Motley Fool Money - Small Cap Investing 201

Episode Date: August 20, 2022

Institutional money is not invited to this party. Bill Mann and Ricky Mulvey continue their series on small cap investing, one area where individual investors have a shot at beating the market. They look at the stories behind some companies you know (and ones you probably don’t), and discuss: - How to discover new small cap opportunities - Metrics that can tell you a lot about a company’s future - Small caps for chicken wing lovers and fans of workers' comp insurance Stocks discussed: CPNG, WING, RENT, RRGB, EIG, CTAS, PENN, NWINF Host: Ricky Mulvey Guest: Bill Mann Engineers: Dan Boyd, Annie Franks Learn more about your ad choices. Visit megaphone.fm/adchoices

Hi everyone, I'm Charlie Cox. Join us on Disney Plus as we talk with the cast and crew of Marvel Television's Daredevil Born Again. What haven't you gotten to do as Daredevil? Being the Avengers. Charlie and Vincent came to play. I get emotional when I think about it. One of the great finale of any episode we've ever done. We are going to play Truth or Daredevil.

What? Oh, boy. Fantastic. You guys go hard. Daredevil Born Again official podcast Tuesdays, and stream Season 2 of Marvel Television's Daredevil Born Again on Disney Plus. One of the best pieces of advice I've ever gotten from someone is that you should be jealous of your equity. And there are small cap managers out there who have come public without selling any shares into the public markets.

I'm Chris Hill, and that's Bill Mann, Director of Small Cap Research at The Motley Fool. Ricky Mulvey caught up with him for part two of their series on Small Cap investing. They talk about how to discover new opportunities among small cap stocks and some key metrics that can tell you a lot about a company's future. Last week, we laid out a framework for small cap investing. This week, we're diving a little deeper. Joining us again is Bill Mann. He accepted the calendar invite and he's also the Small Cap Investing Director.

The Motley Fool. Thanks for joining us again. Thanks for letting people know that my presence on this show is just due to my availability. That is correct. You can't have one without the other. First, I want to start off with some framing questions a little bit different than last time. We talked about the benefits kind of of holding onto small caps for a long period of time, but it's also like investing is kind of a game. So if small cap investing is a game, then who is this game for?

When you think about small cap investing, you're talking about companies that generally speaking have less available information. They are less liquid. And frankly, a lot of people just haven't really heard of these companies, which means that your ability just to come across them is somewhat reduced. You need to be willing to be an active participant in the markets in order to be a small cap investor in order to do it well. Now, by active participant in the market, I don't mean that you need to be a trader. What I mean is that you need to be willing to do the work to learn about companies that are going to have a lower level of information about them than you might be used to with some of the larger companies. Then on the flip side of that,

who is, you know, who are the types of investors, the types of folks you would recommend, you know, turn off the podcast, go home, stay away from the small cap game. Well, I mean, one of the things that we talked about last week, that is true on an individual level is that small caps tend to be much more volatile than larger cap companies. And that has to do with a lack of information, a lower market cap, and simply a little more obscurity and a little less liquidity. I happen to think that small cap investing is one of the areas where individual investors have an absolute advantage over institutional investors. It is one of the areas in which if you are willing to do your homework, you are able to get into companies both

earlier and in some cases, ones that institutions cannot buy. I think it's worth I know we mentioned that last week, but I think it's like kind of worth diving into that idea a little bit deeper. If you're a Charles Schwab, a TD Ameritrade, if you're a major mutual fund company, it straight up isn't worth your time to look at the small cap companies because often you're investing more money than the market caps of some of these companies. That's exactly it. And to be a diversified mutual fund in the United States, you cannot put more than 5% of your money into any. any one company. So you immediately start to think about just the mechanics of a company of a mutual fund that's got several billion dollars and that's under management.

What good is it to them to go and find a hundred million dollar company if they are limited by how much of the company that they can buy? Also, how much of the fund they can commit to that company. So there are all sorts of limitations that really make it so it's not worth their while to play in this pool, which is why it's great for us as individual investors. People get excited about IPOs because of the pops and things like that. That's not really truly where the advantage is for investors. The advantage for individual investors is investing in places where institutions cannot go. Well, and I think there is a couple exceptions.

Like, you can buy, there are small cap index funds. Like, VB, the Vanguard small cap fund is a very popular ETF with very low expense fees. I guess the only, I shouldn't say issue, but the cost of that is it's literally, it's thousands of companies within that one ETF, which in itself is an advantage. You have the diversification. But this is, to your earlier point, like, if you do the homework, there are drastic differences in the qualities of these companies. I think that's absolutely right. And research has actually borne this out. There are a much higher prevalence of companies that fail or underperform within small caps. The other reason why I think that small cap investing from an institutional standpoint is a little

bit, is not necessarily the way that you want to go, is that the definition of small caps at the institutional level is fixed. So like, for example, a company like Activision, which is now a massive company, when it first came public, it was a small cap company. But at some point, if it is a successful small cap company, it moves into the midcap space and it moves into the large cap space. So you can't continue to hold it as an institution, which we as individual investors can. I mean, very famously here at the Motley Fool, David Gardner did that with Amazon, having held it since 1998, when it actually was a small cap. So we do have that advantage. Since these are less talked about, less followed, how do you look for interesting small caps? I mean, Ricky, this is going to sound a little

diminutive, but just open your eyes. The fact that companies aren't talked about that much means that one of the things that you can do is you can just start to pay attention. Whenever you, you know, whenever you go to the store and you choose one product over another, there's a, there's, a point in time where you can say, well, who makes this? Or when you hear someone talking about being excited that a, you know, that a chain is coming to your area, or you, when you hear your kids talking about a website that they use, all of these things, they don't feel like research, but particularly in the small cap realm, they are. And so most of the companies that I own that I bought when it were small caps really came from some form of personal experience.

And, you know, this goes back a long ways. It's perhaps, you know, maybe the most famous story of someone doing this was Peter Lynch, who was the longtime portfolio manager for Fidelity Magellan, went to go have lunch one day, and he noticed a line going out the door at Taco Bell. And so he went back, and this was before Taco Bell became part of Pepsi and then part of Yom. And Taco Bell had its own ticker. And with not that much more research, he bought part of it. And that turned out fantastically well for them.

So the great news with small cap companies is that if you see something small that's well-run, that's public, that's really a big part of your research. So in many cases, though, you're looking for younger companies. And within the past couple of years, a lot of the younger companies have SPACT or IPOed at extraordinarily high levels. Now they're down. So I guess there's two parts of this question. Or I guess there's one part of this question. Market timing tends to be a losing game. But it seems like now might be a richer environment to look for small caps now that a lot of those valuations have been brought back down to Earth.

You know, I like the way that you put it that way. And again, because small caps are actually defined by the market as by the size of market cap, there were a lot of companies that were actually very small companies that had midcap and even large cap valuations that have now come way back down to earth. You know, like, for example, there is a, there's a Korean company that came public in 2021 called coupon. And it is a combination of Amazon and eBay and it's a wonderfully run company. It's now much lower in price. And so it, therefore, it is a market cap. So, I mean, it is a small cap. So in some ways, there is a level of risk that comes with smaller companies with higher share prices or higher valuations, when they come back to Earth, you get to see

that risk sort of turned on its head where the expectations that are being put into these companies now are much, much lower. And Ricky, they're really the same companies. I mean, obviously, the environment has changed from 2020 and 2021, and let's hope we never go back to that again, but at the same time, these companies are not that far away from that same part of their development curve as they were then at 60, 70, even 80 percent lower price than they were even a year ago. Last week, we talked about some of the metrics to watch. Sales, trading volume, minimum share price, all that good stuff. Let's look at some more. One of which we didn't talk about

on last week's show, but I think is worth bringing up is insider holdings. What are you watching for in terms of management owning the company that they're managing. Yeah, I think with small cap companies, you want, you want someone who is lashed to the mast of the company. And we talk a lot here at the Motley Fool about companies being founder-led. That's a bit of a shortcut to saying that you want a, you want a CEO who is absolutely positively dedicated to making sure that this company succeeds. And one way that you can see that their interests are aligned with yours as shareholders is straight insider ownership. What percentage company does the insider own?

I mean, this gets to be somewhat absurd with larger cap companies because you're talking about companies that are billions and billions of dollars. But in the smaller cap companies, If you see a company that is valued at a billion dollars and the founder owns less than a million dollars in shares, you know that this founder has in some ways traded away whatever interest he or she has in the business for some sort of upfront payment. And it doesn't mean that this isn't a talented founder. This isn't a talented CEO. but it is a way that you can determine whether they are going to be really, really motivated to see that share price go up over time.

They're not exactly playing in a contract year. They're not playing in a contract year. That's right. When you own 10% of the company, every day is a contract year. I think it's also we're talking about how these companies manage share count a little bit. Younger companies have more opportunity to widen them. is getting diluted out of a younger company that, is that something you watch is how they manage that share dilution? We had a conversation earlier before recording about rent the runway a little bit.

Right. Right. And rent the runway, I believe that their share count went up about six times between last year and this year. I mean, it's an extraordinary amount. Now, that in and of itself is not 100% concerning because they did go public. And, When a company goes public, they are, in fact, selling shares to the public. But it is a tremendous amount of dilution, and it does tell you in some ways that the insiders are more interested in selling than they are, making sure that they retain as much equity as possible. I mean, one of the best pieces of advice I've ever gotten from someone is that you should be

jealous of your equity. And there are small cap managers out there who have come public without selling any shares into the public markets. It's all secondary and pre-public shareholders who want to sell. And again, it's not a sure thing. And that a company that you see a big share dilution is a bad company and a company that doesn't dilute shares is a good company. But it's a pretty good way When you're looking at profitability, cash flow from operations, free cash flow, is that something that you're keeping a close eye on? Or are you given a lot of these companies the benefit of the doubt? Hey, these are younger. They might need some time to reach profitability.

It really depends. Yeah. For younger companies, you absolutely do. You have to keep in mind when companies go bankrupt. And in smaller caps, they really do actually go bankrupt more often than large caps do. I think that the reasons why probably makes sense, they are much more on a razor's edge. It's not a lack of profits that causes a company to go bankrupt. It's a lack of cash. You really do see situations where companies aren't showing much profitability, but at the same time, they are either generating cash flows or they're not burning that much. Now, with a younger company, that's something that I'm pretty comfortable with just so you can see the path, even though you have to keep in the back of your mind the knowledge that you are doing something

that is a little bit higher risk anytime that you own a company that is not currently profitable. But yeah, cash is king. And so what you need to do with smaller cap companies that are not generating profits or are not generating free cash flow is test the thesis. Make sure that you understand what the path is. Are they in a heavy development stage? And keep yourself honest. If you see a new excuse for why they're not free cash flow positive or they're no closer to profitability, that's a company that you probably want to get out of pretty. Off the cash flow statement, off the balance sheet. Are there any metrics or data points that you

like to look at as a small cap investor? You know, one of the things that I think is really important with small cap, with small cap companies, and this might sound funny, but I really want to see a rising number of customers. And so you have small cap companies, and sometimes they will have customers where you see the biggest customer is 60% of their revenues. And that means that this company is in some ways captive or hostage to that big company. So if you see a company with a rapidly growing number of customers, and this is something that they all disclose in their 10Ks, if you know where to look for it, there's a management discussion of the business, and they will describe how many and what types of customers they have. So one thing I love to see is a breadth and growing number of customers for these small cap companies.

All right. We've done the academic portion. Let's look at some real live companies. Get some real live fish on the line. Last week, we talked about how every company has good dysfunction. It's the question you have as an investor is what do you look past and then what sort of puts up a red flag. So let's go off that point. Are there companies that you see with some good dysfunctions? and then are there any dysfunctions that you're happy to watch on the sidelines? You know, one company that I really do admire is Wingstop. The ticker is, as you might guess, W-I-N-G. It is a franchisor of the Wingstop brand.

It sells chicken wings and boneless wings and all sorts of deliciousness in about 1,600 franchised restaurants all around the United States. One of the things that I look for with restaurant companies in particular is low food costs and low cost of production. And a very well-known CEO by the name of Saleem Basul, who was the CEO of Middleby, was a kitchen supply company, talked about companies that were in the restaurant space that treated their kitchen like a, factory. Now, that sounds terrible. I mean, you know, as a purchaser and as a customer, you don't want them to, you know, you don't want to think of your restaurant as being a factory. But what he means by that is where the steps are all standardized and it takes as much

cost as possible out of the process. And wing stop as a small cap company is one of the best in the business. Not a little bit of a pivot. Didn't they do the thigh stop during the chicken wing shortage? They did. That's right. That's one of the areas of dysfunction. I mean, so obviously, if you were to talk about the risks to wing stop, I mean, you've got the one, maybe the best one is that people will stop eating chicken wings, but I mean, come on. But chicken wings by themselves are a singular supply risk that they have. And wings, like a lot of other things this last year, the price went parabolic. And so, yeah, they shifted, I think, in a very very, very funny, clever way, and people embrace it. Speaking of restaurants, there's one that I've been happy to watch on the sideboards, and that has been Red Robin, where their dysfunction as a company seems a little bit more difficult to surmount.

It's so disappointing, isn't it? I mean, they've got a huge number of franchises. They sell wine milkshakes. How is it possible that this hasn't worked? have, so looking through some of their financials, they've had about, this is last year, not this year, 1.2 billion in sales and a price to sales ratio of 0.22, which is that of a grocery store, not a restaurant. And the reason that, well, I think there's questions for me about essentially, how are you not profitable selling hamburgers to Americans at a beloved chain? And then

number two, for me, has been management, particularly the way that they've been, handling the balance sheet. As of 2021, Red Robin had 23 million in net cash, 51 million in short-term debt, and $620 million in long-term debt. Right now, latest numbers, they have a market cap of about $130 million. Yeah, it's really incredible, isn't it? Now, they've got about 600 restaurants, 500 of which they own, and then they have about another 100 of them that are franchised. And you can't understand why a company that has franchises would have would have cash dynamics like that. Now, this is a company that has been pretty good at selling, but has been absolutely positively lousy over time at managing its costs. And it's very different from

something like Wingstop, where it's easy to say, okay, their costs are down now, are hired now because of one input or two or three inputs. This is a case of a company that has never gotten its cost structure under control. And I don't care how many hamburgers you sell. The point of a company is not to sell as many hamburgers as possible. It's not to sell as many wine milkshakes as possible. It's to make money. And they have not figured out how to do it.

And their stock is down 70% since 2015. You're not talking about a company that has seen its stock drop sharply over the last year. That is seven years worth of the market telling the company that it needs to change its ways. CEO Paul Murphy is retiring. And he is just just as an observer, I do enjoy watching how he handles conference calls. In the latest one, this is just how he opened the presentation to investors. Quote, is the headlines have become increasingly negative as it relates to consumer confidence, general inflation, and the likelihood of a recession, casual dine-in traffic

has been trending downward. Still, when we evaluate our sales and traffic trends relative to our peers in the same markets, we are outperforming the casual dine-in segment, end quote. That to me is an absolute heater telling investors, like, all right, to start this off, listen, folks, the economy is bad. It is really bad out there. I don't know if you've heard. I know I'm going to get asked about this. The economy's bad. I feel bad beating up on Red Robin. I like the restaurant.

I like going there. And I want it to be profitable. And that's why I follow it. But it's just been difficult. Let's speak a little bit more positively. I don't need to keep beating up on hamburgers. But one thing you brought up in the last show was a way to frame companies as an investor. As you say, if this company disappeared, it would be extremely painful to its customers.

This isn't exciting at all. Prepare yourself. We're about to talk about. Workers' Compensation Insurance. I'm buckled in. So we're talking about a company called Employers Holdings Incorporated. The ticker is EIG. It's based in Reno, and it provides insurance to companies specifically for workers' compensation,

which is an area for companies that is an enormous, almost open-ended risk if their insurers do not handle it properly. properly. Employers holdings, this is essentially their only line of business and they are really, really good at it. And you know, we like not to think much about insurance, but it really bears remembering how many things would cease to happen in this company, in this country, excuse me, if companies were unable to have insurance that protected them against specific types of claims and maybe at the top of the list is workers' compensation. Bill, it is incredibly difficult for me to tell if you're pausing for comedic timing or if your screen has simply frozen.

And these are the joys of remote recording. How about both? It could be. Sure, why not? Last thing, one quality we talked about in last week's episode is, hey, it's okay to look at products that customers just really seem to like. Going back to the Peter Lynch idea. So when you think of smaller companies with the products that customers really seem to like,

that's the fill in the blank. What do you think of? Well, so there's a company that's based actually in the UK, but almost all of its businesses is here in the United States, about 80% of it, called Naked Wines. And Naked Wines sends, you're going to like this, they'll send wine to your door on a subscription basis, and their customers love it, and the vineyards love it, because the vineyards get to lock in an entire vintage of wine, and it's pre-sold to vintage one, to naked wines, who then sells it out to their customers. So an absolutely wonderful model. It's a really small company, and obviously, as we have come out from the pandemic, people are leaving their houses

again. Maybe we don't need as much wine mailed to our house as we did in late 2020. But it's a It's a company that has a tremendous amount of what's called customer retention, which means that very few of people who actually try naked wines end up leaving it. Supply side. That seems kind of nice that you don't have to deal with the entire complex distribution process of all the wine shops that seem to be independently owned, multiple wine distributors. It's definitely solving a problem. I clearly see the problem that it's solving.

Yeah, and also vineyards, basically all of their investment is up front. And so there's this strange pressure because they know the optimal day to pick their grapes. I mean, these are basically very, very high-end chemistry experiments. But they also know that if they pick them, oh, just a few days sooner, they start to get their cash sooner. So if their cash is fronted to them, they can actually optimize on, the quality of the grapes, the end quality of the wine. So from beginning to end, it is a better process for really everyone involved. The other thing is companies don't just start out as small caps.

They can also go back to being small caps in this past, let's call it, bearish market. You've seen a lot of companies that went to the midcap land and then turned out to be small caps. Sure, there's lemonade, there's upstart. But also, if you look in the, we'll call it the dredges of the S&P 500, there's a flooring manufacturer called Mohawk Industries. You got your sin stocks, Penn Gaming, Win Resorts. And you also got an IT outfit called DXC technology. So let's call that.

Let's call some of these companies that Midcap Graveyard. And it doesn't have to be from an investability perspective, but are there any of these companies that went to midcap land and came back that are interesting to you? Well, we already talked about Coupang earlier, but Penn National, Penn Entertainment, is absolutely, one of those. Yes, it is a sin stock. They've got casinos in 20 states, 44 properties, and they are a management company of casinos. And I don't know about you, Ricky, but I really

do believe that 20, 30, even 50 years from now, we Americans will still gamble. Yes, I'm pretty confident in that. It's like, this is the thing I struggle with, which is like, I want to invest, It's invest in the best vision of the future. But also, I think part of the future might look a little bit like that movie idiocracy. And if I can sit on my couch and gamble on the baseball game, UFC fight, NFL game that's on TV, like, am I going to deny that that makes the game somewhat more exciting? Yeah, my best vision of the future is not in a casino outside of St. Louis on a Thursday night. It just isn't.

I think that's pretty fair. But idiocry is exactly right. And we should. We should embrace the fact that we as human beings do like to have fun and we do like

us a good gamble. We really do. There's absolutely positively nothing wrong with that. And Penn National is a company that's been incredibly intelligent about how they go about

deploying places for people to do this all around the United States for America. We're moving to the wrap-up as we're completing these two episodes on small-cap investing. Is there anything you think that we didn't talk about for the small-cap curious that you would want to make sure they know before they enter this investing space? The best thing that you can do with any small-cap is go and get their annual report and read the letter to shareholders, which will, generally speaking, be written by the CEO or the chairman, whoever the most important person at the company is.

And in those words, you can get a sense of what this company is about and what this leader is about. Because these companies are so, they are so specifically dependent upon good management, you really want to know what this management is. And so one thing that I like to do, actually, is just go on to YouTube and see if there's an interview with the person who is running the company. And in almost all situations, you'll be able to find something and you will get a sense of whether this is a person that you would like to put your money with or if this is a person who you would like to wish good luck.

It's not so fun to gamble outside of St. Louis on a Thursday night, but it is a lot of fun to read a company's annual report in its management discussion for shareholders. Bill Mann, thanks for being a part of this series. Thanks for guiding us through the small cap investing landscape. Hey, thanks so much, Ricky. As always, people on the program may have interest in the stocks they talk about, and the Motley Fool may have formal recommendations for or against, so don't buy yourself stocks based solely on what you hear.

I'm Chris Hill. Thanks for listening. We'll see you tomorrow.