacuum in participation provides a real opportunity for individuals and small firms focused on doing their own homework.

Another advantage of investing in smaller companies is that they are easier to understand. They tend to have single product lines and relatively straight-forward financial structures. The disadvantages of the space include the presence of troubled or overly speculative companies. For the fundamental researcher, these companies may not offer any opportunity for a research advantage. They may also introduce the real risk of permanent loss of capital.

MOI: You have limited your assets under management in order to concentrate on your best ideas while avoiding market cap creep. How do you go about designing a marketing strategy if you are primarily concerned with the quality of investors rather than the quantity of assets?

Bares: When capacity is limited, the quality of a manager’s client base is of paramount importance. We were able to survive the 2008-‘09 downturn while retaining all of our institutional clients and capital. This is a testament to the high-quality roster of clients that we have attracted from the foundation and endowment space. Their perpetual time horizon and limited liquidity needs allow them to be patient with us. Their assessment of our performance is not measured in months or quarters, but instead over rolling multi-year periods. To attract this type of investor, we have found that traditional marketing is not really effective. Prospective clients must obviously be made aware of your presence and your investment approach, but word of mouth and reputational capital are usually the difference between passing interest and serious due diligence on the part of an institution. Many institutions and consultants share ideas about prospective managers, which heightens the importance of intangible qualities such as honesty and integrity. Building the management company slowly and methodically and placing a primacy on the interests of the client will create invaluable reputational capital. Delivering on promises like capping assets also builds trust.

MOI: At the recent VALUEx in Zurich/Klosters, Bryan Lawrence of Oakcliff Capital made the point that investor redemptions in late 2008 and early 2009 reflected at least in part value managers’ failure to properly communicate and condition their investors for tough times. What best practices can you share when it comes to communicating with your investors?

Bares: I advocate complete transparency, and I view investment management as a service, not a product. Clients deserve to know what we are doing and how we are thinking at all times. This helps engender trust. It also keeps us on our toes. Since we function as a research arm for our clients in small stocks and are paid to provide our very best ideas, we are absolved from many of the higher-level tactical decisions in our clients’ portfolios. The measurement of our success is against a relative small-company benchmark. We had poor absolute performance in 2008, but given our long-only orientation, our clients did not expect us to deliver positive results. I would agree that tempering client expectations should be part of every manager’s job, and we definitely do our share of that, especially after periods of strong performance.

MOI: What advice would you give to an aspiring active manager in small-cap stocks? What are some ways of identifying pockets of potential inefficiency?

Bares: I would advise aspiring managers to temper their own expectations for success. Even the best investment process can underperform for years. Value managers who lived through the late 1990s can attest to that. Building a successful firm takes a sustained commitment to an investment strategy. Attracting long-term clients is not easy either. Many of us were not lucky enough to begin with an existing roster of multimillion dollar clients. Landing our first institutional account took almost three years. Engaging in outreach to prospects and existing clients is a necessary part of the business. Balancing the time pressure of commitments on the investment research side of the business and on the marketing and operations side is very difficult in the early years.

Identifying pockets of inefficiency is a broader endeavor than most people think. It is not limited to finding undervalued assets on a balance sheet that others may have missed. True informational advantages are rare, even in small companies. Moreover, they are usually poor sources of long-term investor return. Flipping a $10 company with $1 worth of undiscovered real estate on the books is not a repeatable recipe for sustained outperformance in my opinion. I would argue that an investor’s time is better spent trying to identify analytical and behavioral inefficiencies. These efficiencies might include the market’s misunderstanding of the exceptional capital allocation ability of a management team, or the competitive strength of a company. Spinoffs being indiscriminately sold for structural reasons are another example.

MOI: If you were an institution evaluating a small-cap value manager, what would be the key questions you would want answered?

Bares: I would want to get comfortable with the investment philosophy and process, the people, and the operations of the business. I would want to understand how the investment process would produce repeatable results that should, over time, compound my capital in excess of benchmark returns on a net-of-fees basis. I would also want assurance that the stewards of my capital are honest, hard-working people with reasonable incentives. Finally, I would need to get comfortable with the operations of the manager. Simple questions such as “How do you get your investment edge?”; “What is the background and history of the investment team?”; and “How can I be assured that you can execute on what you say you will do?” would shed some light on these issues.

MOI: “Edge” is a rather elusive concept, and it often seems institutions are most impressed by investors who convey an ability to exploit a specific type of market inefficiency, even if the inefficiency could prove to be fleeting. Is there a way to differentiate between a temporary and permanent “edge”? Is judgment a legitimate source of competitive advantage, or does “edge” need to be based on some type of information advantage?

Bares: I am in agreement that “edge” is an elusive concept; however, there are concrete examples. A quantitative analyst who relies on specific factors may have performed extensive back testing to support the existence of anomalies. I would argue that an “edge” in this sense is temporary. Widespread adoption of factors or models nullifies their value. A more permanent advantage might lie with the analyst who understands a specific industry better than others, or with those who are better able to assess a company’s management and competitive position. I do not think that an “edge” needs to derive directly from an informational advantage.

MOI: In your book, you discuss various performance drags that are somewhat specific to small cap investing. Which of those drags do you consider to be most detrimental to an investor’s long-term performance?

Bares: The illiquidity of small-cap stocks causes wider spreads, higher market impact, and longer implementation of investment ideas. These enormous implicit costs could nullify all of the advantages of being in the space. Investors need to be careful when they buy and sell in small caps and should have a longer-term investment horizon.

MOI: There is a perception that small-cap value is a tough hunting ground because small companies can “stay cheap forever,” as they are removed from the limelight of the investment industry. Is this perception justified? Do you require a catalyst in order to consider an investment in a small company?

Bares: There is some truth to the notion that some small companies trade at low multiples for extended periods. We have been holders of a few of these in the past. Our process has evolved slightly over the years, and we now have a preference for smaller companies that can become materially larger. The market may ignore dominant businesses that stay small for extended periods. But companies that have ample opportunity to reinvest for extended periods, or that grow through acquisition, are not ignored for long. We do not require a catalyst to make our initial investments, but we certainly want to know as much as we can about why an opportunity exists for us before we make an investment.

MOI: It seems that management quality may be even more important in the case of a small company, yet most small-cap CEOs are relatively unknown among investors. How do you go about assessing management?

Bares: Assessing management is difficult, as many have risen to their perch in business by possessing soft skills that could cloak potential weaknesses. Likeability can become an insidious bias when assessing a management team. The approach we have taken is develop expertise through experience. We have met with hundreds of management teams. Only by doing the difficult work of visiting companies can an investor develop a baseline for what an exceptional manager looks like. We are looking for people who excel in strategy and operations, and give the right answers to our questions about capital allocation. When insiders own a material amount of company stock, our comfort level with their future capital allocation decisions increases. A management team’s historical actions can give us insight into how they may act in the future. We have developed a preference for people who have been successful in the past with other companies. When we find these people, we have been successful in investing in their encore performances.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.