- Below you can read another interview that was conducted for my newsletter.
- This time with another fellow SA contributor, Safety in Value.
- We have a chat about balancing long-term investments with short-term trades, Canadian market and much more.
- This is only an excerpt and does not include SiV's top ideas.
After a bit of a break, I am happy to present an interview with Safety in Value, a frequent OTC investor and an SA contributor who is running his own marketplace and investments. I hope you will enjoy the discussion.
As a start, could you please share with us how did you end up analysing microcaps and OTC entities?
I started analysing microcap companies largely by coincidence. My investing journey started using stock screeners, and I would inevitably find that when I sorted for the cheapest companies, the ones I thought had the most investment potential were the smallest. Over time I focused more and more of my efforts on small companies, to the point that it is now the vast majority of my investing.
Could you please describe your investment strategy and what are the most important factors in it?
Ecclesiastes 4:12 says “…a threefold cord is not easily broken.”
My investing strategy is to segment my investments into three main types, which I believe will be not highly correlated to each other. That allows me to take more individual security risk than I would otherwise be comfortable with, and allows me to fish in the cheapest stocks. These are inevitably cheap for a reason, so some of them fail.
The three types of businesses I buy are as follows:
- The very cheap. These are businesses where things are so cheap that practically speaking good news (a catalyst) isn’t really required, all that needs to happen is for the worst case to not come true. Generally these investments are net-nets, but I will also look at undervalued asset plays as well in this bucket. I have a deep affinity for unknown real estate assets, and think that knowing what the market missed is definitely nice.
- Great businesses. These are entities where time is on your side. I like owning these for two reasons – it takes the pressure of to find new investments as I can hold them for a long time, and if I’m wrong about valuation the business value will probably catch up. This is different from net-nets, where if you hold them for a long time or are wrong you are probably losing money, at least on an opportunity cost basis. I also like quality businesses because I think they are less likely to be permanently impaired in an economic downturn.
- Special situations. I invest in these as a diversifier to quality businesses. They are short term trades, often tenders or merger arbitrage. That means that there is constantly cash coming into my portfolio as ideas mature. That is nice, because it allows me to take advantage of market dislocations or drawdowns. Also, these types of ideas are often easier to find than deep value ideas when the market is high, like it is right now. This type of idea diversification allows my investments to perform well throughout the cycle.
Could you hint towards your ‘portfolio allocation’ to each strategy? And what features do you want to see in a great business (and could you perhaps mention an example)?
I don’t have a specific allocation goal towards each strategy, instead, I pick what I feel are my best ideas at any given time and let the allocation vary. It often varies substantially, especially if there are a number of good arbitrage ideas, in which case that segment will increase significantly in a short period of time.
Quantitatively, a great business is usually one that will have a high return on equity, and I strongly prefer that that be generated by a high return on assets, not a bunch of financial leverage. Qualitatively speaking, a great business is one that has some sort of economic moat. I also prefer that there be a reasonable and not-capital-intensive scenario for significant growth in the underlying business when investing in this segment. Of course, it goes without saying that I prefer good valuations as well.
The qualitative segment is the trickier part, but is also the more important. Any business can generate a high ROE through financial engineering, and many have done it with fads or transient profits. But to be a sustainably great business, it is important that competition no be able to eat into the high profits of a great business, which is why a moat is critical.
I will give you two examples. Innovative Food Holdings (OTCQB:IVFH) is a company that sells specialty foods to chefs across the country. They have chefs on staff who sell the products and provide ideas, and they source from thousands of small and artisanal suppliers. This provides them with a two sided network moat, because it would be cost prohibitive for small producers to market to thousands of restaurants, and cost prohibitive for any individual restaurant to source from many producers. That allows them to earn sustainably high returns on capital, because their network makes them more useful to new entrants on both sides of their market. Also, there is a logical growth pattern, because food is getting more experiential and fancier all the time. This has doubled since I recommended it to subscribers in June, but is still relatively cheap.
Note: IVFH can be found in our database. I added it on the 4th of October. It appreciated 15% since then.
A second (admittedly non-microcap) quality business that I really like is Interactive Brokers (NYSE:IBKR). They have a moat based on a technology advantage of being the cheapest. That attracts active traders and funds, which are the most valuable clients a broker can have because they trade the most. I am a client myself, and am constantly wowed by their execution and pricing. I have discussed this idea with US-based investors who inevitably say they think Fidelity/Schwab/whoever are nearly as good, and that is where I think sometimes being located in Canada is a big advantage.
While US markets are competitive for brokers, international markets are much less so. While IB may be only slightly better/cheaper than US options, none of those US options are available in Canada or most other countries. That means that IBs international markets have a much bigger competitive edge than its domestic ones, so I suspect they will continue to see significant growth. This has also appreciated dramatically this year, but I continue to hold (and bought more when it dipped in the spring).
This is a long-term hold for me, so even though it is not cheap at present, I am holding. They have a huge cash buffer that they’re using to prove how safe they are to institutional clients, but I expect some of that money to get returned.
Would you say that due to increasing automation it is harder to spot profitable tenders or merger arbitrage?
I don’t think automation makes it harder, it just pushes the profitable tenders down market. I mostly operate in microcap arbitrage, because the big funds that are using automated signals can’t play in that sandbox anyway. And automation or not, emotions always play a part in the markets, even on big cap deals. Cabela declined to $53 in early August on worries the government was taking too long to approve the sale of its credit card division, which was holding up the sale of the company for $61.50 to Bass Pro. The government approved the deal in September, which allowed a great return for investors willing to be patient, as the approval was always likely after they changed the terms of the deal to cover of the original objections.
Catalyst or valuation? Which one do you think is more important when it comes to a stock?
I look at catalyst and valuation as a continuum. On the one hand, a net-net has a great valuation, but often no catalyst. A merger arbitrage deal is often undervalued (compared to the offer) by only a few percent, but the catalyst of the offer means the IRR can still be very good. Quality businesses are in the middle, with generally higher values and business improvement being a medium term catalyst. I’m willing to offset value for catalyst and vice versa, so I consider both factors.
What do you think are the three biggest challenges that you have encountered so far when dealing with the microcap / OTC market?
The biggest three challenges in the microcap market are governance, governance, and governance. Companies that are very small are generally not going to attract the attention of the SEC or other regulators, which means “are these people going to steal from me” should be part of your investment checklist in this space.
Of course, the flip side is that because of governance risks, many investors write off the area completely, which reduces valuations when businesses with good or great governance are found.
What are some of the common red flags connected to governance that you usually identify? And what was the most egregious case of bad governance that you have encountered?
Management compensation is one I usually look at, as well as related party transactions. While even good microcaps often have related party transactions from the biggest shareholders helping to keep things afloat, you can often get a sense of their objectives in the filing. A shareholder providing a company below market financing is very different from one using it as a personal piggy bank. I also look at how likely it is that an activist could change the governance of a company. I will probably eventually lead an activist campaign against a microcap (and have interacted with activists in the past) but if management has full control it is very difficult to dislodge them, and probably not worth the effort. I do like to see management own a stake, as that helps with alignment, but it is very much a goldilocks situation – I prefer management with a stake that is “not too big, not too small.”
I’m afraid I don’t have a specific worst governance example. Once I find governance not acceptable, an idea goes into the “no” pile, and I don’t spend any more time on it. Given how many companies I look at, that pile has thousands of names, many of which are there for governance reasons.
How do you think about liquidity when you are dealing with your investments?
I think about liquidity in relation to my expected holding time. I don’t worry about liquidity on the buy side (if my orders don’t fill that’s life) but rather consider whether I’ll need to sell and if that will be possible. A compounder type investment isn’t something where I am likely to require liquidity, because I assume I’ll be happy to hold it perpetually. Similarly, merger arbitrage deals have a built-in exit strategy, so I don’t worry about underlying liquidity too much. On the other hand, net-nets are something where I generally plan to sell in less than a couple of years, so liquidity is more important.
I also like to invert liquidity problems into liquidity benefits. I often trade around my positions, buying at the bid and selling at the ask. In some microcap stocks that can be a significant spread, and market makers don’t generally act in that segment of the market. By providing liquidity to those who need it, you can add to a profitable long-term position.
Do you use any other ‘trading strategies’ apart from the obvious use of limit orders when it comes to the OTC market?
I’m not much of a trader generally. I will act as a market maker on some small issues, and I occasionally trade around positions if they move for non-fundamental reasons, but trading isn’t something I consider a core competency.
I know that you cover a lot of Canadian companies as well, why do you think that the opportunities are present in this market?
I think there are many opportunities in the Canadian small cap market for the same reason there are opportunities in the US OTC market. The market is overlooked because it has a poor reputation. While there are many junior and speculative mining, oil and gas, and marijuana companies in the Canadian small-cap space, there are also lots of real businesses. These are generally overlooked by most investors, which is why there are such great opportunities.
Are there any unique features in the Canadian market that are different to OTC market? Also do you believe that the governance risk is the same?
Canadian companies all required to report their financials publicly on Sedar (the Canadian equivalent of Edgar) which helps a bit with governance I think, because it eliminates the “dark” companies. On the other hand, Canadian regulators are generally a lighter touch group, which has allowed the markets here to become specialists in such exciting sectors like junior mining and cannabis. I generally avoid these companies except in arbitrage type situations.
Generally speaking, I think small Canadian companies are roughly equivalent governance wise to small US companies. I don’t geographically target my investments, so my weighting varies depending on where I have found the best ideas recently.
Do you have any sources that you repeatedly use for idea generation?
I get my ideas primarily from two places. The first is lists and loose screens. I will pull up lists of companies and go through every one, often with a very loose screen (for example, recently profitable, reasonable debt to equity, small market cap). The second is suggestions from other investors. I find that ideas people mention in passing are often the best ones.
Could you please list the three most obscure businesses that you have ever encountered? (It does not have to be a public business that is now traded)
King George Financial (TSXV:KGF) – This company has a bunch of real estate investments. It has almost no liquidity, and a controlling shareholder. However, their returns have been excellent, and it has more than doubled since I profiled it for my subscribers.
Gardiner Dam Terminal (no symbol) owns a grain elevator in Saskatchewan, Canada. The company’s shares are tradeable through the company, but only if you live in Saskatchewan. The company’s terminal is consistently profitable, and they will probably get bought out by their joint venture partner at some point. I don’t live in Saskatchewan and don’t own any shares.
Lewes Football Club in the UK is owned by shareholders. They pay 30 GBP per year for the privilege. They play well below the top flight leagues in a small stadium. Each owner is limited to one share. In a spurt of democracy, they are willing to sell shares to Americans, you can find more information here: Lewes FC Owners USA
How do you justify spending time on research, i.e. how do you think about your opportunity cost?
I started investing as a hobby, and ended up doing well enough at it that I no longer need to work. Since investing is my passion and I’m relatively young, I justify spending time on it in a couple of ways. The first is that compounding my capital is important to my families ongoing financial future – because I don’t have a job, my only non-investing income is from Seeking Alpha and my subscription service, which don’t come anywhere close to covering my expenses. Doing a great job at investing is thus important to me, so worth spending time on.
The second reason relates to my relatively young age. I have a lot of time to compound my capital, but also to compound my knowledge. I strongly believe that time spent on research and learning now will pay off in current returns but also in future returns as I become an even better investor over time. Finally, I love investing research – the filings, the lists of companies, the thrill of the hunt. I would do this for fun even if it wasn’t financially important, and everyone needs a hobby. I admit that probably makes me a nerd, but I learned to make my own choices without regard to what others think a long time ago.
Do you have any favourite books connected to either OTC, investing or business in general?
There are of course all the classics (Ben Graham) that everyone recommends. I also like Ken Fischer’s The Only Three Questions That Count, and Joel Greenblatt’s You Can Be A Stock Market Genius.
Finally, in the spirit of our previous interviews and the current US president (i.e. tackling insanely complex questions via the ‘old’ Twitter), I have the following question. What do you think automation/robots will bring to investing? (140 characters limit).
An extension to passive investing is robo-investing, which will open up bigger holes for stock picking as more buy the index.
Let’s hope so! Thanks a lot for the discussion SiV. I thoroughly enjoyed the discussion and hope that the readers did as well.
Feel free to leave any comments underneath and don’t forget to follow Safety in Value on Seeking Alpha.
Safety in Value’s Disclosure (not current): I am long IBKR, TSXV:KGF and IVFH.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.
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Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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