The Small-Cap Condundrum

About: Bluegreen Vacations Corporation (BXG), LBTYK, LPG, SPOT, Includes: BBBY, BRFRF, BRFRY, BRK.A, BRK.B, CHWY, DISCK, FSTR, RIO, UPWK, VOD, W
by: SA Marketplace

Small-caps appear highly valued on an index level, but also lag their larger peers even with 2019's strong start.

We ask a panel of Marketplace authors what they're seeing among the less-followed names in the market.

While there are some questions about whether the sector as a whole offers value, our authors share a few ideas they like specifically.

And even as the discussion starts on small-caps, we drift into larger companies. A sign of the times?

By Daniel Shvartsman

The first half of 2019 saw a lot of green in the markets, as broader indices recovered from the brief bear market in the second half of 2018 and returned to new heights. Despite that, the wall of worry continued to grow, even if the specific concerns changed. Instead of a rising rate environment, expectations have shifted to a possible rate cut even with good job numbers. Geopolitical flashpoints have (re-)emerged in Venezuela, Iran, and in the ongoing China-US trade conflict. European economic growth appears to be slowing, and nobody's quite sure where we are in the US cycle. Oh, and another presidential election cycle is beginning.

So, what to make of this all? We decided to take the temperature of the markets with a midyear Marketplace Roundtable. We asked our Seeking Alpha Marketplace contributors - authors who run investing services and provide ideas and guidance to members about how to think about the markets or at least certain parts of it - to share their views on the current climate and how they're positioning as a result.

Over 55 authors participated in our survey. We've grouped their responses into several categories, ranging from tech to commodities, biotech to dividends and income investing. We're going to share their responses in those grouped categories over the coming week or so. Each discussion will have two common questions about the market as a whole, two sector-specific questions, and a round of current favorite ideas. We hope you enjoy the discussion, and welcome you to join with comments on these issues or on any key points that didn't come up, or follow-up questions.

Today's discussion focuses on small-caps. As an asset class, these stocks have lagged their larger peers, even though the Russell 2000 as an index sports a high valuation. And even as we ask about small-caps, we find a few of our panelists looking at bigger companies. We have the following panel to weigh in on the situation:

Please check the end of article for disclosures - authors disclosed positions based on stocks they respectively discussed.

Coming into 2019, markets had a degree of doubt about the trade war, the direction of the Fed, and our place in the economic cycle. That doubt seemed priced in. We're around all-time highs now, 25% up from lows - is the market doubt resolved?

J Mintzmyer: It seems clear that the market heavily overshot on its fears, but it's also interesting to note that certain sectors - energy and shipping come to mind - are still valued at near all-time record low valuations. These lower valuations extend to other areas of the stock market, including industrials and retail. The market "doubt" is certainly not resolved yet in shipping, but rates in all segments we cover are higher over the past 12 months than in the year previous. I see significant value opportunities in this market despite the broad indices at or near record levels.

Safety In Value: The market always has something to worry about, which is where the old expression "climbing a wall of worry" comes from. While I don't predict the general market direction, I do note that expanding the investment universe to include small companies statistically has improved returns. It also gives the stock picker an edge, because there are more options to pick from. There are definitely pockets of value in small stocks even at current market levels.

Joshua Hall: The only thing the market is confident about is the direction of the Fed. However, I think it is ahead of itself. A resolution to the trade war could throw a wrench in the outlook for rate cuts and do damage to the long bond, long conservative high-income stocks trade that is popular right now. Many market participants have been wrong about the end of the economic cycle for years now. I think many are missing the fact that China is now such a large piece of the global economy that there really are two cycles at play for investors: a purely domestic U.S.-focused credit cycle and a global industrial economy. There is some overlap, but the "end of the cycle" mindset of the past no longer works the way it used to.

Long Hill Road Capital: The market is always going to be concerned about one thing or another, to one extent or another. I don't find it useful to get caught up in these topics. My focus is to own a concentrated portfolio of high-quality businesses that are trading at prices that reflect very modest long-term expectations. These businesses are so well-positioned with such strong advantages that it feels almost inevitable that they will be far bigger and more profitable 10 years from now. The younger Long Hill Road used to assume these sorts of businesses couldn't possibly be cheap, but I now appreciate that some can be perennially undervalued. Amazon's (AMZN) never "looked cheap" before, yet it has been a 1,032-bagger since its IPO. That is perennial undervaluation.

What in your sector has changed in the first half of 2019, or what has your attention as you're researching positions?

J Mintzmyer: Although we've done quite well YTD (as I write this, our Speculative portfolio is up 32% YTD and our Risk/Reward portfolio is up 20% YTD), the majority of the shipping sector still sits near all-time low valuations. We're finding a few companies with surging cash flows who are still caught up in the "trade war" misnomers, leading us to significant dislocation trades.

Michael Wiggins De Oliveira: Old companies versus new companies (is a key theme). For example, practically any brick-and-mortar retailer trades extremely cheaply. One specific example being Bed Bath & Beyond (BBBY). BBBY trades for less than 5x FY 2020 EPS. BBBY has a rock-solid balance sheet, with plenty of cash, it is highly free cash flow-generative, with shareholder activists agitating the Board for change, and a strong share repurchase program to boot. Compare this sort of investment with the likes of Wayfair (W), which is burning cash and trades at a soaring valuation. There is simply no comparison in valuation.

Joshua Hall: Outside of iron ore and rare earths, it has really just been more of the same in industrial & technology metals. An interesting commonality that I am now seeing in the charts of many miners is a longer-term funnel pattern pointing to an inflection point perhaps later this year. By this I mean that the share prices of many miners are bottoming against lower trend line resistance going back to January 2016 and poised to break out of the downtrend that they have been in since early 2018. I see similar patterns in U.S. banks.

Long Hill Road Capital: I try to always to be learning about businesses that are a very small fraction of their future size, looking out 10 years or longer. That includes studying the filings and conference call transcripts, but also talking with their customers, suppliers, competitors, former executives, or other industry participants. My objective is to understand as many of these businesses as possible so I can be prepared to invest if one of them is suddenly trading at fantastically low price. Given the nature of stock markets, it is usually only a matter of time before that happens. A few companies I've looked at lately are Burford Capital (OTC:BRFRF, OTC:BRFRY), Upwork (UPWK), and Chewy (CHWY).

How are you positioning for the back half of the year and into 2020, and why?

J Mintzmyer: I'm particularly excited (and generally bullish) about the pending IMO 2020 low-sulfur fuel regulations for shipping companies. I expect we'll see significant profit improvements for the firms with modern tonnage and engine exhaust scrubbers. I've made a few specific allocations to maximize the play here.

Safety In Value: One thing I'm looking at in the back half of 2019 is bubbles. It seems possible to me that there is a bubble in certain venture capital/IPO firms. My next big piece for subscribers which should come out in the next week or so is symptomatic of my philosophy on bubbles. It makes sense to take as much of the money out of a bubble as possible while positioning for it to burst. This piece focuses on a real estate firm that is taking transient business in a bubble area but is valued based on its long-term business, so downside if the bubble breaks is minimal.

Joshua Hall: At the beginning of 2019, I told subscribers that I thought lithium was going to be a 2nd-half 2019 story after some more pain. I have a feeling that there is some sort of headline catalyst coming that will change investor sentiment. Perhaps it is a major acquisition, especially from outside the industry, like from a Royal Dutch Shell (RDS.A). Perhaps it is finally the realization that a 10-fold increase in lithium supply over a decade will not come as easy as many think. There are now too many major commitments to electric vehicles, and the pressure of the supply chain need is building. Something is going to break. I just sense that one major news headline could do it.

Long Hill Road Capital: I'm close to fully invested in nine great businesses. My top four holdings are about two-thirds of the portfolio. I don't have specific expectations for what their stock prices will do in the second-half of this year or next year. However, even assuming fairly modest long-term expectations, I expect them to compound at some double-digit average annual rate for quite a long time.

The Russell 2000 has joined in on the recovery but is still lagging the S&P 500 both YTD and since the December lows. Are you seeing any trends within the small or micro-cap space that either make you feel better about looking for investments there or concern you?

J Mintzmyer: I see substantial value opportunities in shipping and energy. I primarily "stay in my lane," and I focus on providing the world's best shipping equity research for Value Investor's Edge.

Michael Wiggins De Oliveira: There seems to be a large divergence between companies which are posting slower growth but are highly free cash flow-generative, compared with newer, faster-growing companies with no profitability in sight. This is trend is evident across all ranges of companies; examples come from media companies like Discovery (DISCK) to basic material companies such as L.B. Foster (FSTR), which are extremely cheaply priced, particularly when compared with companies which are posting extremely rapid growth, with no profitability (once you account for stock-based compensation), but are selling the dream to investors.

Safety In Value: I think the small and microcap space is an exceptional place to be looking for ideas right now. As noted, valuations of small companies have lagged the broader market recently, but small firms have outperformed over time. This sets the market up for a great reversion to the mean rally in small firms. Additionally, most of the "known unknowns" that seem likely to affect the market are trade-related, and small firms are usually more domestic-oriented. That means they are less likely to be harmed by trade issues, but benefit from stimulus (like lower interest rates) that targets the trade-based economy.

Joshua Hall: Many of the small-caps that I follow outside of mining are just way overvalued. From my perch, the small-caps are lagging because of this and may continue to do so.

Long Hill Road Capital: I don't have a top-down view about this. There are certainly far fewer institutional investors looking closely at small-cap and micro-cap companies, so there is plenty of room for mispricing. That said, even widely followed mega-cap companies can be significantly mispriced. Of my partnership's 9 holdings, 7 happen to be mid-cap or large-cap, while 2 are small-cap. That's not by design. I just try to invest in companies where the future growth feels most inevitable to me and their stock prices reflect very modest expectations.

What is one of your current favorite ideas, and what's the quick thesis?

J Mintzmyer: Current momentum favorite is Dorian LPG (LPG). They trade around a 40% discount to net asset value, which is where you'd expect a distressed situation to be; however, this company is actually drowning in cash flow in the current market. Although we don't expect the current rates to last, at levels of $60-70k/day for their ships, Dorian trades about 1.5x current cash flows. The balance sheet is great, liquidity is strong, the NAV discount is large, forward supply/demand is good. I've seen a lot in shipping, but I've never seen something quite like this...

Michael Wiggins De Oliveira: Liberty Global (LBTYK) has a huge spin-off looking to get the green light from the European Commission (EC) at the end of July 2019. This spin-off has recently been rumored in a Reuters article to be given the go-ahead by the EC. If Liberty Global does divest of this asset to Vodafone Group (VOD), it will receive $12.7 billion in cash and $10 billion of debt will come off Liberty Global's balance sheet. Given that the stock only trades for $20 billion, this John Malone company (29% shareholder), with Berkshire Hathaway (BRK.A, BRK.B) as a 6.2% shareholder, which is led by outstanding management, will be trading extremely cheaply. Management will most likely make a huge buyback.

Safety In Value: Bluegreen (BXG) is a timeshare developer. Their parent company made a takeover offer at $16, but backed out because of a big lawsuit from a major supplier. The lawsuit was settled for $0.56 per share, but shares are still under $12, and are cheap compared to the other firms in the industry. The shares have been recovering after arbitrage buyers bailed out, but still offer excellent value. I wrote this up fully here.

Joshua Hall: Plain and simple, Rio Tinto (RIO). Iron ore is over $110 per tonne, and the stock is priced for $65 per tonne iron ore. The forward-looking dividend yield is likely going to be in the 7% range. The company is raking in cash, and a new share repurchase plan or acquisition could be coming soon to provide another catalyst. No one seems to believe the iron ore rally can be sustained. If it dies tomorrow, you have a big margin of safety with the current valuation. If it runs longer and hotter than expected, then Rio Tinto will have even more cash to reward shareholders.

Long Hill Road Capital: It feels inevitable to me that Spotify (SPOT) will be far bigger and more profitable in 5, 10, and 15 years. Many investors, even those who look for mispriced growth, seem to dismiss the idea of investing in Spotify because they think the major labels, who control the majority of music rights, will never allow it to capture greater economics. The idea that Spotify is the next Netflix (of audio) is quickly dismissed because they assume the concentrated supply of music rights and the variable cost structure will never allow the company to show meaningful operating leverage. Here's my view. Spotify is already critically important to the labels. Streaming music is already the majority of recorded music revenue for the labels, it's the only form that's growing, and Spotify is the largest contributor. At the same time, Spotify is expanding into all forms of audio, notably podcasting, but also meditation, audiobooks, and perhaps news, weather, sports, and entertainment one day. As a result, over time, the labels should become increasingly reliant on Spotify, while Spotify becomes decreasingly reliant on the labels. So, I expect margin expansion to come from a greater mix of higher-margin content (i.e., podcasting, etc.), better economics with the labels due to lower royalty rates and monetizing its data-driven insights (the "marketplace" strategy), optimizing the ad-supported business with greater self-serve/programmatic, and fixed cost leverage. I also think management's long-term guidance for R&D of 12-15% of revenue is quite high. At some point, given the revenue growth outlook, that would become a very large chunk of R&D spending in dollar terms. I'm not sure it will be quite that high. A final point is that Spotify's ad-supported business is underappreciated. One day, every car on the road will have an embedded modem, and drivers will seamlessly access Spotify (paid or ad-supported) and other streamers from the dash. Given streaming is a demonstrably better user experience than terrestrial radio (due to interactivity, personalization, discovery, playlisting, etc.), I consider it inevitable that streaming will replace AM/FM radio over the long term. "Everything linear dies," Barry McCarthy (Spotify's CFO) likes to say. The labels and artists would also applaud this shift, because in the U.S. terrestrial radio is not required to pay performers and copyright owners, only songwriters. Globally, terrestrial radio is a $40 billion market. There are other players, but I view Spotify as best-positioned to capitalize over the long term. As for valuation, I maintain four different 20-year scenarios for Spotify. I can't predict the future, but my guess is the future will fall somewhere within these four scenarios. When I discount the cash flows for each scenario, I conclude that today's stock price seems somewhere between fairly priced in a disappointing future to staggeringly cheap in a bright future.


Thanks to our panel for participating! As a reminder, you can check out their profiles and services at these links:

We continue the mid-year Roundtable tomorrow with a post on biotech. If you have any thoughts on the small-cap discussion above, please chime in below!

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.

Additional disclosure: J Mintzmyer is long LPG.
Safety in Value is long BXG.
Michael Wiggins De Oliveira is long BBBY, DISCK, FSTR, LBTYK
Joshua Hall is long RIO.
Long Hill Road Capital is long AMZN and SPOT.