SA Interview: Small And Microcap Investing With Aaron Warwick

Jan. 15, 2022 7:30 AM ETQIPT, QIPT:CA20 Comments
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  • Aaron Warwick focuses on opportunities where the market has not yet figured out or appreciated a company’s fundamental business and/or upcoming catalysts.
  • His concentrated portfolio approach, typical traits of a “breakout” investment and why he focuses on small and microcaps are topics discussed.
  • Aaron Warwick shares a long thesis on Quipt Home Medical.

Feature interview

Aaron Warwick is an individual investor who enjoys collaborating with others on Seeking Alpha, as well as on the new Breakout Investors platform he helped start. He focuses on opportunities where he believes the market has not yet figured out or appreciated a company's fundamental business and/or upcoming catalysts. We discussed how to tell the difference between an unwarranted selloff versus one that is warranted, how following a stock for years can provide an edge and how to separate the signal from the noise listening to management on conference calls.

Seeking Alpha: Walk us through your investment decision-making process. What area of the market do you focus on and what strategies do you employ?

Aaron Warwick: First of all, I want to express my thanks for this interview and allowing me to share some of the things I have learned over the years with other Seeking Alpha investors. So many in the Seeking Alpha community have helped me, and it's always good to be able to pay that forward. I also want to thank my mentors (who wish not to be named) for all the guidance they have given me, and continue to provide.

In terms of my decision-making process, it may seem strange given that I tend to make concentrated investments, primarily in the volatile small cap space, but my first step in the decision-making process is assessing risk. There's a phrase: "The best way to make money is to not lose money." Earlier in my investing life I made the mistake of focusing on the reward side of the equation. This led to some nice wins, but then I would give it all back on another investment. So, allocating for risk is of the utmost importance to me. But that is something I can only determine, of course, through extensive research.

In approaching the market, I primarily focus on small or micro cap companies, which I know we will discuss later my reasons for that. But I do not focus on any specific industry. I focus instead on situations where I believe there could be a disconnect between the company's fundamental value and the market pricing. And when I say that, I don't mean I am looking for a 20-40% mispricing, unless it is something very short-term, like I wrote about with respect to CRSS in 2021. Normally, I am looking for the possibility of at least 100% upside. And that does not mean the stock should immediately be 100% higher, but that with a few things going the right way for the company, in the next year or two, I see that it could or should be at least 100% higher.

A few years ago, I really had to spend a lot of time looking for companies. I went to the LD Micro Main Event and attended many of LD's virtual events, and still do. But, because I can't watch every single one of the presentations, I would give them about five minutes max to capture my attention, and if they did not, I would move to the next. And I think that's one benefit of my approach: I'm not looking to make twenty different investments each representing 5% of my portfolio, or less. I'm looking for companies that could be anywhere from 5-20% of my portfolio at a given time, depending on how much risk I project. But one of the advantages of my risk assessment process and my desire for a concentrated portfolio, is my ability to pass on many investment opportunities and never look back.

I think the final thing to note here, as I know we will cover several other things later in the interview, is that I manage my allocations percentages like a hawk. This allows me to naturally take advantage of fluctuations in the market or in my more volatile positions. If a stock runs, I trim it so it does not become too large as a percentage of my portfolio. Likewise, when it dips, I will add some more so that its percentage allocation in my portfolio does not become too low. Doing this regularly ensures that I almost always have cash available for these fluctuations. It also means I'm naturally managing the risk, because all things equal, a stock at a higher price is riskier than the same stock at a lower price and vice versa.

SA: To follow up, what are typical traits of a "breakout" investment? How do you find them in the idea gen process?

Aaron Warwick: I mentioned earlier my appreciation for my mentors, and I will take this opportunity to thank my fellow "Breakout Investors" who collaborate with me on our new (free) platform. We are really trying to build a community of investors interested in collaborating to help with the idea gen and the process of continuous research. Almost all of us involved in that platform would be considered part-time "retail" investors, although we do have several professionals who contribute as well. But when you put us all together, I think you have something special.

The tag line of our platform, which is the typical trait of a "breakout" investment, is being "ahead of the curve." What we mean by that is we look for underappreciated companies whose stock we believe will break out of its current trading zone once the market begins to understand and appreciate what they are doing. I think anyone who goes back and looks at my articles can see this as a common theme. I'll give some examples.

Look at INFU. I first wrote about them in January 2020 and noted they were at a point where their operating leverage was going to kick in. And it's done that, and the stock responded well. I followed up on them after they were irrationally hammered by the Covid crash, and when the market figured that out, the stock rallied and rewarded shareholders a second time.

Another example is BTCY. I wrote about them being poised for disruptive and explosive growth, and eventually the market woke up to what they are doing and re-priced the company.

These are just two examples, but virtually all of my articles are about companies that I believe are underappreciated when I first start to follow them, and when the market as a whole figures this out, they will be re-rated or re-priced and we will benefit from them breaking out, and their story becoming more well-known.

SA: You focus on small and microcaps - can you discuss the reasons for this? What are the challenges to investing in this space?

Aaron Warwick: The reasons for my focus on small caps and microcaps is simple. It's because these companies are undercovered and generally underappreciated by Wall Street. And this leads to them being inefficiently priced, with this almost always meaning, underpriced. Now, the challenge in this space is that the risk is high relative to larger, or even mid-cap, stocks. And because of lack of volume, there is also the risk of volatility. But with that risk comes an advantage for those willing to do the research and take that risk, and to be comfortable with that volatility. While many others just avoid this space in general, you can find companies on the cusp of doing something special. But I will say, I pass on probably 95% of the companies I find or others bring to me for research. Because of the risk factors, it pays to be selective.

SA: How do you tell the difference between an unwarranted selloff versus one that is warranted? What are typical causes of the former so readers can be on the lookout for them?

Aaron Warwick: I think the only way to know the difference is to know the company well. I mentioned already what happened with INFU during Covid. But I also wrote more recently about how the company made a slight pivot to their operating plan, which disappointed or spooked some investors, and which I used as an opportunity to significantly increase my position in the company. In short, I recognized the company took a six-month or so respite from being a cash cow to investing in the business for massive growth, which will soon turn them back into an even bigger cash cow. I know that company well, and I had zero doubt that management would execute.

There are so many causes of unwarranted selloffs. A big one, of course, is just general market fluctuations. When there is a correction or a shock like Covid, investors tend to throw out the baby with the bathwater. They shoot first and ask questions second. This can create phenomenal opportunities if you know a company's fundamentals are still intact. A big one I see fairly regularly are insider sales. Investors tend to overreact to those. Especially in small caps. They forget that most of these small cap insiders are not generationally wealthy, so even if they sell a decent number of shares, it usually means nothing in terms of how the company will perform moving forward.

But the general rule I follow is to ask myself if a selloff is caused by a fundamental negative change with the company. If it is not, then the selloff is unwarranted and presents a buying opportunity. If I liked a stock at $10, and for some non-fundamental reason it drops to $8, then I love it even more!

SA: Does following a stock for years provide an edge over investors who are "new" to the name? If so, how?

Aaron Warwick: That's a great question, and my answer is that it varies. In most cases, I do believe following a company for years provides an edge. I mentioned INFU already. Knowing that company well helped me to take advantage of two unwarranted dips in their stock price. Another company I've followed for years is Smith Micro (SMSI). Knowing that company very well has provided me with opportunities to increase and decrease my position based on things happening at the company. To be clear, since I've been writing about SMSI, I've always had a long position. But based on how the stock has traded compared to what I know about the company, my position size has varied significantly. For example, coming into 2021, it represented 20% of my portfolio. At other times in the year it was much smaller than that, but it is now once again-because of what is going on at the company fundamentally, and how the market does not seem to appreciate that-an outsized position for me at this time. I think the risk at the current $5 level is quite low.

On the other hand, knowing a company well can also lead to a bias or blindness that can hurt you. Too often, investors become emotionally attached to a company or stock. This is especially true when you've made good money with that stock in the past. SMSI is a great example. I love what SMSI did from a long-term fundamental standpoint in 2021, as I wrote about in my articles, but the results included the company having a volatile year in the stock market. Some investors refused to acknowledge there could be short-term pain for long-term gain, all, in my opinion, because they became too emotionally attached to the stock. Another example of this was the old HMNY stock. People made a lot of money on their MoviePass relationship, and then did not see the writing on the wall before the stock crashed, all because they became biased or blinded by an emotional attachment to the stock.

So, ultimately, while following a stock for years and doing the actual research is usually highly advantageous, we also have to be careful to analyze our potential biases and possible emotional attachments. Because, generally speaking, investing on an emotional basis is a good way to lose a lot of money!

SA: Can you discuss how you're able to separate the signal from the noise listening to management on conference calls or presentations, and pick up on what other investors might miss? Can you give an example?

Aaron Warwick: Another great question, especially since my approach, in general, is to establish a good relationship with management. And as with any good relationship, my relationship with management has to be based on trust. Unfortunately, the micro and small cap worlds have a reputation of questionable people in management. We could cite numerous examples of hucksters in that space. Yet, in reality, those types of people are few and far between. Most small cap management teams, at least in my experience, are decent, honest people. Still, like management of almost any organization, they are usually bullish on the company and what they are doing, or they would not be in that job. So, I still have to separate between what I believe to be an objective analysis of the company versus the potentially subjective and/or biased view of management.

One of the best ways to do that is to read prior earnings call transcripts. During my due diligence phase I go back through those transcripts. I usually go through calls at least two years back. This helps give a sense of several things. First, is management demonstrating that it is trust-worthy? Not usually from the standpoint, as I mentioned, that they just flat-out lie, but can you trust them to hit the targets and guidance they give? Or are they perpetually too bullish? On the other hand, sometimes they may even be perpetually the beat-and-raise type. But from reading those and then seeing how things played out, you get a sense of their reliability and how much you can trust them.

Let me give an example of this. When I went back to study Inuvo (INUV), I could see that management was reliable in terms of hitting the targets they gave, and so I trusted, when I wrote about them, that they would deliver. And they did-in fact, they became EBITDA positive ahead of their guidance. And I had little doubt that would happen, because when you review their commentary from the past two years, you quickly learn they can be trusted to do what they say.

But in addition to that trust factor, there is another important reason to review the transcripts and to actually speak with management. And this is more of a qualitative factor versus the more quantitative approach I outlined just a minute ago. When you build a relationship, or even when you just familiarize yourself with the way management communicates, you can start to learn how to read between the lines or to pick up signals management is giving. When you become familiar with the way a management team communicates, you can sometimes pick up on a slight change in the way they speak, even the sound of their voice. And sometimes that is bullish, sometimes bearish. But unless you are intimately familiar with the way they normally communicate, you will miss that. Human communication is complex, and there's a lot more to it than simple words. But to pick up on those qualitative factors, you have to establish a baseline for how a person normally communicates, so you can then pick up on any deviation.

The final thing worth noting here is that, whenever possible, I look for sources that objectively verify something management has stated. A great example of this is my recent coverage of Perma-Fix (PESI). You can see in my article I link to sources that confirm what management is saying. And when that happens, when you find objective, third-party sources that confirm management's guidance, then it builds that important trust factor.

To summarize, in the end, the main thing to look for is trust and reliability. Does management normally execute on what they outline? If they say something, can you be almost 100% certain it will happen as they guided? Can you find objective, third-party data points that confirm management communication? If the answer is "yes," then you know you can trust management. You know it's worth the time to continue to nurture and build that relationship. If not, then you move on to find a company whose management is trustworthy.

SA: Does tax loss selling still create mispricings or not as it's so well known?

Aaron Warwick: I don't have any objective data to prove this, but my gut tells me it still has an impact, and I think that's especially true in the small and micro cap spaces. And the reason I highlight these smaller names is, again, because of the relative volatility and lack of liquidity. Some of the names I follow and on which I've written-look at them-they might trade only 10,000-20,000 shares some days! So all it takes to create a mispricing is one relatively large shareholder trimming a position for tax loss harvesting. If you have several dozen to several hundred shareholders doing that, then even more is that the case. In fact, on our Breakout Investors site, someone put up a post about many names we follow where we believe that was happening towards the end of 2021. And we have positioned ourselves to take advantage of that temporary dip as we expect these names to recover in early 2022.

The one thing I will say that, perhaps, has changed from years past: I think some of that tax loss selling begins a little earlier than in the past. Some investors may sell earlier in Q4, expecting others to be selling closer to year-end. So they try to get out before there could be more pressure for that reason. And in 2021, you also had some investors saying they were tax gain selling. They thought taxes could go up significantly in 2022, so they locked in gains at a lower tax rate.

Personally, I do not make investing decisions based on tax loss (or gain) selling that way. I do, of course, make decisions in terms of how I allocate between taxable and non-taxable accounts. But I do not sell any core position for tax reasons. I just find that type of thinking normally distracts from the fundamentals, and stocks in which I invest can be volatile, so selling for a tax reason and saving a few percent here or there may lead to me missing out on much bigger gains before I can re-enter the position without tax consequences. I understand others might reasonably have a different approach, but I think my style of investing is not conducive to worrying about tax consequences from the perspective of year-end selling.

SA: What's one of your highest conviction ideas right now?

Aaron Warwick: My highest conviction idea right now is Quipt Home Medical (QIPT). It's by far my largest position, not because of the potential upside-which is large-but because of the corresponding low risk. As I stated early on in this interview, I've really learned to manage towards risk, and so I love this name because I perceive it is low-risk.

Specifically, the company trades at around 4-5x EV/2022 AEBITA (based on current guidance). Management is extremely trustworthy and reliable. High quality, high character people. Fantastic operators. And they have a long runway in front of them, growing both organically and via accretive acquisitions. I believe 2021 was a transitional year for them, and that their stock price will be re-rated at some point in 2022.

As I've written about them, they had a real headwind going against them with a warrant overhang mid-year 2021. Then, I believe, you had some tax-loss and technically-driven selling the remainder of the year. And that's all on top of changing their name, their reporting (from CAD to USD), and their uplisting to Nasdaq.

In early 2021, the company traded in the $7-$8/share range, which at that time, I thought was a relatively reasonable price, although I expected them to continue to grow to a higher valuation as the business grew. But now, the company trades for lower, despite the business being stronger than ever. They would be a cash cow, if not for the fact that they put their operating cash flow into accretive acquisitions, almost immediately turning low-margin businesses into high-margin businesses, thus increasing their own cash flow in the long run.

I am completely comfortable with this investment, even if it continues for years to trade at 4-5X EV/AEBITDA, because the company will continue to grow via accretive acquisitions and organic growth. Their AEBITDA will grow consistently, thus increasing their EV. And at some point-even if it's only at a time when another public company or private equity eventually acquires them-they will get a much, much higher valuation than 4-5X AEBITDA. And on the risk side, their type of business is only increasing, and reimbursement rates are strong for the foreseeable future. And because of these factors, I see at least 200% upside potential over the next 3-5 years, with very low downside risk at current prices.


Thanks to Aaron for the interview.

Aaron Warwick is long INFU, SMSI, INUV, PESI, QIPT and may add a long position at any time in BTCY.

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