Andrew Walker Positions For 2016: Small-Caps, Big Opps

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Includes: AKRX, NVLN, SPY
by: Andrew Walker, CFA

Summary

The small-cap universe is massive and creates meaningful opportunities.

Focusing on areas where there is panic helps investors focus on those opportunities.

Energy and healthcare represent two areas seeing a ton of panic currently. We explore why.

Today, we are sharing the outlook for small-cap stocks in 2016 from Andrew Walker of Rangeley Capital. Over the past week, SA Managing Editor George Moriarty and Andrew conducted an email interview, which we are pleased to share below. Small caps always help Seeking Alpha stand out from the crowd, and we are very happy to share Andrew's thoughts this year.

George Moriarty (GBM) -- First, let's lay out exactly what you define as the small-cap space. Where is your floor and what is your ceiling for these stocks?

Andrew Walker (AW) -- Thanks for interviewing me, George! I think there are two answers to this question: a rote answer and a bit more thoughtful one. The rote answer is I consider small cap stocks to start at a market cap over $250m or so and end around the $1B market cap. I’ll try to give the more interesting answer in the questions to follow.

GBM -- What attracts you as an investor to focus on small-cap stocks?

AW -- Ahhh, now we’re to the thoughtful stuff! I actually didn’t set out to have a focus on small cap stocks, but ended up focusing on them because that’s where I saw the most opportunity. There’s nothing wrong with investing in an Apple (NASDAQ:AAPL) or a Google (NASDAQ:GOOG) or a Berkshire Hathaway (NYSE:BRK.A) today; however, the fact is that, over the long term, investors in those megacap companies are limiting themselves to S&P 500-like returns plus or minus a few percent. It’s simply the law of large numbers: if those companies were to do significantly better than the S&P 500 for a few years running, they would basically become the S&P. But if you’re willing to put in the time looking through small cap stocks, maybe you can identify the next Netflix or Microsoft or (perhaps more likely) the next company to get acquired by one of those megacaps for a big premium. Do that once or twice a year and an investor can significantly outperform the market.

GBM -- What edge does a focus on small caps give you as an investor vs. someone that focuses on the large caps?

AW -- When I was in high school, the online poker craze was peaking. One thing I’ve always been focused on is tracking progress and results, so I would track how I did every time I played (i.e. today I played for an hour at the $1 table and made $4; I played two hours at the $2 tables and lost $8). I quickly realized that I was consistently making money at the lower dollar value tables and losing money at the higher money table. The reason was at the lower value tables the skill level was much lower, while at the higher level tables players spent much more time playing and had a higher skill level. I saw similar things in everything competitive: when you play sports with just your friends versus in big competitions and tournaments, running marathons in local races versus big time events like the Boston Marathon, etc. I reasoned it would be no different in small caps versus large caps: if you spend your time looking at very small companies, your competition will be much smaller and less professional. If you’re looking at a huge company like GE (NYSE:GE), you’re going to be up against 40 sellside analysts from JP Morgan (NYSE:JPM) and Goldman (NYSE:GS), and 100 buyside analysts who do almost nothing but follow GE every day. It’s very tough to have an edge in that situation when your competition is that smart. If you’re looking at a company with a market cap of $50m, you might be the only person looking at it, or perhaps the only person spending significant amounts of time looking at it.

Investing in smaller companies isn’t, in itself, an edge. Akin to the poker analogy, you still need to have more skill than the investors who are sitting down with you at the small cap table. But it certainly is an easier game to play (and one more likely to lead to mispriced opportunities) than investing in large caps.

GBM -- This is a massive universe, without much traditional research. How do you start your selection process for stocks to research and invest in?

AW -- The massive universe is exactly why the opportunity exists. I think the best way to approach it is to follow the Warren Buffett approach: start with the A’s. Find a big list of publicly traded companies and start researching them one by one: flip through their annual report, look around at their website, etc. If the company looks attractive, dig in further. If it doesn’t, just pass and move on. All of this rock digging will do two things: 1) you’ll start to learn about a bunch of different industries and 2) you increase the odds you’ll uncover a true hidden gem.

If it sounds like a lot of work, it’s because it is a lot of work. The market is generally efficient and it’s not easy to outperform. However, over time it does get a bit easier as you’ll start to build a knowledge base of companies, industries, and corporate events and will recognize when something has the potential to be mispriced or undervalued. For example, once you’ve got experience investing in NOL-shells, you come to recognize it as a potential source of value and will understand what to look for and how to think about valuing the next one you see (part of what attracted me to Unwired Planet).

GBM -- Looking ahead into 2016, what sectors and companies do you see as particularly attractive?

AW -- I like to hunt in two places: where no one else is looking (small caps) or where everyone else is panicking. The two areas where I think there is the most panic today are healthcare and energy companies, so those are the areas we’ve spent the most time looking. Unfortunately, the energy companies seem to be in a lot of trouble without a quick rebound in oil prices, which makes them difficult to invest in, but healthcare companies seem particularly attractive, which is probably why both my colleague Chris DeMuth and I made our top picks for 2016 healthcare companies (Chris’s was (NASDAQ:POZN)/(OTCQX:TBUFF); mine was (QLTI)). I also particularly like Akorn (NASDAQ:AKRX): its share price is still cheap due to lingering effects from their accounting restatements, but the underlying business is performing well and I think they’ll get taken out for a significant premium in the next year or two.

GBM -- Thanks for walking us up to the meat of the discussion here. So two more questions:

Tell me what's driving the panic you see in healthcare? Is it ACA? Shkreli?

AW -- Putting politics and policy aside, ACA has been generally good for investing in the healthcare sector. It substantially increased the number of people covered by insurance, which has been great for everything from hospitals (increased volumes and lower bad debts from uninsured) to pharma (more insurance and hospital trips = more drugs taken). The recent panic started with a tweet from Hillary Clinton about Shkreli’s drug pricing, but it runs much deeper. Pharma companies had discovered that there was basically no immediate recourse for significantly increasing a drug’s pricing, so more aggressive pharma companies began buying other companies and increasing their drug pricing substantially. While Shkreli was the poster child for it, Valeant, Horizon, and Mallinckrodt (among others) were all equally aggressive in taking price. The whole sector began to trade on lofty multiples because analysts began to price in continued massive price hikes or takeover premiums on the assumption that a Valeant or Mallinckrodt could offer a large premium to any company that was “under-pricing” their drugs and realize immediate value from raising pricing post-acquisition. The recent “panic” in healthcare has been as much related to the realization Valeant and Mallinckrodt can’t buy every drug company at a huge premium as it has been to the cessation of price taking and the associated rapid growth.

GBM -- And finally, accounting issues scare a lot of people. What has Akorn done to clean that up that makes you confident a buyer can trust their books and acquire them?

AW -- Accounting issues do scare a lot of people, myself included. However, that fear is opportunity - investors tend to sell without regard on the announcement of accounting issues, which gives the opportunity to acquire businesses at a discount if you’re willing to take a fundamental view of the business and understand what is going on. In Akorn’s case, the accounting issues were related to historical results due to rebate accounting for their acquisitions and management announced it would not affect their go-forward results. In addition, in the November update, the company provided a cash and debt balance that showed they were generating more cash than we expected. In the end, the accounting issues will get resolved, and once they do their assets are so valuable and rare (there are only a handful of standalone specialty generic players left) that someone will pay up for Akorn.

Disclosure: I am/we are long POZN, TBUFF, AKRX, QLTI, UPIP.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.