Leveraging Active Investing with Small-Cap Stocks

Leveraging Active Investing with Small-Cap Stocks

By Julie Hammond, CFA

Posted In: Drivers of Value, Equity Investments, Portfolio Management

Elizabeth M. Lilly, CFA, finds her investment opportunities in unusual places. After breaking her iPhone screen in 2016, she did some research and discovered ZAGG, an under-the-radar stock that produced replacements. It turned out to be a serendipitous find.

That general curiosity about the world and how it works has served Lilly well during her 25 years as a small-cap stock portfolio manager. She believes that small-cap stocks offer a tremendous opportunity to those willing to do the research: Small-cap investors can generate returns if they dig deep into a company’s financials, conduct multiple valuation analyses, meet face-to-face with management, and have a patient, long-term focus.

Lilly, who recently founded the small-cap value manager Crocus Hill Partners, outlined her investment approach at the 2017 CFA Institute Equity Research and Valuation Conference.

The Case for Small Caps

Even after a quarter-century in the space, Lilly said she is amazed that inefficiency still exists in the small-cap market. If anything, the sector may have gotten even more inefficient over the years. Lilly explained that the stocks she invests in are sparsely covered by Wall Street analysts, are more volatile, and have lower valuations.

Lilly believes a number of market trends will continue to propel the sector:

1.      Small caps typically outperform in rising interest rate environments. There’s a misperception that all small-cap companies are burdened with a lot of debt, Lilly said. In fact, many continue to actively deploy cash through dividends and stock buybacks.

2.     M&A activity is often a catalyst for growth. M&A activity targeting small- and micro-cap companies has continued at a robust pace. This has been driven by activists encouraging companies to unlock value and large firms seeking growth through acquisitions.

3.     Small caps outperform over long periods. The idea of a “small-cap premium” has been challenged in the past but has not been disproved. Aswath Damodaran has noted that small companies are more likely to be overlooked and the undervalued ones likely to have bigger payoffs.

4.     Volatility equals opportunity. Small-cap investors can often use market turmoil and liquidity events to their advantage.

Valuing the Business

Lilly enjoys rolling up her sleeves and doing the hard analysis necessary to value small businesses. She looks for off-the-radar companies, conducting intensive qualitative and quantitative analysis to uncover hidden value. “We look closely at the balance sheet, income statement, cash flows, and margins and the interrelationships among them — five years back and five years forward,” she said.

Valuation is an imprecise art, but Lilly explained, “Our aim is to buy $100 worth of value for $65. We look for enough downside protection through a margin of safety with significant upside potential.”

She also looks for a catalyst that will ultimately unlock the stock’s value. This catalyst could be a new leadership team, a new market in which to sell products, the selloff of underperforming businesses, renewed focus on high-achieving ones, or exogenous factors like industry consolidation. “You need a catalyst to surface value,” Lilly said, echoing a bit of wisdom she learned from working with Mario Gabelli.

Lilly is most interested in management’s long-term strategic vision for a company. That means at least a three- to five-year time horizon. Her questions for management focus on its process for allocating capital and whether all its business segments are earning their cost of capital. She also likes to see incentives that keep the board and management focused on the long term.

The most crucial piece is her assessment of the C-suite: “You’ve got to visit the headquarters and look in the whites of the eyes of the management team,” she said. “This is something you cannot get from quarterly conference calls.”

Sound Advice

Earlier in her career, Lilly learned value investing techniques under the tutelage of Robert Bruce, founder of the Bruce Fund, and Warren Buffett. “The best advice I ever received from Warren was to know what you own and really understand the business you’re investing in,” she said. Her mentors also conveyed the importance of working with good people and emphasized that management can make the difference between a good investment and an outstanding one.

In the end, Lilly said, “You have to ask yourself: Do you believe in management and do you want to be their partners?” Understanding the goals and incentives of company leadership is essential to evaluate whether it can execute on its vision and whether it’s focused on creating value or becoming big.

“If you ask me why I love what I do,” Lilly said, “it’s because you can generate very high returns over long periods.” She thinks that small-cap stock investing is an excellent way to leverage active management, if you do the research and are guided by your curiosity.

Like Buffett, Lilly clearly enjoys her work. And who wouldn’t? It’s a rare opportunity to transform iPhone mishaps into alpha.

Happy investing