Motley Fool Money - Small Caps w/ Strong Brands

Episode Date: January 14, 2023

You don’t put premium gas in a rental car. And that attitude is why we like to find companies with a high degree of inside ownership. Bill Mann, director of small-cap research at The Motley Fool, joins Ricky Mulvey to discuss: - How to think about allocation for smaller companies - Key small cap metrics to watch - Boring businesses that warrant more attention - A closer look at a real estate brokerage, a coffee supplier, and a Bitcoin holding firm that masquerades as a software company Companies discussed: CMG, WDFC, GGG, TREX, RDFN, WEST, MSTR Host: Ricky Mulvey Guest: Bill Mann Engineer: Tim Sparks Learn more about your ad choices. Visit megaphone.fm/adchoices

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I think that what you really want to do is focus on companies that seem to be doing want-to's, as opposed to has-dos, right? So you will see companies out there that are smaller companies that are going out and they are investing. They're investing in new factories. They're investing in new initiatives. They are actually showing you that they have some financial strength. I'm Chris Hill and that's Motley Fool's senior analyst Bill Mann. He's also the head of small cap research here at The Motley Fool. Ricky Mulvey caught up with Bill to talk about how to narrow your search for small cap stocks, key metrics to watch, why boring businesses can make great investments,

and one business that deals in the sexy world of rust prevention. These are the companies that are like harder to cover on the show because... Yes, exactly. I mean, we're not talking about Amazon and Netflix as much. These are the ones... These are the waters that institutional money dare not fission. And that's exactly. Right, that's why small caps are a place where every investor should try to pay attention

because it's not easy. Before we dive into some of the individual names, if you're a beginner, how do you approach capital allocation for these companies? If you're investing like, this is not your 401k money necessarily, but you're saving a couple hundred bucks or a hundred bucks every month and you're looking to invest in some stocks, how do you think about investing in small caps with that kind of budget and mindset? So one of the things I think that a lot of people tend to get wrapped around with small caps is to think of them as being higher risk because they are smaller companies.

And they think that if you're buying a small cap company that you are buying a pre-revenue company or a company that has something wrong with it, small cap companies are not the dent and scratch section. of the market. They are simply companies that some of them are newer, but some of them are just simply smaller. But you have companies that are household names that just happen to be smaller. When we first started running the small cap service at the Mali Fool, we put Chipotle in there. Now, Chipotle is a multi, multi-billion dollar company now, but it was at the time a very well-known company that was on the rise.

So I think when you're thinking about small caps, maybe the best thing to do is to not be too fancy about it. I don't know if this is good news or bad news for you in small cap land, but more companies are in the territory since we lasted this show a few months back since then. You got more to choose from. Since I think that's probably bad news. Since then, it's become more expensive to borrow money. I'd also say that investors have less patience for unprofitable companies where the real

values and the data and the friends we made along the way, let's just say. You know, Ricky, was there a question in there? I'm sorry, I just was going on to tell you about my next thing. Go for it. I have a question and I'll get to it in a sec. Okay. I think it's really important to realize that when you go to business school, and Every MBA program, every stock analysis course starts with something that's called the rational actor.

And what is actually the case is when you have a large rise in the stock market, people tend to behave the same way. And you have a large drop in the stock market, which we have had people tend to behave in the same way as well. And the way that they behave when things get bad is that they lower their perceived risk. And so they move away from these exact kinds of companies. So, yes, there are more of them. There are more small caps. Some of these small caps, I think, it should be said, are small caps on their way to zero. They may never come back to where they were before.

But those are the types of companies that we need to be focusing on? I mean, are there metrics that you're paying closer attention to for these smaller companies? I mean, for me, a couple of the ones I've been looking at lately are maybe zooming in more. on stock-based compensation and the current ratio. Yeah, I think stock-based compensation is something that you should always pay attention to in a very simple metric. And I know metrics are really, really great for radio shows. People love that, you know, to be asked to break out the abacus.

But just as a rough estimate, just taking what their stock-based compensation costs were and comparing it to their revenues. then with some companies, you'll see it's 40, 50, 60 percent. There are some companies where their stock-based compensation exceeds the amount of money they brought in, not as profits, but as sales. And you have to, as in any case, Ricky, ask yourself why. Is it because this is a brand new company with a really whizbank technology and that's just where they are in their cycle? Or are you talking about a company that is not particularly shareholder friendly and the management team is taking whatever it can, regardless of outcome for shareholder.

So it's definitely one. Like with every measure, though, you need to put those sorts of things in context. I think one of the biggest things that you can look for with small cap companies is you want a company that shows some growth in revenues, but is at the same time, not taking on a lot of debt. Yeah. Yeah. And that's, so to clarify, the current ratio is your current assets over current liabilities.

And if you're, I'm thinking if I'm doing some more, let's just say, speculative shots, that that's a way of saying, all right, is this company going to drown or be able to come up for air if the economic cycle turns in a little bit? A hundred percent. And it and it has to be said that in the same way that your mortgage at your house doesn't speak ill of you. you or your financial future, there is not much that is illegal, immoral, or fattening about companies that take on debt, but the thing that you need to ask yourself in every situation is, are they doing this because it is an advantage for them, or are they doing this because

they have to? And with smaller cap companies, usually the margin for error is a little bit thinner. So if their current ratio shows a high degree, you know, shows a high degree, of leverage in the system, maybe that's a company that you should pass by and get your excitement some other way. We'll maybe get to one of those in a little bit. The themes to watch, right now are you, when you're doing your research, are you more interested in the comeback stories, let's just call them the dogs of the S&P 500 or the ones that haven't reached that rarefied air yet?

You know, I think that there is, I think that when you come to a period of time that we're in now, a lot of times in the market, the times that feel worst are the times that when you're actually being given a gift. Because when people flee segments of the market, they tend to, they don't tend to differentiate between the quick and the dead. We saw this in 2022. What was the one segment that did that really did okay? It was the oil and gas segment. And that was because for years, people had just moved away from that segment of the market. And I think that that's true now. So rather than just saying, well, these companies were the bottom end of the S&P 500 and now they are small caps, I tend to think of it this way.

If we have as investors moved in the same direction and we've moved against or away from certain sectors of the market or certain industries, what are the best performing companies in that industry and are they small and have they been cast off in the same exact way because people are simply just trying to shed risk? And the good news in small caps, and it never feels like good news is that, you know, that's something that when you see that, there is a lot of opportunity out there. It's kind of the reverse of real estate where instead of looking for the, what is it, the worst house in a good neighborhood, you're looking for the best house in the worst neighborhood. Oh, I'm doing real estate wrong too. That's what you're telling me.

The other filter I've been thinking about and love it when we get self-referential on here, but I had a conversation with Jim Gillies and Ian Butler a couple months ago about hidden moats. And Jim described it is a willingness to claim a mountain that nobody else wants. Is that a good filter too? Like a couple examples for me are like a company like Treks, which builds, which does composite decking or fake wood that doesn't necessarily rot or like Graco, which just makes highly specialized fluid handling equipment, where you're not seeing a lot of entrepreneurs on Shark Tank trying to get into those areas. Is that a good filter to look for small caps?

Absolutely. One of my favorite companies ever is the WD40 company. And you wouldn't think of WD40 as needing its own company because all it is is the silicon spray, right? But it is a mountain that not only nobody else has, you know, is, is, you know, has tried to for, they couldn't possibly do it at this point because WD40 has come to the top of the mountain. They've built, they've built a fortress. They put a moat around it. And they filled the moat with WD40, which, as you know, is kind of slippery. So there are absolutely companies like that.

And they don't tend to be sexy. I mean, you know, nobody would, you go to a cocktail party and you say, bought the WD40 company, and people are going to look at you in a certain way and that way doesn't seem to be one of admiration. So, yes, it is absolutely the case that there are tons of companies that have those types of moats that are things that you should think about when you're thinking about investing in smaller companies. Well, it's not just that.

I've been thinking more lately about trying to recognize my biases as an investor. And one of them is I just love storylines. So it's easier for me to shut out, because I get producer brains so I can shut out a company where I'm like, ah, that's boring. And it's not that it's a bad company. I just find it less interesting than digital advertising or media and entertainment. I'm having a hard time because I really do think since you've brought up Greco or you said Graco. Greco? I have no idea how it's pronounced.

I've only seen it written. We should call them. fluid handling equipment, right? What could possibly be more boring than that? But you know what's not boring? The amount of money that that company makes. So I think that there's absolutely something to be said for the storylines that start with, why would someone be interested in that? Speaking of non-boring companies, how about some of those platformy tech companies. Because a lot, I mean, a lot of them have been coming back down to earth. I've been having a lot of debate primarily with myself lately about like a company like Redfin, where it's a company

that in my mind has a real value proposition, which is that it's cutting the 3% realtor commission and building in a model where you have a company and sales agents that benefits the buyer and seller. But it's also a platformy tech company with a ton of problems going into a down real estate market that nobody knows when it's going to end. Yeah. And Redfin, it is a company that I like and admire. I particularly admire their CEO. It was a man named Glenn Kelman.

I also admire the fact that they have built a really, really powerful brand, right? Because of that process, because of the promise of lowering, of lowering, of a really powerful brand. lowering the Realtor Commission of making themselves to be a default substitute for a, what is a process that, let's face it, everybody hates. Like, everybody hates this process. So you have Redfin, which right now is in a market that is retrenching, but I don't think that you could suggest to me. I mean, not even you, Ricky, would suggest that we are done.

buying and selling houses in this country. No, people need to move. People need to move. People are going to need to move. Maybe they don't want to move as much as they did even a year ago because of interest rates or things of this nature. But they need to. You're talking about a business that at its core has its own velocity. It's just going to continue to happen.

And Redfin, for whatever else you want to say about the market right now, and whatever, you know, they have made mistakes along the way and they've been very open about the mistakes that they have made. But through those kinds of mistakes and through those kinds of learnings, if you've got a CEO like Glenn Kelman, I think you're going to end up with a very powerful platform that has a lot of advantages when things turn around. Something that I'll give him credit for it because I'm about to not give him credit for a few things and the company take credit away for a few things is their layoffs are terrible. And the way that Redfin has managed them versus their competitors, like there's one

real estate brokerage website that I don't want to name, the CEO goes on CNBC and says, this is our third round of layoffs. However, I'm confident that this is the bottom of the market and things will turn around from here. And Glenn Kellman does the exact opposite, which is we're doing layoffs. This is why this could last. months or it could be years. I don't know. And part of the reason is because he was the CEO of the company through 2008, I think. Right. Right. So which are you saying? Which do you prefer? What do you mean? Like, I know, I prefer the lack of confidence because I rather have a CEO that's learned from history versus making a confident forecast. Yeah, I think it's, I completely agree.

Now, I do think that CEOs know very well that they are, you know, that part of their job is, is rallying the troops and, you know, speaking to their company's strengths. But there is a sense of, a sense of humility and probably a better way to put it is a sense of their own role in reality. It's reality-based management, which you don't see with a lot of companies. And yeah, I happen to agree with you that that is something that you should absolutely admire about how he is making those decisions. And because, you know, you're right, they're painful decisions and he doesn't want to be where he is, but he's not overselling what's coming down the pike. Yeah. This is a company with, it's got about $500 million in cash on the balance sheet,

1.9 current ratios. We continue that theme. And as we continue this therapy session, the things I'm really concerned about, Bill, it's still issuing too many shares. It's got high stock based compensation. And you like companies where, what is it, the leadership is tied to the masks of the company. And this has relatively low inside ownership where three and a half percent of the shares outstanding belong to insiders. Yeah. And I think that those two things are, especially with a small cap company, right? I don't think that you could go to a massive company. Like the person who is running IBM right now, you would not expect them to own 15 percent of the company. You would expect

the founder or the CEO, long-time CEO of a small-cap company to own more than he does. And unfortunately, for companies that depend on stock-based compensation, I think you're going to see a lot more dilution in 2023 than you did in 2022, because a lot of times what companies are doing or are saying, Ricky, your stock, your stock, your stock base compensation. Last year was $50,000. This year, we're going to make it $75,000 because you're incredible at what you do. But if the stock is down 40%, what you're talking about is a number of shares that it isn't 1.5 as much, it's three or four times as much across the board. Yeah, I should note that I do own stock in Redfin, but I wouldn't say it's, I have a ton of confidence

at it. Speaking of it. But Ricky, if you can't, if you can't, if you You can't pick out the things that are risks or are negatives about the company that you own, because every single company has them, every single one. If you can't do that, I don't know that you're thinking about it deeply enough. Fair enough. But on the theme of inside ownership for these smaller companies, I mean, especially in tougher business environments like right now, how do you see decision-making change, whether it's capital allocation, hiring, change when your company inside?

owners own a lot of the stock. It's not so much that I can point to changes. What I tend to think that you see is more decisions that are optimized on the longer term in the same way that nobody puts premium gas into a rental car. I think that if the management team does not have that deep incentive of ownership of the company, there is a risk that they will make decisions that are much more short-term oriented. And while we all love to see a stock go up very quickly, you know, because of short-term things, they aren't necessarily sustainable over the periods of time that you would want that to happen. Don't want to put premium gas in it. I'm going to steal that line about premium gas in a rental car. One small cap that I want to check up on that I know you have

more negative feelings on that actually you've predicted that they would do something on this show is micro strategy. It's a Bitcoin holding firm that Masquerades is an enterprise software company. Its CEO Michael Saylor had declared that it will never not ever sell Bitcoin. Turned out that it sold more than 700 Bitcoins, an average price of about $17,000 late last year. Never came pretty fast, didn't it? came pretty fast. How'd you see that one coming? They had to. I mean, I take Michael Saylor at his word that he doesn't want to sell any share any of their Bitcoin. And I do think how you describe micro strategy is fairly accurate. They have almost no revenues from their software operations.

It is a Bitcoin, it's a Bitcoin holding vessel is what it comes down to. But there's it's also a leveraged Bitcoin holding vessel. So to the extent that they have to fulfill the terms of the death that they hold, sometimes those choices get taken out of their hands. And margin calls tend to, you tend to pick up the phone on those. Right. You'd best. Well, I've been thinking about this story quite a bit because this is a leader where I've found some of my investor biases where I believed what the guy was saying. about the future of Bitcoin. What was it? This is like owning blocks of Manhattan in cyberspace. And there was such a confident and charismatic delivery with it that I didn't buy the stock,

but I found him credible. And it's one of those things where, for me at least, it's been a lesson of don't necessarily look for charisma and overdone confidence in your company's CEOs. Yeah. I think it's so important because you've really do, and I'm not saying that someone who also happens to be really good at sales or, you know, at, you know, at getting you to buy into what it is that they are trying to do is snowing you. I wouldn't suggest that. But you do need to keep your, your cloak of skepticism up as high as you can. you are dealing with an incredibly charismatic CEO. And whatever it else it is that we think of Michael Saylor, he definitely absolutely is that.

As we continue the theme of current ratios, Micro Strategy is a current ratio of about 0.8. And that's basically the same as Kroger, but what are numbers without context? Exactly. This was in the theme of debt. Did you get a chance to check out West Rock Coffee? Yes, I did. So, West Rock Coffee is another small cap that I wanted to check in on.

We've had the CEO on the show, and I think it's interesting because it went public via SPAC, but it actually has customers in revenue. Now, I avoided investing in it because I personally liked the CEO, and I am noticing that bias where I recognize charisma and that sort of thing. And I could be totally wrong. I want the company to do well, and it has a real customer value property. position selling coffee and tea extracts to different quick service restaurants, trying to build a facility to make ready to drink coffee. When you looked at it, what were your impressions

of the company? Well, I have to belie that when you talk about small caps, you have to be a little bit careful because I spent a little bit too much time when you sent this over instead of looking at Westrock Coffee. I looked at the Westrock Corporation, which does corrugated cardboard. I thought, well, that's kind of an interesting sidebar company to go along with coffee. But they actually are two different businesses. And, you know, I think that, you know, I think that as you're talking about any company that's in, you know, it's in consumer packaging. And I would really describe this as being a supply chain company, but they, you know, they do provide their own goods.

Incredibly well capitalized. It seems like, you know, the CEO is a man named Scott Ford. And it seems very, very much like he has, he's got a great experience in the industry, in the consumer packaging industry. So they're not particularly brand driven. So I actually think that this company is pretty interesting as one that, as you say, came public through SPAC, which while SPACs were neither in moral, illegal or fattening, they were a way for a whole lot of lower quality businesses to get onto the public market.

But that absolutely doesn't mean that all of the companies that came public via spec were lower quality. All right. So if you're fishing in these waters, you've bought a small cap company. It's probably more difficult now than it was 12 months ago to look at your investments. What's your mindset advice right now? If you're fishing in these waters that institutional money dare not enter. I think that what you really want to do is focus on companies that seem to be doing want-to's, as opposed to has-dos, right? So you will see companies out there that are smaller companies that are going out and they are investing.

They're investing in new factories. They're investing in new initiatives. They are actually showing you that they have some. financial strength. And it may not make the company look better over the short term because any type of an investment like that does, in fact, reduce their overall capital. But it may be a sign that they have a degree of confidence that you just can't find from a company that just has a manager or CEO who's talking a big game. Look for the quieter companies who are expanding in some ways. seem like they're being very smart about their application of new capital.

And I think you can find some winners if you really, really focus on that. Something about being opportunistic when others are fearful. That's exactly it. Bill, man, always great catching up with you. 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 ourselves stocks based solely on what you hear.

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