February 4, 2025 • 31 mins
The Russell 2000 ended the year on a sour note over unease about where interest rates could go. In this episode of Inside Active, host David Cohne, mutual fund and active-management analyst with Bloomberg Intelligence, along with co-host Michael Casper, US small-cap and sector strategist at BI, spoke with John Barr, managing director at Needham Funds and portfolio manager for the Needham Aggressive Growth Fund (NEAGX) about hidden quality compounders and why investing with a margin of safety is crucial for long-term success. They also discussed why owning established businesses helps with downside protection, why founders are a shortcut to finding great management and how meeting with private companies can help with long-term success.
See omnystudio.com/listener for privacy information.
Mark as Played
Transcript
Episode Transcript
Available transcripts are automatically generated. Complete accuracy is not guaranteed.
Speaker 1 (00:14):
Welcome to Inside Active podcast about active managers that goes
beyond sound bites and headlines and looks deeper into their processes,
challenges and philosophies in security selection. I'm David Cohne, i
lead mutual fund and active research at Bloomberg Intelligence. Today
my co host is Michael casper, Us, small cap and
sector strategist at Bloomberg Intelligence. Mike, thank you for joining
(00:37):
me today.
Speaker 2 (00:37):
Thank you, David.
Speaker 1 (00:39):
So you've recently published a note on the Russell two thousands.
I guess we should say not so great December. Can
you give our listeners a brief overview of just what
went wrong last month?
Speaker 2 (00:50):
Yeah, pretty much everything. So the Russell two thousand and
December down about eight percent or so a little bit
over eight percent for the month. Every single sector in
the red, led by declines and materials, healthcare and financials,
so some behemoths in their healthcare and financials obviously two
of the bigger sectors in the in the index, Tech
(01:12):
and consumer staples actually fell the least, but still everything down.
What was interesting though from our standpoint is we have
a sentiment indicator called the bi Market Pulse Index. It
looks at risk taking across equities and bond markets, and
it actually ticked higher, kind of led by low volatility
(01:35):
outperforming high volatility stocks for them, or high volatility stocks
performing low volatility stocks for the month caused the market
Pulse index to tick a little bit higher. So we're
still watching that it is showing a little bit of concern.
Especially some of these factors that we look at are
smooth out over a three month timeframe, so picking up
(01:56):
some of that November rally, but still moving higher. But
I think really what wereent wrong under the surface was
the moving rates. We had highlighted at the end of
last year that the Russell two thousand was pretty fairly
priced on the multiple given where consensus expected rates to
go over the next year. And obviously what we're hearing
from the FED and what we're seeing from the Tenure
is that there's a healthy dose of skepticism that the
(02:21):
original rate cut intention will actually be followed through in
twenty twenty five. So a lot of that volatility I
think was driven on the multiple side from Fed unease
or unease about where rates might go. Obviously, consensus for
revenue growth not going to change too much on a
(02:42):
month on month basis. So it was really driven a
lot by the multiple in sentiment and where rates are
expected to go over the next year.
Speaker 1 (02:49):
Well, hopefully the next few months will be a little better.
But on the topic of small caps, I'd like to
welcome our guest, John Barr, Managing director and executive vice
president of need and Funds, portfolio manager for the Needam
Aggressive Growth Fund tickern eag X. John, thanks for joining
Inside Active.
Speaker 3 (03:07):
Great. Thank you, David, it's great to be here.
Speaker 1 (03:10):
Well, let's start off by talking about your career. You
know we've met and so I you know you've got
an interesting career trajectory. Can you tell our listeners how
you got your start in the investment business.
Speaker 3 (03:21):
Yeah, they're really three parts to my career, And the
first is that I had a whole first career in industry,
and it was predominantly in electronic design automation, which is
CAD software used to design semiconductors and printed circuit boards.
(03:42):
And so fourteen years in that industry at marketing, sales,
sales management, product management. I lived in Japan and set
up distribution, so lots of industry experience, and I also
worked for or predominantly small companies but been through small
(04:06):
venture backed companies, conserving cash through an IPO, through friendly merger,
hostile takeover, white night layoffs being and then finally being
the last person out the door. So I've kind of
been in the shoes of the companies that I look
to invest in. So yeah, lots of industry experience, and
(04:30):
then just mentioned the second part is other financial industry
experience and leaving industry, I had the chance to go
to the cell side and follow the industry that I
came out of for a number of years, so had
that additional experience. And then also venture capital has been
(04:53):
something that has been a strong interest for a long time.
And as on the cell side, I worked with sourcing
ideas for Needham's Venture Fund at the time, and then
I was on the board of a private company that
successfully sold and have maintained that interest and involvement since.
(05:19):
So significant other financial industry experience too, and now been
a portfolio manager slash analyst for over twenty years.
Speaker 1 (05:29):
So you know that brings us to the Aggressive Growth Fund,
which is, you know what we really want to focus
on for this episode. Can you kind of walk us
through the investment process for that fund?
Speaker 3 (05:39):
Yeah, so it we look for I call it hidden
to quality compounders, and when we look to purchase a company,
it's in a stage that I call a hidden compounder,
and then we look to hold it while it transitions
to strong to strong financial performance, and then hold on
(06:05):
even more while it becomes a quality compounder. And I
like to joke that even the quants can find it
when it's a quality compounder. But in the early stages,
we're looking for some specific characteristics that aren't readily apparent,
(06:25):
so that that's the process from a high level. Some
of the characteristics of it are very long term holding,
so turnovers about ten percent, so averaging a ten year
holding period. And so we're looking to find those small
(06:46):
cap companies that the market hasn't yet discovered, hold them
through that transition, and then hold them even longer to
point where some of them become mid and even even
large caps and we were able to hold on to them.
(07:08):
So I might just mention the criteria that we look
for when we first purchase one of those companies, and
they're four key criteria. The first is that the company
has an established business, but then is investing in something
new that the market doesn't yet recognize, and it can
(07:28):
be a product or a service, and the established business
maybe not so exciting, not growing rapidly, but profitable or
generating cash to support the new thing. So while we're
growth investors, we're not growth at any price. We're not
looking for companies that just have the new thing. We're
(07:51):
looking for companies that have that established business and that
helps us with downside protection as well. And we're prepared
to look beyond the typical Wall Street model of a
year or two to give the new thing time to develop,
and that can be a year or two or even
(08:14):
three or four. And so that's the first thing that
we look for. And then secondly a big market. Can
the company grow to be five to ten times its
current size, because if we're going to be invested for
ten years, the company with success needs to grow. And
then third, great management. Every investor says they invest in
(08:36):
great managers. To me, the shortcut is founders, family or
long tenured, because they tend to think long term. Like
we want to be invested, we need to be careful
that they're not just self dealing and controlling management team.
(08:57):
But we've had great success with that class of management
and then the final criteria is investing in a margin
of safety price and that can come from the balance sheet,
it can come from the value of the established business
or other areas as well. So ideally it's it's it
(09:20):
looks like a boring stock, it's got a flat stock chart,
the market's not excited about what they're doing. But it's
also not something that's been cast aside. That's a that's
a falling knife. So that's that's what we look for,
and then we look for the for the transition, and
then then the further transition.
Speaker 2 (09:39):
And what do you think might be in store for
small cap stocks as a whole going into twenty twenty five.
Do you see any catalysts on the horizon that might
help narrow the gap with the S and P five
hundred Michael.
Speaker 3 (09:50):
That's a great question. I tend not to pay much
attention to the macro side of things and very focused
on on the companies and a few specific tailwinds sector tailwinds.
I think there's one thing that we can point to,
(10:11):
which is small companies have have typically benefited from M
and A and with the change potential change at the FTC,
there may be more opening for small companies to be acquired,
and it's been even our small companies that really it's
(10:33):
hard to imagine any kind of market dominance or monopoly
kind of situations. The M and A has just been tough.
But I think that that's one element that could could
help small small caps. But we see lots of opportunity,
plenty of companies that meet our criteria that we think
(10:55):
will provide great returns over time.
Speaker 1 (10:58):
What did have a follow up? You know, one of
the things you mentioned was, you know, having kind of
that margin of safety in terms of valuations. Are there
are specific metrics you use when you're looking at valuations.
Speaker 3 (11:12):
There are many things that we look at. So we
will when we first enter, we'll look at the balance
sheet and potentially we can find hidden real estate value
or something that's not recognized. I'll look at some of
the parts because we'll have the established business and then
project what we think the new thing can look like.
(11:32):
We will look at enterprise value to EBIT. Enterprise value
to revenue, particularly useful for a company that's under earning,
which many of ours will be. When we first purchase
enterprise value to EBITDA. But then as Charlie Munger says
about EBITDA. It is something bulld ebit DA, and you
(11:56):
have to be very careful that it's not all just
getting plowed back into to stock comp or cap X.
But a unique thing that I look at is a
Berkshire Hathaways, a form of Berkshire Hathaways owner's return on
capital which takes into account capital spending, maintenance capital spending,
(12:20):
and expansion capital spending, and major movements in cash flows.
So we're not so much looking at an annual cash
flow as cash flow over the cycle of this investment
that we're looking at.
Speaker 2 (12:42):
Did the election or any of the proposed policies of
the incoming administration change any of your investment thesies.
Speaker 3 (12:49):
I mean, we're really looking out longer term, and I
think this changed in the FTC maybe something, but other
than that, not really so much. I might just mention
though that. So I described the strategy tactically for I've
managed the fund now for fifteen years, and we've really
(13:12):
been focused on infrastructure broadly defined. And yes we're growth,
so we have some elements of physical infrastructure concrete, roads
and construction companies, small bit of that, but lots of
technology infrastructure and that has meant data centers and semiconductor
(13:36):
manufacturing going back for fifteen years and even before that
in my previous experiences, those have been important areas, and
I just mentioned data centers. It was a good business,
somewhat cyclical, we really liked the business. And then in
twenty seventeen the hyperscalers started to build out, and then
(14:00):
in twenty twenty one came AI and we think we're
still in very early stages of data center build out
and semiconductor manufacturing has lots of tailwinds and it happened.
It also somewhat cyclical still but major tailwinds for leading
(14:24):
edge and for regionalization and really helping the data center
build out too. So infrastructure broadly defined, and then we
have some labs and fabs for other industries too, but
that's a major area of focus. So it's the companies
that are behind the scenes supplying the engineering tools and
(14:47):
the manufacturing tools and manufacturing services that we're invested in,
which means we're going to miss the hot new consumer
app but we've found that the cap X and where
we invest there's there's more durability to it and it
(15:10):
matches what Needham is strong at and it also remembering
my background for chip design software matches my background too.
Speaker 2 (15:19):
And what do you see is maybe the biggest risk
of stocks or maybe your portfolio and some of the
calls that you have in there in the coming year.
Speaker 3 (15:27):
We really try to look beyond a year. So uh,
we're currently I mean, what has what what hurt a
bit last year? Two elements. First, the industrial economy is
not robust and UH, you know we've we've seen weakness.
(15:48):
There's housing and autos are two areas that then ripple through. UH.
And then the other element is consumer and UH in
particular killer the lower income consumer has also been suffering.
And I don't know that either of those is there's
(16:10):
tailwinds in the next six months. So those those are
those are probably the biggest concerns. UH. And then if
you want to if you do want to look at macro,
you probably have to look at the increasing the tenure
as it's creeping up at four seven and potentially heading higher.
(16:31):
There's there's a lot of depth to to to refinance.
But I try to look forward now the five to
ten years and assume that everything that things will be
normal when you look out there.
Speaker 2 (16:48):
Yeah, and are there any sectors you find particularly compelling.
I was looking through a little bit of your portfolio characteristics.
I know you're you're have you into tech, So maybe
outside of tech, are there any you know, sectors that
that you really like at the moment?
Speaker 3 (17:02):
I like so as I described infrastructure, broadly defined picks
and shovels that enable the big, high profile industries. An
area where we added a few new investments last year
relates to skilled labor, and I can highlight a couple
(17:25):
of companies that were new additions in the last couple
of quarters. One is Lincoln Tech and the others Universal
Technical Institute UTI. And these are the skilled labor trade
schools and small market penetration, big big need for the
country and strong growth prospects, and they were kind of
(17:51):
thrown away in the mid two thousands when with all
of the for profit institutions. But these companies provide a
real service and value. They could also benefit from a
change in administration. So those are a couple. And then
(18:11):
we have a small company that provides hazardous gas detection
companies called black Line Safety that has strong growth, gaining
market share and provide safety for those for those workers.
So that's that's one area, as you earth. Yeah, just briefly,
(18:33):
I'll mention another that's related to that, which is construction
services and a data center of semiconductor manufacturing, life sciences manufacturing.
Lots of we in the country need a lot of
new manufacturing facilities. So we have invested in a couple
(18:56):
of spinouts from utilities. One is the Everest Construction Group,
which spun out of the Montana Dakota Utility MDU, and
another is Century which spun out of Southwestern Gas. And
so these these are construction services companies. Jacob's Solutions is
(19:19):
a third. Matrix Services is another. So I think that
construction services are an important area that we've invested in
the last year.
Speaker 1 (19:30):
Earlier, you kind of alluded towards, you know, helping kind
of protect the downside, and so I'm just curious if
you had any processes in place to, you know, in
terms of handling risk or volatility.
Speaker 3 (19:43):
Yeah, it's it's really around the companies. When we buy them,
we're buying them with that margin of safety and and
that that has helped. This leads to the question of
portfolio construction too. So when we first purchase, we will
buy a fifty thirty to fifty basis point position, and
(20:06):
we can take a year to build a position small cap,
maybe not so liquid. If they run away from us,
it's unfortunate, but oftentimes we have that time to take
and so we'll get our entry price, and that will
(20:26):
those entry level those hidden compounders may grow up to
two hundred basis points, and then in the transition they
may go up to three to four hundred. And we'll
be adding purchases in the late hidden and early transition phases,
and once they're into the quality they may be a
(20:50):
larger market cap, so we're not purchasing anymore, and the
market is more recognizing, so we're not purchasing more. So.
The risk protection comes from the valuation sensitivity at the beginning,
and then the portfolio construction, which keeps those early stage
companies small in the portfolio so damage is limited. About
(21:12):
half of the hidden make it to the next stage,
and then we do have some doozy of losers in
the tail of those hidden that don't make it, but
most of them we're getting our money back or a
significant portion of it, or making a small game. But
the real returns from the portfolio come from those half
(21:37):
that make it to transition and then the twenty five
to thirty percent of those that make it into the
quality stage. And over half of the outperformance has come
from about twenty companies that we've invested in over this
(21:58):
fifteen years. It ranged from five to one hundred baggers
based on the first purchase. So the risk control really
comes from that valuation sensitivity, but then letting the real
winners go and produce outside the returns.
Speaker 1 (22:24):
So how do you handle CELL decisions? You know with
both you mentioned you know there are some losers, but
also when you have a company that hits that quality stage,
how do you determine when to sell those?
Speaker 3 (22:35):
Yeah, and sometimes valuation can seem stretch. But for me,
I've learned its best not to pay that much attention
to it because sometimes, and in these twenty or so cases,
the fundamentals catch up with that valuation that seems stretched.
(22:56):
So Cell discipline. Once they hit ten percent of the portfolio,
and we've had a few that have, we will we
will trim and hold it back there. When we're also
a diversified industry fund, so we're limited to you can
(23:17):
have position. Once a position is over five percent, you
really don't buy more of it, so that provides risk
control as well. And then when we are a small
cap fund, categorized as a small cap fund, so when
they cross eight to ten billion in market cap, we
can still hold them, but we're not buying any anymore.
(23:41):
And so that's Those are some of the main elements.
Speaker 2 (23:45):
And do you have any major takeaways from the third
quarter earning season or what are you watching maybe as
the fourth quarter results roll in? Are there any concerns there,
you know, anything specifically.
Speaker 3 (23:57):
I mean, as I mentioned before, we're looking for any
type of turn in industrial economy, specifically autos chemicals, and
any relief for the for the lower income consumer. So
(24:17):
any any green shoots that we see there we're watching
for in the portfolio and out of it, of course.
Speaker 2 (24:26):
And we talked a little bit about M and A
already and how that might pick up a little bit
in twenty twenty five and beyond. Do you see maybe
the same happening for I POS or track I POS
kind of as a long term Yeah, so flow into.
Speaker 3 (24:39):
Russell I love to me so my interest in the
ventures side. We love to meet private companies. We like
to get to know them when they're private. So we
know what to do when they when they go public,
and it also helps helps you understand what's going on
in the market if you're actively in interested in private
(25:01):
companies and then taking them into the public market. It
has been it's been a tough time in particular. We
love a great small cap I PO that the big
guys aren't focused on and the headlines aren't focused on,
and doesn't run away from you. We're optimistic that the
(25:22):
new year will will bring some Yeah, and you know, Michael,
just to add further on that, I think we're also
probably in a good position for some more high profile
I pos the of the larger caps, and we will
follow them and be interested in them. But that no,
(25:46):
that's not what we do. But freeing up the mag
seven to to do M and A would be a
good a good thing for small caps.
Speaker 1 (26:00):
So we you know, we still have a little bit
of time left. So there's one question I wanted to
ask as well as you know, if we talk about
market caps, one of the things I've looked at with
small cap funds is there are a lot of companies
with larger market caps than we've seen historically. If you
go back ten twenty years do you think small cap
companies are just generally getting bigger compared to historical market
(26:23):
caps or is this kind of, you know, the way
things are going to be until there's more m and
a activity in small caps.
Speaker 3 (26:30):
Yeah. I think Socks Sarvey inz Oxley when it was implemented,
put extra expenses which made it hard to go public
as a smaller company. And then this rise of capital
that's available for late stage venture and private equity allows
(26:51):
companies to stay private longer. So it's definitely a trend.
But we still there's plenty of small caps. And the
other element is that funds have gotten larger. Pools of
capital are just larger, so they can't afford to spend
the time to get to know the small and micro
(27:15):
caps like we can. And so I think there's still
great opportunity in small caps, despite the fact it's very
different than when I started on the buy side over
twenty years ago. And you'd have plenty of one hundred
to two hundred million dollar market cap companies and at
(27:36):
this point those are considered micro caps. But we'd love
fishing in that pond because those are the ones where
you can get the fifty to one hundred x if
you get the right ones.
Speaker 1 (27:52):
Definitely. Well, we just have one question before we let
you go. We'd love to know what some of your
favorite financial books have been.
Speaker 3 (28:01):
Great question. I love that question. Well, so I'll start
with the Berkshire Hathaway Letters, and I think they're essential
reading for anyone interested in breaking into this business. And
then I'll go with any of the Warren Buffett and
Charlie Munger biographies, and I'll just highlight a couple of
(28:21):
amonger ones because there aren't quite so many. One is
Poor Charlie's Almanac, and then the second is Damn damn right,
and there is only a third. So I would read
as much about Charlie as about Warren. I think Seth
Klarman's margin safety is important. But you can't buy the
(28:45):
book because it is only an original print and they
cost a thousand dollars, but you can find the PDF
out there. I think Christopher Meyer's one hundred Baggers is
a good one. And then there's a book called the
Art of Execution by Lee Freeman Shore which was put
(29:05):
out about four or five years ago, and it's developed
He looks at investors in different archetypes and it's looking
at performance at underlying and more than just alpha outperformance
and attribution coming from allocation and selection. It's looking more
(29:30):
at decision making within the investment process. I think that's
an area that is right for research and understanding. And
then I just point one more which is not an
investment book, but I think a great book and it's
called Outlive by Peter Attia, and it deals with the
(29:55):
importance of, well, what we can do to fight the
four horsemen of disease, cardiovascular disease, Alzheimer's cancer, and metabolic
type two diabetes, and what you can do from nutrition
and exercise perspective to live a long, healthy life. And
(30:17):
I will add that that helps me helps inform me
in investing in healthcare companies which are more sick care
than healthcare, and I really look for things that are
on the right side of that nutrition and exercise model.
Speaker 1 (30:38):
Oh this is great, John, Thank you for joining us today.
Speaker 3 (30:41):
David, thank you very much, and thank you, Michael.
Speaker 1 (30:44):
Thank you both and Mike thanks for serving as my
co host today.
Speaker 2 (30:47):
Thank you, David.
Speaker 1 (30:49):
Un till our next episode. This is David Cohne with
Inside Out It two Stars of the Old Town
Welcome to Inside Active podcast about active managers that goes
beyond sound bites and headlines and looks deeper into their processes,
challenges and philosophies in security selection. I'm David Cohne, i
lead mutual fund and active research at Bloomberg Intelligence. Today
my co host is Michael casper, Us, small cap and
sector strategist at Bloomberg Intelligence. Mike, thank you for joining
(00:37):
me today.
Speaker 2 (00:37):
Thank you, David.
Speaker 1 (00:39):
So you've recently published a note on the Russell two thousands.
I guess we should say not so great December. Can
you give our listeners a brief overview of just what
went wrong last month?
Speaker 2 (00:50):
Yeah, pretty much everything. So the Russell two thousand and
December down about eight percent or so a little bit
over eight percent for the month. Every single sector in
the red, led by declines and materials, healthcare and financials,
so some behemoths in their healthcare and financials obviously two
of the bigger sectors in the in the index, Tech
(01:12):
and consumer staples actually fell the least, but still everything down.
What was interesting though from our standpoint is we have
a sentiment indicator called the bi Market Pulse Index. It
looks at risk taking across equities and bond markets, and
it actually ticked higher, kind of led by low volatility
(01:35):
outperforming high volatility stocks for them, or high volatility stocks
performing low volatility stocks for the month caused the market
Pulse index to tick a little bit higher. So we're
still watching that it is showing a little bit of concern.
Especially some of these factors that we look at are
smooth out over a three month timeframe, so picking up
(01:56):
some of that November rally, but still moving higher. But
I think really what wereent wrong under the surface was
the moving rates. We had highlighted at the end of
last year that the Russell two thousand was pretty fairly
priced on the multiple given where consensus expected rates to
go over the next year. And obviously what we're hearing
from the FED and what we're seeing from the Tenure
is that there's a healthy dose of skepticism that the
(02:21):
original rate cut intention will actually be followed through in
twenty twenty five. So a lot of that volatility I
think was driven on the multiple side from Fed unease
or unease about where rates might go. Obviously, consensus for
revenue growth not going to change too much on a
(02:42):
month on month basis. So it was really driven a
lot by the multiple in sentiment and where rates are
expected to go over the next year.
Speaker 1 (02:49):
Well, hopefully the next few months will be a little better.
But on the topic of small caps, I'd like to
welcome our guest, John Barr, Managing director and executive vice
president of need and Funds, portfolio manager for the Needam
Aggressive Growth Fund tickern eag X. John, thanks for joining
Inside Active.
Speaker 3 (03:07):
Great. Thank you, David, it's great to be here.
Speaker 1 (03:10):
Well, let's start off by talking about your career. You
know we've met and so I you know you've got
an interesting career trajectory. Can you tell our listeners how
you got your start in the investment business.
Speaker 3 (03:21):
Yeah, they're really three parts to my career, And the
first is that I had a whole first career in industry,
and it was predominantly in electronic design automation, which is
CAD software used to design semiconductors and printed circuit boards.
(03:42):
And so fourteen years in that industry at marketing, sales,
sales management, product management. I lived in Japan and set
up distribution, so lots of industry experience, and I also
worked for or predominantly small companies but been through small
(04:06):
venture backed companies, conserving cash through an IPO, through friendly merger,
hostile takeover, white night layoffs being and then finally being
the last person out the door. So I've kind of
been in the shoes of the companies that I look
to invest in. So yeah, lots of industry experience, and
(04:30):
then just mentioned the second part is other financial industry
experience and leaving industry, I had the chance to go
to the cell side and follow the industry that I
came out of for a number of years, so had
that additional experience. And then also venture capital has been
(04:53):
something that has been a strong interest for a long time.
And as on the cell side, I worked with sourcing
ideas for Needham's Venture Fund at the time, and then
I was on the board of a private company that
successfully sold and have maintained that interest and involvement since.
(05:19):
So significant other financial industry experience too, and now been
a portfolio manager slash analyst for over twenty years.
Speaker 1 (05:29):
So you know that brings us to the Aggressive Growth Fund,
which is, you know what we really want to focus
on for this episode. Can you kind of walk us
through the investment process for that fund?
Speaker 3 (05:39):
Yeah, so it we look for I call it hidden
to quality compounders, and when we look to purchase a company,
it's in a stage that I call a hidden compounder,
and then we look to hold it while it transitions
to strong to strong financial performance, and then hold on
(06:05):
even more while it becomes a quality compounder. And I
like to joke that even the quants can find it
when it's a quality compounder. But in the early stages,
we're looking for some specific characteristics that aren't readily apparent,
(06:25):
so that that's the process from a high level. Some
of the characteristics of it are very long term holding,
so turnovers about ten percent, so averaging a ten year
holding period. And so we're looking to find those small
(06:46):
cap companies that the market hasn't yet discovered, hold them
through that transition, and then hold them even longer to
point where some of them become mid and even even
large caps and we were able to hold on to them.
(07:08):
So I might just mention the criteria that we look
for when we first purchase one of those companies, and
they're four key criteria. The first is that the company
has an established business, but then is investing in something
new that the market doesn't yet recognize, and it can
(07:28):
be a product or a service, and the established business
maybe not so exciting, not growing rapidly, but profitable or
generating cash to support the new thing. So while we're
growth investors, we're not growth at any price. We're not
looking for companies that just have the new thing. We're
(07:51):
looking for companies that have that established business and that
helps us with downside protection as well. And we're prepared
to look beyond the typical Wall Street model of a
year or two to give the new thing time to develop,
and that can be a year or two or even
(08:14):
three or four. And so that's the first thing that
we look for. And then secondly a big market. Can
the company grow to be five to ten times its
current size, because if we're going to be invested for
ten years, the company with success needs to grow. And
then third, great management. Every investor says they invest in
(08:36):
great managers. To me, the shortcut is founders, family or
long tenured, because they tend to think long term. Like
we want to be invested, we need to be careful
that they're not just self dealing and controlling management team.
(08:57):
But we've had great success with that class of management
and then the final criteria is investing in a margin
of safety price and that can come from the balance sheet,
it can come from the value of the established business
or other areas as well. So ideally it's it's it
(09:20):
looks like a boring stock, it's got a flat stock chart,
the market's not excited about what they're doing. But it's
also not something that's been cast aside. That's a that's
a falling knife. So that's that's what we look for,
and then we look for the for the transition, and
then then the further transition.
Speaker 2 (09:39):
And what do you think might be in store for
small cap stocks as a whole going into twenty twenty five.
Do you see any catalysts on the horizon that might
help narrow the gap with the S and P five
hundred Michael.
Speaker 3 (09:50):
That's a great question. I tend not to pay much
attention to the macro side of things and very focused
on on the companies and a few specific tailwinds sector tailwinds.
I think there's one thing that we can point to,
(10:11):
which is small companies have have typically benefited from M
and A and with the change potential change at the FTC,
there may be more opening for small companies to be acquired,
and it's been even our small companies that really it's
(10:33):
hard to imagine any kind of market dominance or monopoly
kind of situations. The M and A has just been tough.
But I think that that's one element that could could
help small small caps. But we see lots of opportunity,
plenty of companies that meet our criteria that we think
(10:55):
will provide great returns over time.
Speaker 1 (10:58):
What did have a follow up? You know, one of
the things you mentioned was, you know, having kind of
that margin of safety in terms of valuations. Are there
are specific metrics you use when you're looking at valuations.
Speaker 3 (11:12):
There are many things that we look at. So we
will when we first enter, we'll look at the balance
sheet and potentially we can find hidden real estate value
or something that's not recognized. I'll look at some of
the parts because we'll have the established business and then
project what we think the new thing can look like.
(11:32):
We will look at enterprise value to EBIT. Enterprise value
to revenue, particularly useful for a company that's under earning,
which many of ours will be. When we first purchase
enterprise value to EBITDA. But then as Charlie Munger says
about EBITDA. It is something bulld ebit DA, and you
(11:56):
have to be very careful that it's not all just
getting plowed back into to stock comp or cap X.
But a unique thing that I look at is a
Berkshire Hathaways, a form of Berkshire Hathaways owner's return on
capital which takes into account capital spending, maintenance capital spending,
(12:20):
and expansion capital spending, and major movements in cash flows.
So we're not so much looking at an annual cash
flow as cash flow over the cycle of this investment
that we're looking at.
Speaker 2 (12:42):
Did the election or any of the proposed policies of
the incoming administration change any of your investment thesies.
Speaker 3 (12:49):
I mean, we're really looking out longer term, and I
think this changed in the FTC maybe something, but other
than that, not really so much. I might just mention
though that. So I described the strategy tactically for I've
managed the fund now for fifteen years, and we've really
(13:12):
been focused on infrastructure broadly defined. And yes we're growth,
so we have some elements of physical infrastructure concrete, roads
and construction companies, small bit of that, but lots of
technology infrastructure and that has meant data centers and semiconductor
(13:36):
manufacturing going back for fifteen years and even before that
in my previous experiences, those have been important areas, and
I just mentioned data centers. It was a good business,
somewhat cyclical, we really liked the business. And then in
twenty seventeen the hyperscalers started to build out, and then
(14:00):
in twenty twenty one came AI and we think we're
still in very early stages of data center build out
and semiconductor manufacturing has lots of tailwinds and it happened.
It also somewhat cyclical still but major tailwinds for leading
(14:24):
edge and for regionalization and really helping the data center
build out too. So infrastructure broadly defined, and then we
have some labs and fabs for other industries too, but
that's a major area of focus. So it's the companies
that are behind the scenes supplying the engineering tools and
(14:47):
the manufacturing tools and manufacturing services that we're invested in,
which means we're going to miss the hot new consumer
app but we've found that the cap X and where
we invest there's there's more durability to it and it
(15:10):
matches what Needham is strong at and it also remembering
my background for chip design software matches my background too.
Speaker 2 (15:19):
And what do you see is maybe the biggest risk
of stocks or maybe your portfolio and some of the
calls that you have in there in the coming year.
Speaker 3 (15:27):
We really try to look beyond a year. So uh,
we're currently I mean, what has what what hurt a
bit last year? Two elements. First, the industrial economy is
not robust and UH, you know we've we've seen weakness.
(15:48):
There's housing and autos are two areas that then ripple through. UH.
And then the other element is consumer and UH in
particular killer the lower income consumer has also been suffering.
And I don't know that either of those is there's
(16:10):
tailwinds in the next six months. So those those are
those are probably the biggest concerns. UH. And then if
you want to if you do want to look at macro,
you probably have to look at the increasing the tenure
as it's creeping up at four seven and potentially heading higher.
(16:31):
There's there's a lot of depth to to to refinance.
But I try to look forward now the five to
ten years and assume that everything that things will be
normal when you look out there.
Speaker 2 (16:48):
Yeah, and are there any sectors you find particularly compelling.
I was looking through a little bit of your portfolio characteristics.
I know you're you're have you into tech, So maybe
outside of tech, are there any you know, sectors that
that you really like at the moment?
Speaker 3 (17:02):
I like so as I described infrastructure, broadly defined picks
and shovels that enable the big, high profile industries. An
area where we added a few new investments last year
relates to skilled labor, and I can highlight a couple
(17:25):
of companies that were new additions in the last couple
of quarters. One is Lincoln Tech and the others Universal
Technical Institute UTI. And these are the skilled labor trade
schools and small market penetration, big big need for the
country and strong growth prospects, and they were kind of
(17:51):
thrown away in the mid two thousands when with all
of the for profit institutions. But these companies provide a
real service and value. They could also benefit from a
change in administration. So those are a couple. And then
(18:11):
we have a small company that provides hazardous gas detection
companies called black Line Safety that has strong growth, gaining
market share and provide safety for those for those workers.
So that's that's one area, as you earth. Yeah, just briefly,
(18:33):
I'll mention another that's related to that, which is construction
services and a data center of semiconductor manufacturing, life sciences manufacturing.
Lots of we in the country need a lot of
new manufacturing facilities. So we have invested in a couple
(18:56):
of spinouts from utilities. One is the Everest Construction Group,
which spun out of the Montana Dakota Utility MDU, and
another is Century which spun out of Southwestern Gas. And
so these these are construction services companies. Jacob's Solutions is
(19:19):
a third. Matrix Services is another. So I think that
construction services are an important area that we've invested in
the last year.
Speaker 1 (19:30):
Earlier, you kind of alluded towards, you know, helping kind
of protect the downside, and so I'm just curious if
you had any processes in place to, you know, in
terms of handling risk or volatility.
Speaker 3 (19:43):
Yeah, it's it's really around the companies. When we buy them,
we're buying them with that margin of safety and and
that that has helped. This leads to the question of
portfolio construction too. So when we first purchase, we will
buy a fifty thirty to fifty basis point position, and
(20:06):
we can take a year to build a position small cap,
maybe not so liquid. If they run away from us,
it's unfortunate, but oftentimes we have that time to take
and so we'll get our entry price, and that will
(20:26):
those entry level those hidden compounders may grow up to
two hundred basis points, and then in the transition they
may go up to three to four hundred. And we'll
be adding purchases in the late hidden and early transition phases,
and once they're into the quality they may be a
(20:50):
larger market cap, so we're not purchasing anymore, and the
market is more recognizing, so we're not purchasing more. So.
The risk protection comes from the valuation sensitivity at the beginning,
and then the portfolio construction, which keeps those early stage
companies small in the portfolio so damage is limited. About
(21:12):
half of the hidden make it to the next stage,
and then we do have some doozy of losers in
the tail of those hidden that don't make it, but
most of them we're getting our money back or a
significant portion of it, or making a small game. But
the real returns from the portfolio come from those half
(21:37):
that make it to transition and then the twenty five
to thirty percent of those that make it into the
quality stage. And over half of the outperformance has come
from about twenty companies that we've invested in over this
(21:58):
fifteen years. It ranged from five to one hundred baggers
based on the first purchase. So the risk control really
comes from that valuation sensitivity, but then letting the real
winners go and produce outside the returns.
Speaker 1 (22:24):
So how do you handle CELL decisions? You know with
both you mentioned you know there are some losers, but
also when you have a company that hits that quality stage,
how do you determine when to sell those?
Speaker 3 (22:35):
Yeah, and sometimes valuation can seem stretch. But for me,
I've learned its best not to pay that much attention
to it because sometimes, and in these twenty or so cases,
the fundamentals catch up with that valuation that seems stretched.
(22:56):
So Cell discipline. Once they hit ten percent of the portfolio,
and we've had a few that have, we will we
will trim and hold it back there. When we're also
a diversified industry fund, so we're limited to you can
(23:17):
have position. Once a position is over five percent, you
really don't buy more of it, so that provides risk
control as well. And then when we are a small
cap fund, categorized as a small cap fund, so when
they cross eight to ten billion in market cap, we
can still hold them, but we're not buying any anymore.
(23:41):
And so that's Those are some of the main elements.
Speaker 2 (23:45):
And do you have any major takeaways from the third
quarter earning season or what are you watching maybe as
the fourth quarter results roll in? Are there any concerns there,
you know, anything specifically.
Speaker 3 (23:57):
I mean, as I mentioned before, we're looking for any
type of turn in industrial economy, specifically autos chemicals, and
any relief for the for the lower income consumer. So
(24:17):
any any green shoots that we see there we're watching
for in the portfolio and out of it, of course.
Speaker 2 (24:26):
And we talked a little bit about M and A
already and how that might pick up a little bit
in twenty twenty five and beyond. Do you see maybe
the same happening for I POS or track I POS
kind of as a long term Yeah, so flow into.
Speaker 3 (24:39):
Russell I love to me so my interest in the
ventures side. We love to meet private companies. We like
to get to know them when they're private. So we
know what to do when they when they go public,
and it also helps helps you understand what's going on
in the market if you're actively in interested in private
(25:01):
companies and then taking them into the public market. It
has been it's been a tough time in particular. We
love a great small cap I PO that the big
guys aren't focused on and the headlines aren't focused on,
and doesn't run away from you. We're optimistic that the
(25:22):
new year will will bring some Yeah, and you know, Michael,
just to add further on that, I think we're also
probably in a good position for some more high profile
I pos the of the larger caps, and we will
follow them and be interested in them. But that no,
(25:46):
that's not what we do. But freeing up the mag
seven to to do M and A would be a
good a good thing for small caps.
Speaker 1 (26:00):
So we you know, we still have a little bit
of time left. So there's one question I wanted to
ask as well as you know, if we talk about
market caps, one of the things I've looked at with
small cap funds is there are a lot of companies
with larger market caps than we've seen historically. If you
go back ten twenty years do you think small cap
companies are just generally getting bigger compared to historical market
(26:23):
caps or is this kind of, you know, the way
things are going to be until there's more m and
a activity in small caps.
Speaker 3 (26:30):
Yeah. I think Socks Sarvey inz Oxley when it was implemented,
put extra expenses which made it hard to go public
as a smaller company. And then this rise of capital
that's available for late stage venture and private equity allows
(26:51):
companies to stay private longer. So it's definitely a trend.
But we still there's plenty of small caps. And the
other element is that funds have gotten larger. Pools of
capital are just larger, so they can't afford to spend
the time to get to know the small and micro
(27:15):
caps like we can. And so I think there's still
great opportunity in small caps, despite the fact it's very
different than when I started on the buy side over
twenty years ago. And you'd have plenty of one hundred
to two hundred million dollar market cap companies and at
(27:36):
this point those are considered micro caps. But we'd love
fishing in that pond because those are the ones where
you can get the fifty to one hundred x if
you get the right ones.
Speaker 1 (27:52):
Definitely. Well, we just have one question before we let
you go. We'd love to know what some of your
favorite financial books have been.
Speaker 3 (28:01):
Great question. I love that question. Well, so I'll start
with the Berkshire Hathaway Letters, and I think they're essential
reading for anyone interested in breaking into this business. And
then I'll go with any of the Warren Buffett and
Charlie Munger biographies, and I'll just highlight a couple of
(28:21):
amonger ones because there aren't quite so many. One is
Poor Charlie's Almanac, and then the second is Damn damn right,
and there is only a third. So I would read
as much about Charlie as about Warren. I think Seth
Klarman's margin safety is important. But you can't buy the
(28:45):
book because it is only an original print and they
cost a thousand dollars, but you can find the PDF
out there. I think Christopher Meyer's one hundred Baggers is
a good one. And then there's a book called the
Art of Execution by Lee Freeman Shore which was put
(29:05):
out about four or five years ago, and it's developed
He looks at investors in different archetypes and it's looking
at performance at underlying and more than just alpha outperformance
and attribution coming from allocation and selection. It's looking more
(29:30):
at decision making within the investment process. I think that's
an area that is right for research and understanding. And
then I just point one more which is not an
investment book, but I think a great book and it's
called Outlive by Peter Attia, and it deals with the
(29:55):
importance of, well, what we can do to fight the
four horsemen of disease, cardiovascular disease, Alzheimer's cancer, and metabolic
type two diabetes, and what you can do from nutrition
and exercise perspective to live a long, healthy life. And
(30:17):
I will add that that helps me helps inform me
in investing in healthcare companies which are more sick care
than healthcare, and I really look for things that are
on the right side of that nutrition and exercise model.
Speaker 1 (30:38):
Oh this is great, John, Thank you for joining us today.
Speaker 3 (30:41):
David, thank you very much, and thank you, Michael.
Speaker 1 (30:44):
Thank you both and Mike thanks for serving as my
co host today.
Speaker 2 (30:47):
Thank you, David.
Speaker 1 (30:49):
Un till our next episode. This is David Cohne with
Inside Out It two Stars of the Old Town
Host
Gina Martin Adams
Popular Podcasts
Stuff You Should Know
If you've ever wanted to know about champagne, satanism, the Stonewall Uprising, chaos theory, LSD, El Nino, true crime and Rosa Parks, then look no further. Josh and Chuck have you covered.
Dateline NBC
Current and classic episodes, featuring compelling true-crime mysteries, powerful documentaries and in-depth investigations. Follow now to get the latest episodes of Dateline NBC completely free, or subscribe to Dateline Premium for ad-free listening and exclusive bonus content: DatelinePremium.com
On Purpose with Jay Shetty
I’m Jay Shetty host of On Purpose the worlds #1 Mental Health podcast and I’m so grateful you found us. I started this podcast 5 years ago to invite you into conversations and workshops that are designed to help make you happier, healthier and more healed. I believe that when you (yes you) feel seen, heard and understood you’re able to deal with relationship struggles, work challenges and life’s ups and downs with more ease and grace. I interview experts, celebrities, thought leaders and athletes so that we can grow our mindset, build better habits and uncover a side of them we’ve never seen before. New episodes every Monday and Friday. Your support means the world to me and I don’t take it for granted — click the follow button and leave a review to help us spread the love with On Purpose. I can’t wait for you to listen to your first or 500th episode!