Motley Fool Money - The Small Cap Show

Episode Date: March 2, 2024

With small caps, come great thrills. What about great rewards?  Ricky Mulvey caught up with Bill Mann, a lead analyst at the Fool and our Director of Small-Cap Research, for a primer on small-cap investing. They check in on a handful of different small caps and discuss: If the disappearance of “the small-cap premium” is a win for investors.   How to navigate environments with limited feedback. The value (or lack thereof) of book value.  Tickers discussed: WINA, COST, DDS, BOC, FVRR, ASR, BRK.A, BRK.B Host: Ricky Mulvey Guest: Bill Mann Producer: Mary Long Engineers: Rick Engdahl Learn more about your ad choices. Visit megaphone.fm/adchoices

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What you're really looking for in a small cap company is the opportunity to invest in a Home Depot when it is a couple of shops in Atlanta or at Chipotle when it is 400 stores, most of which seem to be concentrated around Denver. So there is absolutely something to be said for identifying companies that have a chance of growing large and understanding that in a lot of lot of those situations, the company is going to disappoint you. I'm Mary Long, and that's Bill Mann, director of small cap research at the Motley Fool. Ricky Mulvey caught up with Bill to check in on, you guessed it, small cap stocks. They also discuss the advantages of being able to play below the $1 billion barrier,

truths in horse racing and investing, whether institutional attention is a positive or a negative, and a company that pays dividends in dollars and snacks. It's the Small Cap show. So let's talk about Small Caps with the Motley Fool's director of Small Cap Investing. It's Bill Mann. Thanks for doing this again with me. How you doing, pal? Doing pretty well.

Every so often we get together where I have a list of very specific questions about very specific companies that we normally don't talk about on the show. And I invent very specific answers. That's perfect for everyone. And I want to get there. But I also, you know, investing in the smaller companies, the small caps, this is sort of the black diamond skiing, if you will, of stock investing. So I want to set the table a little bit with some macro stuff. So just so someone who's newer to investing can kind of get their expectations right. And we got to be honest.

It's been a rough stretch for the small cap class. The Russell 2000 is up about 30% over the past five years, which is well under the return for the S&P and the NASDAQ. So I will start with an easy question, what gives? Okay. I'm going to start with a, I'm going to start with a trivia question for you. Yes. How many of the seven largest companies in America are in the Russell 2000? Zero.

You did it. You did it. You got it right. There was a trick question. None of the companies that have. have corresponded with the overwhelming percentage of gains in the S&P 500 and the NASDAQ are in the Russell 2000. Most of the companies that are in the S&P 500 in 2023 actually trailed the performance of the S&P 500. So the same exact companies that are in the index failed to beat the index.

So we have to recognize the fact that it's been a very useful. unique stretch where the largest companies are now a huge part of the biggest indices, and they have been amongst the biggest gainers. Okay. So it's tough to make a broad judgment based on looking at the returns of a couple of indexes, just a little. Bill is pointing his fingers together in a small, small way for the listeners. One of the appeals of small caps, we've talked about it on a previous show,

is that the institutional money can't fish in these waters. The thing I want to follow up about, though, is that there's also a lot of fish staying out of the water because it's a real pain to be a public company, and there's a lot of private equity firms keeping these smaller companies private. So we're going to look at some specific examples, but you've been following this stuff for a while. Do you think there's a bigger quality problem with the small caps that are out there today than a decade or so ago? You described this as black diamond skiing earlier, and I think that that's exactly right. And more to the point, there's been very little payoff on average to go skiing on the black diamonds over the last 15 years. It's been one of the longest stretches of underperformance of small cap companies to large cap companies ever, as long as we've been measuring. I think it's really important to note that when we're talking about small cap companies,

cap companies, that these are companies, not just that institutional investors can't invest in, but ever since the mid-naughties, it doesn't make any sense for Wall Street analysts to really cover them. There isn't enough institutional trading. There's not enough money to be made. And now that we're in a commission-free environment for a lot of companies, spending their time saying, hey, here's a really interesting $800 million company. It's not worth it to the banks. So there is in a time in which there's an endless amount of data available on the internet because of the internet, there is very little in the way of attention being paid to these

companies. So I think that there really is something there. Yeah. From what I've heard from institutional type investors, there seems to be this $1 billion barrier, which is, you know, we really can't focus on companies. that don't hit that that comma mark that we'd like to see. Isn't, isn't it great that that's something that we have as an advantage, right? If you think about an institutional investor, they say like, well, if it, if it trades less

than $20 million a day, it's not worth it for me to do. Guess what, Ricky, that's fine for you and me. It's just a matter of identifying what the good companies are. I would say I'm not as arrogant enough to say that $100 million is not a lot of money. There's also something with the macro stuff I want to follow up on. And this is, you had a conversation with Oswath Demoder that we put on the show. And you revisited the idea of the small cap premium. And I actually can't figure out if this is, the lack of it is a good or bad thing for investors.

Part of the conversation with Oswath Demeter and I wanted to follow up on is he basically said, I can't think of a good reason why small cap stocks should earn a higher return than large cap stocks by themselves, end quote, the idea being is that if you're a small company, you have more room to grow. So investors were paying a premium for that. That seems to have disappeared. Is that a good or bad thing for people looking at small cap companies? So the point that he was making is that in aggregate, this is the case, that there's no real reason that there would be a premium for small cap companies. And in some ways, if you think about it, a small cap company that has come public, they are taking a small cap company that has come public,

they are taking on a pretty high, a pretty high cost in terms of, in terms of regulations, in terms of the attention that is being paid to them. So what we are looking for are the extraordinary small cap companies. And I think that there is, I disagree with him in that regard. Actually, it's not even to say that I disagree with him because he made this point as well. There are companies within small caps that have those characteristics where they can grow, for a really, really long time. But that's not the average small cap company. Yeah, the point was essentially if you have an aggregate number of small cap companies,

you won't get that premium because of the law of large numbers, basically. Yeah, basically that. So, okay, I feel like we've, we've had a little bit of a negativity corner here about it being, it's really difficult to be a public company, especially if you're small. Maybe it's, you know, maybe it's not even classy to be a public company under a billion dollars to, to the eyes of the institutional investors, it's so hard to find these companies. You're talking to a newer investor right now. You know, why are small caps interesting to look at? Why even play this game if you're someone who's interested in picking stocks? Well, I think first of all, you have to get your mindset

right when you're going into small caps because they are as a group, they're going to be more volatile. There's going to be less information about them. And you're not going to have the same level of confidence. You know, when you, when you drive down the street, you see Exxon's everywhere. You walk into, you know, you walk into Whole Foods owned by Amazon and everyone is carrying Apple phones. That is not the case with the average small cap company. You don't get that feedback loop. And so you need to be prepared for a real lack of information. You need to be prepared for a lack of the feedbacks. But everybody else has that same lack of information. And that, and that same lack of feedbacks. And it is certainly definitely the case that in a paramedual

market, like the stock market, similar to horse racing, one of the ways that you can gain an advantage is going to where nobody else is looking before they might come looking there. That is, it's simply a fact. And it is, it's inexorable. It is true. And it will continue to pay off over time, but the mindset that's required to do it is something that not every investor has or should have. So creating that mindset, how do you set your expectations? Is this something where you want to follow a few companies very closely and then maybe occasionally make investments, make, or despite the law of large numbers, do you want to essentially, you know, use that lack of information to your advantage, pick a bunch of companies, make it a small part of your portfolio and hope one

of them really takes off. Yeah, I think it's, I think it's a little bit of both. One of the things that you can do in small caps is you can become very smart about a sector. You have to be comfortable with not only being wrong in a lot of times, but seeming to be wrong, which is the market is moving against you. You can't really use that as your signal as to whether you're correct or not over the short term. There is something definitely to be said in small. small cap investing in getting to know an industry or a trend or some sort of factor of the economy in making that something that you study very intently. And this might be heretical to the motley fool style of investing.

So I'm being careful saying it. And I'm saying it's an urge. It's not something I actually practice. But among the small cap companies that I followed for a few years, they moved so drastically on just a little piece of news. And I find myself wanting to trade more with with small cap companies because I think, you know, this was one analyst downgrade. Maybe the stock should be down by a third. Is this something like is this something you deal with?

How do you how do you deal with that sort of urge in taking in wanting to be more active when these companies move on just small bits of information? You find yourself all the time saying, oh, this can't be right. Yeah. You know what I mean? Like there's no way that they've gotten this correct. This can't be right. Why is this stock up 27% today because it beat by a penny? This is just a reality of investing in companies that there's not a whole lot of information on.

When new information is dropped onto the pile, it's analyzed very quickly. I think the thing to do is to recognize the fact that if you are investing in a company that requires a very small change in reality for a very large, change in market returns, that probably you're cutting it a little bit too close to the line. What you're really looking for in a small cap company is the opportunity to invest in a Home Depot when it is a couple of shops in Atlanta or a Chipotle when it is 400 stores, most of which seem to be concentrated around Denver. So there is absolutely something to be said for identifying companies that have a chance of growing large and understanding that in a lot of those situations, the company is going to disappoint you.

Yeah. Sometimes during this podcast, Bill is going to be talking to the listener, but I appreciate you talking to me for that one. There's also a corner of these companies where it's tough to do the outreach. And sometimes you don't want too much focus from institutional investors because they're not exactly helpful all of the time. Just because you're getting attention from institutional investors doesn't mean they're helpful. So they don't communicate a ton. They're not doing a ton of flashy press releases, but they're still great companies. I think one that we both agree on is Winmark,

which is a, it's a resale company. And I think something interesting happened to the company this year, which is that it crossed the billion dollar mark and then the stock surged. And I don't think, I love the company. I don't think it fundamentally changed. over the past few years, though. There is absolutely truth to the fact that institutional investors have mandates, and those mandates are written down. They are canonical law, and they say things like our investing universe is every company larger than a billion dollars.

So when a company gets above a billion dollars, there are institutional investors out there who basically have, whether they liked the, the company as a $990 million market cap company or not, they couldn't buy it without violating their policy. So there is absolutely something to be said to that. Now, the flip side of that is, is this a good thing or is it a relative thing? Like, you know, on the one hand, we love our stocks to go up. Like, you don't buy a stock going, hey, I'm just here for the, you know, I'm, I'm, I'm just here for the snacks. Like you want. Right. Well, I mean, some people do that. Is there a company that pays dividends and snacks? That would be great.

I'm going to keep, I'm going to think. All of this to say, Ricky, is that institutional attention is really neither a good thing nor a bad thing. But it does. It can be a catalyst if you were in fact right about the company to get it revalued higher simply because it moves onto the radar screen of more. institutions and more money that can buy it. So I think the Costco hot dog counts as a snack dividend because it's something you're absolutely, you have access to below cost. You get it as a part of the membership. So I'm counting that is the snack dividend. I'm going to stay on windmark for a second because it likes to fly under the radar. We've actually had the CEO Brett Hefis on the show, but he doesn't do

earnings calls. And in the comment the commentary for the latest annual report, I will read all of it Now, quote, our 2023 results reflected positive performance by our franchise partners, however, growth was lower in the second half of the year, end quote. Should we pause for a second just to see if there's more? You can, but there's not. That was it? Yeah. And part of it is, you know, we'll let our business performance do the talking.

And I appreciate that. There's some other small cap examples that I think do this. Dillards, which I've talked about on the show, so I don't want to get into too many details here. They do that as well. They're not particularly interested in engaging with analysts because the business, the business performance can do the talking. Are there any small, smaller cap companies that do that, that avoid the spotlight deliberately, but maybe deserve some attention? I mean, I feel like a lot of them do. And I'm not sure that I would put a whole lot of, you know, of meaning into how companies interact with the investing public in terms of.

of their communication style, but there is something that's really important about what Brett Hefis was saying. He was not quoting non generally accepted accounting numbers. He was like, these are our earnings. These are our cash flows. These are not our cash flows when you take X, Y, and Z and X, Y, and Z are all things that make the company look better. So if there is a longer explanation, that's really okay with me. But the explanation should not be in my mind, hey, I'm trying to sell you a story and I'm trying to sell you a stock. Well, there are companies, though. I'm going to disagree. I think communication style is important, but I'm also in that business. So I'm incredibly biased in making that statement. And I think there is a company that's a

small cap company that's followed by the fool. It's Boston Omaha. It's sort of a mini conglomerate that welcomes comparisons to Berkshire Hathaway. And this is one where I think maybe it should have a little bit more of a clearer communication plan explaining to analysts in the investing public what they're doing because I kind of have a theory right now. It might be trading it at like a quote unquote conglomerate discount because it's such a small company with so many tentacles and it's incredibly easy if you're an investing analyst to say I'm putting this in the too hard bucket because.

it's too small and also there's a lot going on with what they're doing. Ricky, wouldn't you say that welcoming comparisons to Berkshire Hathaway is in some ways a communication strategy? Yes. I would say that is a communication strategy. Yeah. Yeah, which is to say that what they are doing, and I don't disagree with you with all of those other things.

I think that's right. But what they are doing in this case is they're shortcutting a whole lot. of a whole lot of communications that they don't need to have. They basically are saying, hey, what Buffett said? We kind of believe the same thing. What other questions do you have? I think it is a better strategy across the board to say less than more. So generally speaking, I think that that's, I think that that's in fact true. I don't, I'm always nervous when I'm being sold a stock. Is it right? It just, it doesn't seem to me like it is an advent of advantageous environment for me to be buying when I am being sold something. But at the same time,

in, you know, in general, I would say less is more. But sometimes companies really do, in the case of Boston Omaha, I would think would be one of them. They could explain more so that you've got a fuller picture of what it is that they're trying to do beyond, hey, we want to be like Buffett. Yeah. And we're doing billboards. We're doing broadband internet. They've got an investment with with sky harbor right now it's also going for less as we talk it's going for less than book value and i know speaking of buffett he's he's had different opinions on the value of book value is that do you think that's important right now for boston omaha or for someone looking at the company uh you know in our conversation with uh with aswath demoder and you know

he had some some real things to say about how book value does not matter as much as it used to because we are in information economy? Like, how do you value a bit in book value, right? It's, you know, it could be anything. It could be, it could be one part of a color blue. It could be part of a code that is the core to Amazon's ecosystem. So it does matter in the case of Boston, Omaha, but it is not something that I would say is going to be a real signpost as to whether a company is going to provide value for you long term or not. Okay. I want to check in. Now, on a small cap that you follow closely, we got a great question from Sam and Astoria, New York. It's about Fiverr, which is a marketplace for services like logo design, voiceovers.

You can have someone to edit your book. They do content creation. It's basically a marketplace for digital services. And he wrote to us, quote, Hey, Motley, Full Money Team, is the future bleak for companies like Fiverr in Upwork? I bought shares of Fiverr in early 2020, an unfortunate peak with the thesis. that the increase of remote work and the ease of contracting roles like developers and designers, that this would be a tailwind for Fiverr. But with the rise of generative AI, is this one of those companies that's becoming irrelevant? There was an episode last January where Dan Pink discussed

how generative AI is a boom to the bottom tier of workers in the knowledge economy. But does that mean it would be cheaper and easier to use AI in these programs rather than contract someone from Fiverr. We'd love to hear the team's thoughts in full on. AI doesn't program itself. First and foremost, so while Fiverr and Upwork have had a fairly sharp dislocation with certain types of jobs disappearing or becoming, becoming less needed in a world of AI, the thing that has happened definitively at places, you know, at Fiverr is that some very sophisticated buyers of gig work are posting thousands of jobs where AI is at the center of the job itself.

So what you're having right now is a bit of a dislocation. So there are some things that are disappearing at Fiverr and Upwork, and then there are some things that are reappearing. I don't think that it's an accident at all that we are seeing a large amount of layoffs at a bunch of at a bunch of tech companies simply because they went into the pandemic in the midst of a hiring binge in the thoughts that things might not change the way that they have changed. And, you know, I never want to, I never want to point to layoffs as being anything other than a human tragedy for the people who are being laid off. But a lot of these jobs are going to be taken over by short-term work and the best platforms that exist are Fiverr and

Upwork. So, yeah. I mean, some of the, I do think there's a narrative problem around Fiverr, though, because they're getting more enterprise customers to do these big projects. But when I look at the website, it's like, hey, do you want to hire someone with a mid-journey subscription to create a logo? And I don't know. What is what does Fiverr need to do to turn that narrative around about how AI affects the company? Does it? Is it doing a good job?

I don't know if it's doing a good job or it's doing an optimized job. You might even start looking at the name of the company, which came along as like, hey, five bucks and someone will do a task for you. Yeah. So I think that they could do better, but I do think that they have done a very, very good job in terms of shifting their business to the realities of what are some very promising developments in the market today. This is on the complete opposite end of the spectrum of Fiverr. It is Grupo Aeropertario del Soreste. It is the complete opposite end of the spectrum of small caps.

We've talked about companies where they have, you know, maybe they're in a couple restaurants in one city and then they can greatly expand. There's also small caps that have a niche and a moat and they have the ability to protect it. This is a group of privatized Mexican airports where most of the traffic, I think, comes through Cancun. And I know you follow this company. This is what I've been looking at. But the question I'm struggling with is basically why is this more attractive than a regular

American utility stock pays a high dividend, fairly low earnings multiple, and it has a lot of the commonalities where it has a moat, but it's not going to necessarily scale quite like the companies we've just talked about. Why is it? So the question is why is it more attractive than a utility stock? That's a fascinating way of framing it up because in some ways you're talking about the same exact type of economic model, a really high fixed cost and then basically a guaranteed rate of pay that comes from negotiating with the government. I think that the overall difference here is the fact that we're talking about Mexican airports. And there is a growth curve there that is much sharper than utilities. And there are ancillary services that they can add that utilities

can't necessarily do. Things like cold storage, things like logistics, things like additional parking. There are so many different areas where the concession gives them some optionality that utilities don't necessarily have. I know this podcast was for listeners. It was also for me.

Bill, thank you so much for joining me on this and I hope we can do it again in a few months. Thanks, Ricky. As always, people on the program may have interest in the stocks he 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 Mary Long. Thanks for listening. We'll see you tomorrow.