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Interview – Nicholas Bodnar (Micro-Cap Specialist)

(Published: November 11, 2016 at 10 A.M. EST)

Our latest interview in the Interviews with the Investing Elite Series deals with the treacherous, yet highly profitable terrain of Micro-Cap Stocks.

The interviewee is Nicholas Bodnar, a young value investor based in Michigan, USA, focused on Micro-cap stocks. Nick has been investing for over six years, and comes across as well experienced in the complex world of researching and investing in Micro-cap stocks. He makes it a point to attend annual shareholder meetings of companies, asking questions to the management, and carrying out due diligence on the business, financial analysis, before arriving at the investment decision.

After graduating from college, Nick started managing his portfolio and writing full-time through his online blog on Seeking Alpha. Writing online has allowed Nick to build a valuable network, showcase his research and continue to evolve as an investor.

Nick prefers to invest in the Micro-cap space due to the lack of competition. Smart money typically cannot invest in the illiquid names that Nick buys – allowing him to establish a meaningful edge. Furthermore, Value Investing and Micro-caps have both historically outperformed the broader market – which Nick feels, should bode well for his portfolio over the long-term.

In the near-term, Nick is likely to work as an analyst on the buy-side. Readers can contact Nick through Seeking Alpha, Twitter or LinkedIn.

Nicholas Bodnar, Michigan, USA

Nicholas Bodnar, Michigan, USA

Interview with Nicholas Bodnar

1. Please discuss your evolution into a value investor. What led you to pursue investing as a full-time activity? 

Nicholas Bodnar: I was drawn into value investing in my sophomore year in college. I have always been an entrepreneur of sorts and investing seemed like another outlet wherein I could unleash my entrepreneurial spirit. After picking up a few beginner books on the subject, it was clear to me, that value investing was the best avenue to long-term returns. Since then, I have been practicing and perfecting the value investing methodology – and will continue to do so, in the coming years.

2. How did you prepare for this? Which books did you read in the course of preparing for your value investing journey? Which are your favorite authors and books as of now?

NB: When I first started to learn about investing, I read as many books as I could get my hands on. A few of the more notable ones that helped shape my current value-oriented style were: ‘Security Analysis’, ‘The Intelligent Investor’, ’Margin of Safety’, ‘Common Stocks and Uncommon Profits’, ‘The Snowball’, ‘One Up on Wall Street’ and ‘The Sleuth Investor’.

I don’t spend much time reading investing books anymore. I believe once you have a good handle on the methodology of whatever investing class you want to practice, the next step is learning more and more about potential investee companies. Likewise, I find reading annual reports and analyzing companies to be far more valuable for the development of an investor than reading investing books.

Not that I am saying I don’t read anymore. If you come to my apartment, there are books lying everywhere. Or just ask my wife where most of my discretionary income goes. Most of the reading I do nowadays is outside of the investing spectrum. A few of my recent favorite – non-investing books – are; A People’s History of the United States, A Divine Comedy, Love and Capital, The Quest, His Dark Material Series and Atlas Shrugged.

3. Which role do you believe is tougher – merely analyzing companies as a sell-side analyst (without investing in them), or generating consistent alpha as a buy-side analyst / portfolio manager / investor?

NB: I find analyzing companies without investing in them, to be easy. Certainly, the work-load for sell-side analysts is likely to increase and the current migration into passive investing could put a lot of stress on the analyst community to come up with good ideas. Furthermore, a sell-side analyst not only has to come up with ideas, but he has to be a salesman as well. For me, it would be hard to wear different hats!

However, I feel a buy-side analyst/portfolio manager’s is a tougher job. Not only do you have to do arduous research, but you have to make a decision on when to buy, sell, hold or whatever, in the allocation seat. This can be psychologically challenging. Furthermore, as a fiduciary, you have a lot of responsibility with other people’s money – which is a whole new ballpark.

Nonetheless, both sides of the industry have their own set of challenges. The best avenue seems to be following a career path that fits your personality style – giving little regard to a potential salary.

4. In the current scenario of abundant access to information and analyses, do you think it’s become harder to find mispriced stocks and therefore generate alpha consistently, particularly among large-caps and mid-caps?

NB: Short answer, yes.

I find investing in large-caps to be tough. Not only is there a humongous amount of information continuously coming out on large-cap companies, but an individual investor will also have to compete with smart money. Moreover, it seems to be a successful value investor/contrarian in large-caps, you need to invest when everyone is fearful. Buying when everyone else is selling is tough psychologically. On the other hand, you don’t need to invest in fear when buying Micro-caps. In fact, most Micro-caps are priced with value multiples due to lack of liquidity, lack of information and sheer size – and not fear.

5. Value investing has seldom worked during long periods of bull markets, when asset prices remain unjustifiably high, prompting investors to remain on the sidelines. How does an investor choose between the two?

NB: That is the tough part of value investing – and as an investor, I am starting to feel the pinch of this prolonged bull market. It is becoming harder for me to identify decent value opportunities, without taking on measurably more risk. Similarly, the lack of compelling ideas and my concerns over an economic contraction have led my portfolio into a larger cash position.

That being said, there is always going to be value out there – it will just be that much harder to find. Thus, finding value in prolonged bull markets will require the investor to step out of his/her comfort zone and/or search in unusual places. Likewise, I have found a decent amount of value in OTC Land, and in more complex investments. Seth Klarman sums this up well in his book “Margin of Safety”:

“The attraction of some value investments is simple and straight-forward: ongoing, profitable, and growing businesses with share prices considerably below conservatively appraised underlying value. Ordinarily, however, the simpler the analysis and steeper the discount, the more obvious the bargain becomes to other investors. The securities of high-return businesses therefore reach compelling levels of undervaluation only infrequently. Usually investors have to work harder and dig deeper to find undervalued opportunities, either by ferreting out hidden value or by comprehending a complex situation.”

6. You are focused on Micro-caps, quite a few of which can be potential land-mines. It’s a high-risk, high-return game. Would you rather not stick to safer bets among large-caps or mid-caps, where capital is safer vis-à-vis Micro-caps?

NB: I find a lot of people perceive Micro-caps as high risk investments full of fraud, pump-and-dumps and venture like companies with little operating history. These risks certainly do exist; however, I do think you can successfully navigate through Micro-cap land safely, when enough due diligence is done.

In regards to risk, I feel like most people perceive risk as a function of volatility. Large-caps are less volatile than Micro-caps – giving them a lower risk-profile. However, I don’t view volatility as a function of risk. I am looking to buy businesses significantly below their implied intrinsic value. If Mr. Market wants to shoot me a quote on Micro-cap stock XYZ at 15% lower than when I previously bought it, due to market volatility, I’ll take it. As long as the implied valuation remains constant – or increases – why should I care if the market is feeling extra volatile?

Moving onto potential land-mines – yes, there are more bad eggs in Micro-cap land than in the large-cap space. This is enhanced once you get into the venture/growth stocks with little to no operating history. To avoid these potential portfolio blow-ups, I focus my energy on Micro-caps that have had an ongoing operation for decades. Furthermore, I look for some sort of asset – inventory, land, facilities, etc. – for downside protection, just in case I am in error with my analysis.

7. How feasible is it for an individual investor to only stick to Micro-caps? Their business models may not be established, or robust, management may lack the competence and vision, and balance sheets may be too small to absorb cycles and other shocks. Please comment.

NB: I think it is certainly feasible for an individual investor to solely focus on Micro-caps. Many of these small Micro-cap companies have had operations for decades. Not every Micro-cap is a start-up with little operating history. For an example, a lot of Micro-caps are community banks. It’s not unusual for a community bank to have operating history of a hundred year or more – and I think that really says something about the long-term business model, if you can find companies like that.

It all depends on where you want to focus as a Micro-cap investor. If you are looking for speculative growth companies, you will take on more risk due to the lack of perceived margin of safety. However, if you are focusing on value opportunities, there should already be a decent margin of safety where most non-systematic risk is eliminated. That being said, there is always going to be risks with any investment class – the goal is to manage and navigate successfully through the risk.

8. In the Micro-cap space, how does an individual investor carry out due diligence before investing? In case of Micro-caps, can an investor carry out channel checks, or otherwise establish if a ‘moat’ exists for the business? How difficult or easy is it for an individual investor to get access to a Micro-cap management? Even if one were to get management access, how would an investor comprehensively evaluate the management? Can an investor take a call on Micro-cap stocks, based purely on published information, and scuttlebutt investing, without engaging with the investee companies’ management? Even if one were to thoroughly research a Micro-cap, would one be able to get his finding vetted by an expert before investing, since the company is way too small for anybody else to track it?

Please discuss a couple of cases where you engaged with a Micro-cap management, or otherwise researched a Micro-cap (names not required), and came up with astounding, contrarian findings, which went against your initial perception?

NB: The due diligence process in the Micro-cap space is different for every investor. Some investors will never reach out to management and stick only with the financials. Others will build relationships with management teams and visit operating facilities frequently. My process is a mixture of both.

Before I do any qualitative due diligence, I go straight to the financials to understand the company. I try to take detailed notes, build some sort of model and go through at least ten-years of financial data. The process is arduous and takes up a significant amount of time. However, the process helps me understand business models, which is much needed in Micro-cap land.

After I have a firm understanding of the business model, I typically try to reach out to management to ask questions prepared from the initial analysis. I’ve found this to be helpful for understanding the firm’s implied valuation. The great part of Micro-caps, most management teams are open to speaking with investors. In fact, it’s not unusual to be the first investor to reach out to management in years.

Comprehensively evaluating management is tough and is an ongoing process. It’s tough to understand management’s incentive, motivation, and their long-term goals with a company. Although, reading proxies can help determine where management sits in regards to the former.

Most management teams will paint a pretty picture for their business and investors can get caught in a conformation bias trap. To protect myself from the alluring effects of management, I try to approach the situation as passively as possible. Furthermore, I won’t buy a stock right after meeting or speaking with a management team – especially if I come out of the meeting feeling good about the investment prospect. Our minds are our worst enemies – it’s probably good to understand psychology on a high-level basis for successful investment management.  

I recently attended an annual meeting of a Micro-cap company. Before I went to the meeting, I felt like the business model was relatively poor, margins were not going to improve too much and the long-term prospects looked bleak. After attending and asking questions, my views changed. The business model was and will probably continue to be poor due to the cyclical nature of the industry. However, the recent capex run-up will give the company much higher margins than they have historically done. If am right, the margin expansion will bode well for the company and long-term returns. Furthermore, talking to management at the meeting helped me understand the value of their hard assets in a better fashion.

Another Micro-cap I have done research on lately – and have actually been buying – initially wasn’t what I was expecting. When I first ran across the name, I thought that the business model was poor due to the commodity-linked revenues, that the company was going to be heavily levered and there was going to be a lack of margin of safety. After doing research, I realized I was quite wrong with my initial impression. Sure, the company was and will continue to be tied to the price of a commodity. However, the fortress of a balance sheet, value-oriented management team and passive business model makes the opportunity quite attractive.

9. What was the market capitalization of the smallest Micro-cap, when you invested in it? What has been your average holding period for Micro-caps?

NB: The smallest Micro-cap I have ever bought, had a market cap under $10 million – I believe it was $7-8 million when I bought it. I would probably go smaller if I found good value, however, the smaller you go, the less likely it is to find a decent investment. Most sub-$10 million market cap companies are still in early growth stages – which doesn’t fit my investment style.

As for a holding period, I am typically a long-term investor. Most of these ideas can take years to reach intrinsic value – or even for the market to realize the opportunity exists. I will take a short-term gain if the intrinsic value is realized in less than a year. This typically doesn’t happen, but has happened a few times to me this year.

10. Which sectors you are positive on as far as Micro-caps are concerned? You named community banks. Are there are any other sectors with promising Micro-caps? Or would you say that Micro-caps involve more of bottom-up research, than sector focus?

NB: I have never really been a sector focused investor. I will go wherever there is value. However, lately, I have found a decent amount of value in Community Banks.

Community banks are interesting. Most are too small and illiquid for institutional investors to buy. At the same time, retail investors have the notion that banks are harder to analyze – yet these same retail investors have no problem buying biotechs or high-technology companies!

There is a learning curve with analyzing and investing in community banks. However, it’s really not more difficult than any other sector. Here is the gist of the business model of community banks: take in funds by way of deposits, loan the funds out, and collect the spread, which becomes the bank’s profit.

I’ve found community banks to have a decent amount of value. It’s not unusual to find a few community banks trading below book value and growing at a decent rate. My favorite community bank is one trading below book, low single-digit P/E multiple, decent ROE and ROA metrics and a lower-end efficiency ratio.

11. Large hedge funds (AuM of say over $10 bn) are usually unable to invest in promising small-cap stocks, or Micro-cap stocks, due to the market cap restrictions. Would investors be better off sticking with small-sized hedge funds (AuM of say $250mn), who may be in a position to invest in small-cap stocks or Micro-cap stocks?

NB: I think there are multiple answers to this question. Yes, large hedge funds will not be able to invest in small companies. On the flipside, small hedge funds have the ability to focus and invest in small companies and possibly, Micro-caps – which should allow them to generate alpha. Initially, it would seem as if investors should stick with smaller funds to generate better returns. However, the size factor isn’t the only thing determining potential returns.

Returns are the function of the portfolio manager’s skills and acumen. A small fund might have a leg up on larger funds – due to sheer size – however, that small fund could also have a portfolio manager not worth his salt, compared to the fund manager at a large fund, with an impressive track record. To sum up, a potential investor should not base an investment in a fund solely on the size of the fund. Moreover, an investment in a fund should be a determination of a reasonable track record, honest and competent portfolio manager(s), a style that matches your goals, etc.

12. How feasible in your view, are purely Micro-cap focused mutual funds or hedge funds? Like the stocks they invest in, would such funds have to remain small in terms of assets under management (AuM) in order to generate alpha consistently? For one, liquidity (trading volumes) is simply not there in case of most Micro-caps. Even if a fund were to acquire a chunk of shares in a Micro-cap, exit would still be difficult, without impacting the price, and therefore, the fund’s returns and performance. Are investors in Micro-cap funds usually locked in for say a year or 18 months? How does one go about evaluating a Micro-cap fund for investing?

NB: Funds are hindered by how big they become. If you are a Micro-cap fund manager, anything over $100 million in AUM typically becomes challenging when dealing with these illiquidity issues. If you want to continue to invest in the Micro-cap market, with the ability to achieve higher returns, it’s essential to keep the size of your fund small.

It’s tough to build a position in a Micro-cap company. A lot of these companies lack adequate liquidity – requiring an investor to have patience executing limit orders. It could take days, weeks, even months to establish a meaningful position. And when a position is established, exiting the position is just as hard. Because of the illiquid nature of the Micro-cap space, a long-term vision is of utmost importance.

If you are not investing for the long-term, your returns could be hindered in the Micro-cap space. Due to the illiquid nature of the space, it can be typical for a fund to lock investors in for a certain amount of time before they can exit the fund. This is good for the fund’s long-term returns, but bad for investors, if they are in need of liquidity.

As for evaluating a Micro-cap fund to invest in, there should be a few different channel checks. It’s important to check a fund’s historical performance, the long-term goals of a fund and what their investing style is. If a fund’s style is based primarily on growth with a mixture of options – and you are looking for straight value – that fund probably wouldn’t fit well in your comfort zone.

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