Nick's Micro-Cap Fund: An Introduction To A Model Portfolio

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Includes: AXR, CKX, CNRD, CTO, IWC, IWM, KEWL, MAYS, MVLY, OTEL, OTTW, PACI, PICO, PLBC, SPRS, SPY, TIXC, UCP, WBB
by: Nicholas Bodnar

Summary

I have constructed a portfolio of my top 15 ideas.

The portfolio is based upon value investing methodologies, with a high emphasis on margin of safety.

The portfolio will be an active fund, giving me the ability to buy and sell when opportunities arise.

My goal is to preserve wealth while generating decent returns.

It is one thing to be a good analyst and another to be a good portfolio manager. In my belief, you can be a great analyst, yet a horrible portfolio manager. Due to my economic constraints, it's almost impossible for me to manage an active portfolio. With my wife finishing up grad school and myself making a wage close to the minimum, actively investing my income is counterintuitive and prone to more risk - just in case I need my savings now.

For experience and also for research purposes, I have constructed a micro-cap portfolio - Nick's Micro-Cap Fund - based upon value investing methodologies. All companies owned in the portfolio have a type of margin of safety; with a good majority having 'calculated' up and downside based upon their asset value.

The goals of the portfolio are to outperform major indices such as the iShares Russell 2000 (NYSEARCA:IWM), iShares Micro-Cap (NYSEARCA:IWC) and the SPDR S&P 500 ETF (NYSEARCA:SPY). Based upon academic research, a portfolio of micro-cap value companies should outperform the market in the long-run.

A second goal is to measure the performance of this portfolio against my Rising Sun Portfolio - a net-net portfolio with Japanese, Singapore and Hong Kong companies. I would like to compare my ability to actively pick stocks and manage a portfolio of companies I know well, against a straight quantitatively based portfolio where almost no emotions will be involved.

Rules

All buys and sells will be enacted at the close of every day. Furthermore, the portfolio was started at 8/12/2016 with $100,000 - 80% invested. For simplistic reasons, there will be no transaction fees. Dividends will be included and there will be no limits on portfolio construction or reconstruction. I will track the performance daily and provide updates weekly. There will also be casual update on positions, new buys and sells. I also plan to spend time writing on the epistemology of why I did something, or why I didn't, within the portfolio.

Goals

The main goal of Nick's Micro-Cap Fund is to understand my actions within portfolio management and to better understand why I did or did not do something. Additionally, even though the portfolio is a 'model portfolio', managing it should provide valuable experience if and when I am ever managing a large sum of money - be it mine or other people's money. Furthermore, I will clearly be able to see the mistakes I made, hopefully learning from them as well. Finally, as time passes, I may construct other portfolios - comparing and contrasting the results of each portfolio against each other.

Portfolio Construction

The companies initially bought within the portfolio can be seen below, with the corresponding percentage position.

I have also provided a brief introduction of each company and my rationale for including them in the portfolio below.

Cash - 20% of the Portfolio

Cash represents 20% of the portfolio. The portfolio has a high cash position for two reasons. First, a 20% cash position is defensive and will help protect against downside. Secondly, the cash position will allow me to take advantage of opportunities as they come my way. I built this portfolio with principles based upon a margin of safety. I want to preserve capital - that is the main goal.

Ottawa Savings Bancorp (NASDAQ:OTTW) - 9.00% of the Portfolio

OTTW recently announced a second-step conversion. After the conversion (sometime in 3Q16) the company will have a significant amount of capital and will trade significantly under TBV. Management has also announced that they will used 50% of the proceeds from the second-step to buy back shares. Probability is on our side with this investment - mutual conversions have historically outperformed the broader market. I believe there is 100-120% upside in the next three years.

The biggest risk is what management decides to do with the capital post-conversion. If they spend the money on aggressive acquisitions, there could be downside. However, management has stated in their S-1 that they plan on buying back shares with 50% of the proceeds. This mitigates downside.

PICO Holdings (NASDAQ:PICO) - 7.5% of the Portfolio

An investment thesis in PICO is based off activists taking control, a significant discount to NAV, asset-based protection and monetization on the horizon with double digit upside. Based upon my estimated intrinsic value, PICO is worth between $16.00-21.00/share, a 60-110% upside from the current price.

As with MAYS, one of the key aspects for an investment in PICO is based upon their asset-backed downside protection. Moreover, the company owns 25,887 water rights, 408,000 water storage credits, 10,949 acres or land and 56.9% of UCP, Inc. (NYSE:UCP). Activists have realized the significant discount to the company's NAV, de-staggered the board and pushed on other 'touchy' issues. We should start to see monetization soon, with hopes of closing the NAV gap.

The risk is if activists are not successful in their endeavors and/or it takes too long to monetize the assets; eating into the upside. Despite activist involvement and a de-staggered board, the same management team is running the show. A lot has changed in the past year, yet, there is still a lot of work that needs to be accomplished. Secondly, the longer the monetization process takes, the lower the IRR.

JW Mays (NASDAQ:MAYS) - 7.00% of the Portfolio

I choose to put MAYS in the portfolio for several reasons, but also for one main reason. MAYS is trading significantly below my estimated 'NAV' and has vast downside protection just in case we are at the peak of the business cycle. If we are at a peak in the business cycle, MAYS shouldn't experience too much downside. Furthermore, I'd rather be wrong with a type of asset-based protection than wrong with no protection - think of it as a type of insurance. Conversely, I welcome more downside as a chance to continue building a position in the company.

MAYS isn't just a company with a significant amount of margin of safety, but also upside potential. Based upon my intrinsic calculations, the upside to NAV ranges upward of 80-150% the current market price. The company also has 75% of its legacy leasing revenues rolling off by 2021. The company charges rents way below comp averages and should experience a gradual uptick in rental revenues as these leases run-off. By 2021, the company has potential to increase their free cash flow at more than a 300% rate.

I don't think there is much downside with MAYS. However, an investment in MAYS could be an opportunity cost. Management may not raise rental prices and the company could be sitting ducks. On the flipside, the downside protection is very attractive and the company has real potential to double.

AMREP Corporation (NYSE:AXR) - 7.00% of the Portfolio

An investment thesis in AXR is based on undervaluation to the company's land holdings. The company has around 17,500 acres of land on the balance sheet valued around $3,600/acre. From 2005-2015, the company has sold its land on average for $59,514/acre. Despite the fact that the majority of the land on the balance sheet is considered 'undevelopable', undeveloped land has sold for around $26,000 per acre in the past ten years. Based upon the sum-of-the-parts model I built, I believe the company could be worth $9-15/share - a 62-169% upside from the current price.

The biggest risk is dead money, management's allocation capabilities and a slowdown in the Rio Rancho market. I am not too concerned about dead money and management has come a long way in the past few years. A slowdown in Rio Rancho could halt sales and is, in my opinion, one of the larger risks. However, the absolute discount from NAV provides an extremely high margin of safety and there should be minimal downside at this point. In fact, further downside would be welcomed by more buys.

Keweenaw Land Association (OTCPK:KEWL) - 7.00% of the Portfolio

KEWL is a major supplier of logs and pulpwood in the Michigan Great Lakes area. The company owns 168,000 acres of fee timberland and 402,000 acres of attached and severed mineral rights.

An investment thesis in KEWL is based mainly off the company's downside protection and long-term capital appreciation. Once again, I believe we are nearing a peak in the economic cycle - leading me to find more 'safe' investments with downside protection. Furthermore, KEWL should perform well in an inflationary environment, which is another benefit in an investment.

In terms of upside, I believe that KEWL has 45-100% upside due to their significantly understated NAV. Interestingly, the balance sheet values KEWL's acres at $102/acre, yet the appraised value is $901/acre - which increases every year. If liquidated, the company's intrinsic value is around $126-172/share, depending on how conservative or aggressive your discount rates are.

The risk with KEWL is 'dead money'. Management doesn't really care about the stock price and they come off as hostile. However, they are decent operators and shouldn't destroy shareholder value. James Mai (famous PE manager) just accumulated a 26% position and may be the catalyst the company needs. Either way, KEWL is my safe play with an upside option.

Otelco (NASDAQ:OTEL) - 6.50% of the Portfolio

OTEL is a very interesting micro-cap that looks very hairy at first glance. The company has a significant amount of debt and the company operates in a challenging industry. I would suggest to not judge a book by its cover and take some time to get to know OTEL; your local rural exchange carrier.

The company operates eleven RLECs with subscribers in Alabama, Maine, Massachusetts, Missouri, Vermont and West Virginia. The small area(s) where OTEL serves allows the company to be the only provider in each of their three core rural communities. This has allowed the company to operate business with low competition, allowing for predictable free cash flow.

A first glance at OTEL screams that the company is overburdened in debt, giving the company a significant risk premium. When digging deeper, the company has paid down over $60 million in debt since their restructuring three years ago and the company continues to pay as much as they can on the facility each quarter. OTEL also has an EV/EBTIDA multiple around 3.61x - lowest in the industry and their cash flow is quite stable. As the company continues to pay down more debt, the valuation will start to rise. If value doesn't rise, I believe OTEL makes for an attractive acquisition target. Finally, 232,780 Class B Shares have converted into Class A shares. I believe the banks that owned the Class B have sold off their shares, allowing the company to trade near its 52-week low.

The biggest risk is the debt facility. If for whatever reason the company cannot pay down their debt, they will default, opening up a whole new can of worms. However, the company is in a much better position than it was three years ago and should continue to improve their risk profile. On a relative basis, the company should be worth over $7.00/share in the mid-term.

Westbury Bancorp (NASDAQ:WBB) - 6.00% of the Portfolio

WBB is a post-converted mutual holding company that recently pasted its three-year post-conversion moratorium expiration. Since converting into a public company the company has bought back 21% of the shares outstanding and recently announced another 10% program. The company is also trading around its TBV and two activist funds have majority positions. Given that the three-year post-conversion moratorium expiration has passed, the company can now accept buyout offers. 59% of fully converted mutual holding companies are bought out after the conversion. If not bought out, management is competent and should allocate capital responsibly.

There isn't much downside here. Mutual conversions have outperformed the market and management is competent. However, a deterioration in the Wisconsin economy could hurt the bank. Furthermore, the company is jumping into riskier loans to grow the NIM.

Consolidated-Tomoka Land (NYSEMKT:CTO) - 5.50% of the Portfolio

The investment thesis in CTO is based upon a significant discount from NAV, management recognizing the discount and stating their intent to monetize and activist involvement. Based upon the research I conducted, I believe the company has an intrinsic value of $76-114/share or a 59-139% upside from the current price.

CTO owns a significant amount of real estate and has recently posted blow-out numbers. Furthermore, there are a wide range of assets in the 2016 sales pipeline which will help CTO continue to post record breaking numbers in the near-term. Finally, an activist investor has gotten involved with intents on either liquidating or selling the company. Either management sells land slowly - eventually converting into a REIT - or the activist investor is successful. If the activist is successful, there will be a lower absolute return. If management is successful, I believe the long-term gains will be more beneficial to shareholders.

The risks with CTO is management not executing. Management could end up sitting on their hands or play games with activists. Not buying shares today due to activist involvement is the antithesis of shareholder friendly. Despite the governance concern, there is a significant amount of downside protection and attractive upside if my thesis pans out.

Conrad Industries (OTCPK:CNRD) - 5.00% of the Portfolio

CNRD constructs, repairs and renovates a wide variety of marine vessels in the Gulf Coast Region. Revenues, earnings and the share price have gotten hammered in the past year due to a soft oil market. Likewise, the industry they operate is cyclical in nature. However, the company has a strong management team, is well capitalized and will do well when the markets turn around.

I molded out a price target for CNRD around $40/share based upon a multiple expansion to 6.0x from the current EV/EBTIDA multiple of ~3.60x. Furthermore, the target price is also based upon EBITDA returning to ~$32 million once the down cycle has ended (2-3 years from now). The company has a very strong cash pile it can utilize and it can still purchase a significant amount of shares.

The biggest risk is a prolonged downturn. The longer the downturn, the lower the anticipated EBITDA reversion and lower IRR. Conversely, the company has a fortress balance sheet and further repurchases at the current levels would be beneficial on an allocation standpoint.

Plumas Bank (NASDAQ:PLBC) - 5.00% of the Portfolio

Plumas Bank is a 12 branch bank that is rapidly growing, without much investor attention. In the most recent quarter the bank broke historical records, yet trades with a P/E multiple under 8.0x. The bank has also opened two new branches and announced the intention of opening a third one in the relative future. New locations will drive deposits and earnings in the near-term. PLBC will either get acquired or return to a fair multiple from further record breaking results. I have a price target of $15-17/share in the mid-term.

The main risk is deterioration in the California market. If the market deteriorates, there may be high loan defaults, affecting organic growth in a negative fashion. However, the bank has a strong loan book, very attractive profitability metrics and has real ability to have record breaking results for the FY-2016.

Mission Valley Bancorp (OTCQX:MVLY) - 4.50% of the Portfolio

Mission Valley is your typical community bank that has garnered zero investor attention in the past few years. Interestingly, as the company continues to post record breaking results, the market has no intention of valuing the bank higher. This is where the value investor steps in and takes advantage of this opportunity.

On July 26th, 2016, MVLY posted the strongest second quarter in the company's entire history. Net income increased 28.6%, total assets grew 10.7%, and net loans increased 22.7%. Furthermore, last fiscal year was the company's most profitable year ever. Despite the fact that MVLY posted a record breaking quarter on Tuesday, the share price did nothing. That's right nothing.

Management is also focused on shareholders, doing four stock splits, initiating its first dividend in 2015 and up-listing to the OTCQX exchange. Furthermore, the P/E ratio is ~8.00x and the P/TBV is trading near 1.00x. As the company continues to grow, the valuation will become cheaper. Either the market will value the company higher or another bank will come in and take over.

The main risk is the company's loan book. They have 87% of their loans in commercial non-farm, commercial and industrial loans. This risk is offset due to their experience lending higher risk-based loans (NPL in the Great Recession were 3.79%). On a conservative basis, the bank could be worth over $12.00/share in the mid-term.

Precision Auto Care (OTCQX:PACI) - 4.00% of the Portfolio

PACI is a relatively unheard of company that few talk about. As a whole, the company is a franchisor of automotive and maintenance service centers on a domestic and worldwide basis. They are known for their fast oil change and lube stations. Currently, the company has 38 owned stores and 218 franchise locations.

An investment thesis in PACI is based upon a shifting business model, absolute undervaluation, a strong management team and potential for growth. Additionally, the company has recently up-listed to the most visible OTC exchange and should have more investor visibility going forward.

Since 2007, management has bought back ~33.33% of the shares outstanding, cut costs, and grown the business. The company is also significantly undervalued on an absolute and relative basis and the high amount of NOLs will allow the company to offset taxable gains for a few years. Furthermore, the company is shifting business models which will result in consistent high single digit topline growth and steady FCF. At the current price the company is pretty undervalued and if growth doesn't transpire the downside is protected from a clean balance sheet.

The risk to the thesis is a significantly competitive industry. There are a lot of oil and quick lube service stations. Additional competition could hinder the topline and compress margins. Also, the company has a lack of liquidity, which is a risk for most investors. Overall, with FCF margins of ~20%, I believe the company is intrinsically worth $1.05-1.22/share in the mid-term.

CKX Lands (NYSEMKT:CKX) - 4.00% of the Portfolio

CKX Lands owns land, timber and mineral interests. They collect income through the ownership of the oil and gas royalties, timber sales and surface leases for farming, right of way and other uses. The company does not explore or operate on its land. The company and the hard assets are located in the state of Louisiana.

CKX is sitting near a 52-week low due to a weak oil and gas environment. Revenues and earnings will be down for the year, yet the company will survive given the cash to debt balance and the overall operating structure of the company (gross margins of >92%). The land is significantly undervalued and if liquidated, the company would be sold for much more than what it's worth.

The risk is dead money. Management isn't very open in speaking with shareholders and they don't seem to be looking to create value. On the other-hand, if and when the O&G environment turns around, the company could easily revert to its mean. Likewise, I don't think the share price is going to fall too much and a drop would actually be welcomed with more buys. I think the stock is safe and a good cash substitute.

Tix Corporation (OTCQX:TIXC) - 1.00% of the Portfolio

TIXC is a ticket broker based in Las Vegas. The company sells discounted tickets, offering customers the best and only discounted tickets for every show in Vegas. Furthermore, the company has bought out all of their competition on the strip and are the only show in town.

The company is extremely cheap, throws off a significant amount of cash flow and pays an attractive 9.95% dividend. The company has an EV/EBITDA of 5.41x, EV/Revenue of 1.35 and a trailing P/E ratio of 2.40x. Finally, the company has a 16.74% FCF Yield - and real potential of continual cash generation given the lack of direct competition.

Management has had a shady past…to say the least - run in with activists, very high salaries and up until the dividend, shareholder unfriendly. Thus, there will be a discount to the company until management proves themselves. The TAM is also maxed out and there is significant customer concentration. Moreover, we will not see growth, unless the company steps in a new market. Finally, Caesars Entertainment (NASDAQ:CZR) and MGM Resorts (NYSE:MGM) are their biggest markets - 70% of revenue generated from the former. This is extremely risky.

The thesis is based upon continual high cash flows, and value becoming its own catalyst. The company is cheap and there is an attractive dividend. Because of the high customer concentration, this can only be a minuscule position in the portfolio.

Surge Components (OTCPK:SPRS) - 1.00% of the Portfolio

SPRS is an ugly and very hairy security. There are a significant number of past management black marks on the stock such as a 'kickback' scandal, excessive executive compensation and just a poorly operated business. However, the company is cheap.

The company has a market cap of $6.7 million and a cash position of $7.23 million. Furthermore, the P/TBV, P/NCAV, P/S and Debt/Assets are 0.56x, 0.60x, 0.23x and 26%, respectively. Additionally, in the past eight years the company has thrown off $7.2 million in free cash flow and has zero long-term debt on the balance sheet. Effectively, with SPRS, you are buying an extremely cheap net-net, with hopes of mean reversion.

The biggest risk is management. There could be another scandal down the road, making investors lose even more hope in the business. Likewise, if management doesn't allocate capital productively, this could be dead money. Conversely, the cash position will probably continue to grow and the market may give the company a better valuation. Value is its own catalyst with SPRS.

Portfolio Commentary

The average market cap of the portfolio is $79 million. Eleven out of the fifteen companies have more cash than debt and seven companies have zero debt outstanding. 37.50% of the portfolio has land based asset protection, with 11.00% in timberland. Likewise, 27.00% of the portfolio has real estate; 7.00% is in property management and 20.00% in real estate development. In addition, 7.50% is in water development, 6.50% in telecommunications and 5.00% in industrial equipment. Finally, there is 9.50% in Regional Pacific Banks, 4.00% in auto repair, 14.50% mutual conversions, 1.00% in general entertainment and 1.00% in diversified computer systems.

The portfolio is concentrated, with five positions equating to 37.50% of the aggregated assets. Despite the concentration, the portfolio is also well diversified and has 20% in cash. On the flipside, there is a significant amount of the portfolio tied into asset plays - especially land, and the 9.50% of the financials are made up of two regional banks in California. Economic turmoil in California could damper returns. Although, both banks have strong loan portfolios.

Six companies have hard assets such as land and property, with two of the five acting as a safe cash substitute. One company is indirectly tied to the price of oil and one appears to be in a distressed debt situation. Three companies have activists involved and five have experienced an activist push in the past. Finally, one company is a net-net, two are post-mutual conversions and one pays a dividend close to 10%.

Concluding Thoughts

It is my belief that the portfolio I constructed should hold up well and shouldn't experience much economic loss if a black swan lands in my territory. Furthermore, my hypothesis is that the portfolio will outperform major indices due to the micro-cap value construction. If the portfolio does not hold up to my expectations, this active portfolio will be a great learning experience and allow me to know my faults in portfolio management. Overall, I am excited to begin this research avenue and very curious to know the thoughts and considerations from my readers.

Disclosure: I am/we are long OTTW, PLBC, PICO.

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.

Editor's Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.