As part of our ‘Best of 2020 Acquirers Podcast Series’, earlier this year Tobias had a great interview with Connor Haley. Connor is the Founder of Alta Fox Capital Management and a Harvard graduate, Magna cum laude. He’s also the number one ranked investor in the MicroCapClub, and he’s got some fascinating approaches to investing. During the interview Connor provided some great insights into:

• How To Find Investing Gems That Don’t Screen As Cheap
• From #1 Chess Player In Texas To Goldman Sachs
• Small & Micro-Cap Stocks Provide Individual Investors With A Substantial Advantage
• The Best Opportunities Are Stocks With A Masking Effect
• Sometimes Businesses Aren’t Actually What They Say They Are
• The 3 Investment Edges Every Investor Should Be Seeking
• Risk Management – Look For Businesses That Can Control Their Own Destiny
• Like Lake Wobegon, Small And Micro-Cap Managers Generate Above Average Returns Over Time
• There Are Some Unique Risks In Small and Micro-Caps
• You Need A Different Valuation Approach For Small And Micro-Caps

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Full Transcript

Connor Haley: I’m ready.

Tobias Carlisle: All right, let’s get underway. Hi, I’m Tobias Carlisle. This is the Acquirers Podcast. My special guest today is Connor Haley of Alta Fox Capital. He’s a Harvard graduate, Magna cum laude. He’s the number one ranked investor in the MicroCapClub and he’s got a some fascinating approaches to investing. We’re going to talk to him right after this.

Speaker 3: Tobias Carlisle is the founder and principal of Acquirers Funds. For regulatory reasons, he will not discuss any of the Acquirers Funds on this podcast. All opinions expressed by podcast participants are solely their own, and do not reflect the opinions of Acquirers Funds or affiliates. For more information, visit acquiresfunds.com.

Tobias Carlisle: Hey Connor, how are you?

Connor Haley: I’m doing well. How are you?

Tobias Carlisle: I’m really well, man. First question, what does Alta Fox mean? What’s the name?

Connor Haley: Great question. First of all, you’d be surprised how hard it is to come up with any hedge fund name that isn’t already taken, shockingly difficult. But I chose Alta Fox Capital, the Alta has a few meanings. One, it means high or lofty in Latin, they have that plug. And then, it’s also the street that I grew up on. I liked that. The Fox I took from one of my favorite philosophers I read in college, Isaiah Berlin has the essay, The Hedgehog and the Fox, the idea of the Fox is a multidisciplinary. I think of investing as multidisciplinary. It’s not about being an expert in necessarily one thing, it’s about taking a different approaches, combining them together and coming to a conclusion. That’s the genesis but the real answer is everything else was taken.

Tobias Carlisle: I heard a story once, that somebody said they call … And I hope I’m not naming any fund, but it was Black Oak and the way that they pronounced it, every time they’d call it up, it sounded like black rock and then they could get calls with people.

Connor Haley: Yeah, you always surprised me.

Tobias Carlisle: Tell us a little bit about your fund. How’s it structured? And what are you hunting for?

Connor Haley: Yeah, it’s structured as a traditional hedge fund. The bread and butter of the strategy is what I call gems, which are underappreciated, high quality, small cap, tend to be growth businesses that in many cases haven’t leveraged their fixed costs yet. There’s an exciting story brewing and the evidence is there, but you have to search pretty deep and you also have to take a long term time horizon to really understand the normalized earnings and free cash flow three to five years out. Trying to find things they don’t screen as particularly cheap on traditional metrics. But if you look under the hood, there’s a really exciting bottom-up story there with an incentivized management team.

Connor Haley: That’s the bread and butter. And then, complimenting that I have the general’s portion of the portfolio, which tend to be a little bit higher cap, a little bit lower turnover, but tend to be your traditional compounders which provide a nice, stable base for the portfolio and require less maintenance time candidly, which allows me to then really dig in to some of those small micros. And then the last portion of the portfolio is special situations, which tend to be higher turnover, very opportunistic, spinoffs, liquidations, post-bankruptcy and things like that.

Tobias Carlisle: And you short too?

Connor Haley: I do short as well. I categorize the fund as long biased. Shorting is opportunistic, within my mandate I don’t have to have any short exposure. It’s really shorting for absolute P&L, occasionally to hedge out various specific risks within the portfolio. But definitely long biased and opportunistic on the short side.

Tobias Carlisle: Just to go back to one of the things you said about the gems. You talk about … They haven’t quite go over their fixed costs yet, they look like they’re under earning a little bit because the business is still in that very early growth phase and you’re projecting out that in three to five years they get over, they start eating those fixed costs and then you see the true strength of the business. Is that what you’re driving at there?

Connor Haley: That’s right. And it’s not always that a fixed cost story, but it often is the case. And it’s really looking for things that have really great unit economics and what can it look like at a bigger scale. And so it could be a franchise or that it just has a corporate function that that drains a lot of cash, but you don’t need to grow it significantly as you triple, quadruple quintuple your units. That can be a really exciting story down the line. It could be a payment processor. There’s a lot of different types of these businesses which … You really need to understand the unit economics and then the industry dynamics. And if you can do that, you can develop a differentiated view three to five years out, and hopefully by the time its screen’s really cheap, it’s at a much higher price. And that’s typically normally a time I’d be [inaudible 00:05:37].

Tobias Carlisle: Right. In the presentation that I saw, I just wanted to talk a little bit about your background. You started in 2007, how did you get started and what attracted you to it?

Connor Haley: Yeah, I got a pretty early start into investing. And I would say I was always very interested in analytical games or competitions or whatever. I was a pretty serious chess player growing up. At one point was the number one ranked player for my age in Texas. And that was my pursuit when I was younger. But then when I got to high school, I took an economics elective my freshman year and there’s a stock market game, you compete against local schools, something like that. And I realize I really didn’t know anything about it. And so, I started reading different things and really didn’t know much but it sparked this fascination. I started reading, I would say, one to two books a week, just really getting engrossed in it.

Connor Haley: And I joined more retail oriented sites like The Motley Fool and TheStreet.com and became pretty active on those sites. And fast forward to senior year of high school, I was spending a couple of hours a day researching investment insight. I still quite didn’t know that much, but I knew a lot more than I did freshman year. And took the unusual steps, I actually reached out to both of those firms, TheStreet.com and The Motley Fool. And to my surprise, they were willing to hire me. And I took a gap year between high school and college and worked for about six months at TheStreet.com in New York city and about five months at The Motley Fool in Alexandria, Virginia. And so, I got to meet Jim Cramer and I got to played board games with David Gardner and … But really the most important thing was I learned a lot about myself and learned a lot about investing.

Connor Haley: And I think it gave me a really great headstart advantage because when I showed up at Harvard’s campus as a freshman, I knew exactly what I wanted to do. I was very motivated and I didn’t waste any time on other things because I knew I wanted to be an investor. I knew eventually I wanted to start my own fund and I was very focused in each of my internships and one internship and just getting the best experience I could to try to accelerate my learning and get to a risk taking seat on the investing side as soon as possible. I was really blessed to have some fantastic mentors and opportunities. My freshman year I worked for a fund called Osmium Partners out in San Francisco.

Connor Haley: I’d written up an idea Jdate.com Spark Networks, was the name of the company and we’re still around. But at the time, their main asset was Jdate.com and I wrote it up on SumZero. I think at the time I was the youngest person that joined SumZero and I was interacting with John Lewis who runs Osmium in San Francisco. And we were talking about the name and it’s like 10 message threads through on the SumZero platform. I was like, “Hey, by the way, I’m not actually a full time investor. I’m a freshman at Harvard and I’d love to work with you.” And he was really generous and thankfully that I was able to talk my way into a job and that was a fantastic experience.

Connor Haley: Then my sophomore year was a similar situation with a fund in Los Angeles, Baker Street Capital, which at the time had a really great track record. Unfortunately ended up blowing up a couple of years later, which was also a great learning experience from my perspective, seeing the beginning of it, how it developed over time. And then my junior year I worked for Goldman Sachs in their special situations group, on their Multi-strategy investing desk, basically investing in Goldman Capital on balance sheet capital and public equities and public debt. Learned a lot about capital structure, it’s really fantastic opportunity.

Connor Haley: And then I was able to leverage that into joining Scopia Capital a multibillion dollar fund in New York city and being their first analyst hired straight out of undergrad, which really was my goal was to join a strong investing group with a good process straight out of school. It was really fortunate. But it all really stemmed from that early interest, which I was able to then leverage one experience at a time. But I’ve certainly been very fortunate to learn from a lot of, I think really great investors.

Tobias Carlisle: What’s your favorite? Chess opening?

Connor Haley: Well, somewhat similar to my investing style, I always favored mortgage secure openings-

Tobias Carlisle: The bird.

Connor Haley: … Exactly. No, actually at four-

Tobias Carlisle: Is that a trick?

Connor Haley: Yeah, at four … I did play that for awhile. I attend favor obscure openings, which maybe weren’t the most sound from a computer analysis perspective. But I knew-

Tobias Carlisle: It blows people’s brains when they see it.

Connor Haley: … Exactly. I would know the theory a lot more than the next guy. I’d forced someone onto my domain.

Tobias Carlisle: It’s always very uncomfortable when it’s attacking that King’s Gambit or whatever. Is it Queen’s Gambit there? And then they didn’t know how to play it. That’s a good position. I like the English for the most part.

Connor Haley: Yeah.

Tobias Carlisle: Why small and micro-cap.

Connor Haley: Yeah. I learned pretty early on, even in high school, even though I didn’t know a ton about investing, I knew enough to know that I didn’t know a lot and I knew that I didn’t have the resources that large investment fund or hedge funds had. And I realized early on if I wanted to achieve market beating returns with a relatively elementary knowledge level and no resources really, the only way I was going to be able to do that was to hunt in a different market. And I discovered small micros as a result. And similar to this I guess like the bird’s opening or obscure chess things, that was micro-cap for me. And it was like, “Wow, I can actually talk to manager teams, I can actually understand these drivers and outwork other people because there aren’t big funds doing a lot of work on these names.”

Connor Haley: And that’s how I stumbled into it. And then at Harvard I was really involved in the Harvard financial analysts club, which is the largest undergraduate finance club on campus. I was in the club for four years and basically help transform their process from … When I started they were pitching stocks and they were pitching Apple and these other companies and it was a college pitch and there was nothing really extraordinary about it, no value add. By the end we were pitching its secure micro-cap and talking to the CEO and go into some micro-cap conferences and really doing value added work. And it was reflected in the returns. And I just discovered micro-cap because there was nowhere else I was going to be able to invest at that time and pretend I had any advantage.

Tobias Carlisle: Let’s talk a little bit about your long criteria. Once you’ve screened for these stocks, what are you looking for?

Connor Haley: I have a big bias towards quality businesses, and that can be defined in a lot of different ways, but for me it starts with the unit economics. You’ve really got to understand that. I think a lot of investors sometimes miss that when they’re looking at consolidated results, which can sometimes be obscured or hidden, but get to the heart of the unit economics. How much does it cost to open a store? What’s that return look like? What’s the break even? Depending on the business it’s going to differ, but understand the unit economics and understand how the cost structure develops over time. For me, it’s high returns on capital, it’s a really competitive advantage. A durable competitive advantage that can sustain those returns on capital because ultimately I think the market is fairly efficient at valuing stocks for the most part.

Connor Haley: And if you give the market a company with a lot of research coverage, very little change, a ton of comparables, et cetera, the markets more likely they’re not going to spit out a value that’s fairly efficient. I’m really looking for the exceptions where the market may struggle to value something. Situations where it doesn’t have a lot of analytics coverage where it’s maybe a newer type of business model that it’s less comfortable analyzing or valuing or situation where there’s a tremendous amount of change that has to be understood not one year in advance from a management guidance, but a multi year story really looking for … If the market’s really good at valuing vanilla stocks, I’m looking for the exotic ice cream flavor that is difficult and really requires a lot of fundamental due diligence.

Tobias Carlisle: And one of the things in your presentation you say you’re looking for that masking effect. Is that the high fixed costs relative to the small set up or what is that?

Connor Haley: Yeah, that would be an example of one masking effect. Another could be … There are lots of different types, it couldn’t be maybe what they own are intangible assets, which are difficult to value which may not show up right now on the income statement or the cashflow statement, but have a lot of strategic value. There’s a lot of different types of masking effects, but I think that’s important. And with small and micros the fact that something’s a micro-cap, I think in and out of itself is a masking effect. Now, if you can pile on multiple masking effects with a really excited fundamental story, that’s when you can sometimes find some really outstanding stories and setups on for equities. But it can take a variety of different forms.

Tobias Carlisle: And what about on the short side, what are you looking for there?

Connor Haley: Yeah, on the short side, I’m really looking for competitively disadvantaged businesses where I feel they’re just secular pressures that can’t be escaped. I’m not sure it can currently, but a name I’ve been short in the past, for example, has been Harley Davidson. It’s just a situation where they’ve got a great legacy historical brand, but the demographics are so damaging for them going forward and there’s really nothing they can do. And they’re trying, they’re coming out with an electric bike, they’re doing all these other things. But at the end of the day, millennials are less interested in buying motorcycles and even when they are, they opt for cheater motorcycles. And so, that’s a very difficult, multi-year headwind along with all these other capital intensive issues and trade and whatever that, that’s the type of business.

Tobias Carlisle: Why are millennials less interested in motorcycles?

Connor Haley: Look, for one, they’re really expensive. For two, I think it’s just a generational thing where millennials seem to be more interested in experiences than material things. I don’t know if I have the perfect answer, but the data’s very clear. You look at the demographics, and it’s not positive for capital-intensive motorcycle manufacturers.

Tobias Carlisle: It’s not an age thing, you don’t just get to 55 and decide you got to buy a hog or something like that.

Connor Haley: Yeah, I guess we’ll see. But if you compare the current millennial base versus historical buyers at the same age and upon a cohort analysis, it’s not an encouraging trend, we’ll see. And I don’t have a position today, but it’s not something I would want to bet on the long side.

Tobias Carlisle: It’s funny, it’s an interesting position because I’ve seen guys, I [inaudible 00:17:14] often been on Twitter say that they have this … The mode is the fact that they don’t sell motorcycles. They sell Harley Davidsons, they sell Hogs. But I have no view one way or the other, but it’s interesting to hear a different view on it.

Connor Haley: Yeah. They definitely have a strong brand. I guess I would just question like, “Who is that brand strong with?” And is that an increasing or decreasing population and more important the population purchasing power. And I don’t have a position today and I’m sure potentially at the right price, everything can be interesting. But those are the types of businesses which are capital intensive, have strong headwinds that cannot be escaped by even the strongest management teams and innovation. I’m just tough to see how the next five years are a lot better than the last.

Tobias Carlisle: Take us through your investment process. How do you generate ideas?

Connor Haley: Yeah, it’s a combination of factors. I do have about a dozen screens I run on about a monthly basis and typically screening for very specific things, they tend to be less valuation driven, more quality driven. We’re looking for quality because a big premise behind my strategy is that, it’s hard to screen for really high quality businesses early. And so I try to find early ingredients, but then it’s a lot of digging within the results. I do run about a dozen screens on a monthly basis. In addition to that, they’ve got a really good small cap network, whether it be through MicrCapClub, whether it be through other buy-side investors that I’ve worked with or interacted with in the past.

Connor Haley: I feel I have a great network to leverage ideas there. And then conferences, meeting companies, et cetera. I do a lot of travel to company headquarters to big part of my process with meeting management teams really. All my ideas start with a hypothesis and then I have to go out and try to prove or disprove it. And meeting management teams is a big part of that. It’s a combination of factors, but ultimately just looking for handful of really good ideas here.

Tobias Carlisle: Tell me a little bit about the diligence process.

Connor Haley: Yeah. It starts obviously … Once I have a population of interesting ideas, I throw them on what I call the big board, which is basically a glorified Excel sheet that pulls in various data from data sources and some et cetera. But it’s really a priority list. At the top is the current portfolio and it has bare base in both scenarios which ultimately spit into a projected IRR for the investment. I’m always comparing the current portfolio against itself along with the watch list to … The watch is basically competing for allocation of gross dollars. My deal with this process they’ll start by throwing the interesting names on the watch list. Obviously going through all the primary filings, really digging through. Ultimately, if I think something is interesting enough, I’ll build a model, pretty detailed model and just try to understand, what has happened historically to this business?

Connor Haley: What are the key drivers? And what do you have to believe either on the long and the short side to understand to be a bull and bear. And then finally it’s really just trying to understand the best bear and bull debates. If somebody’s short, I want to talk to them. If somebody is long, I want to talk to them. I want to talk its employees, suppliers, competitors, you name it. I want to rip this business apart and be able to tell you what the essence of the business is, which I think is really important. And something I’ve learned over time is, sometimes businesses aren’t actually what they say they are meaning … For example, with Harley Davidson, maybe not the best example, but sure they sell motorcycles, but really the essence is they’re trying to sell an experience.

Connor Haley: They’re trying to sell a lifestyle. They’re really in the marketing business and the bikes need to be high quality and good, but they’re selling a brand. And understanding the essence of the business of, what it might say in 10k versus what it really is, and how they succeed or fail, I think it is really important. And then, just trying to diligence, both the long and the short side and rip apart the business. Ultimately trying to get to a fundamental view of normalized domains and free cashflow over the next three to five years, which then are split into the scenarios then feed your IRRs, which has been feed your position sizing.

Tobias Carlisle: Got it. And so, how are you sizing positions? Where you find something good at inception, and then through the whole process as it goes up, are you trimming and so on?

Connor Haley: Yeah. The first part is I have disciplined risk limits, no matter how much I like an idea. A max position at cost for me on the long side is 15% and I’ve only done that once in the portfolios history, I liked things a lot, but it takes a lot for me to put on a full 15% position. And I think that’s just because I have seen other funds fail. I have seen what happens when you really like ideas and you get carried away. The reality is there are always things you don’t know and there are always things that can hurt you. And so even if you’ve spent the last year researching something, you’re still not working in the business and there are things you can overlook. I think it’s important to stay in the game and not let one position ever harm you too much.

Connor Haley: For me that comes out to a 15% max up cost. But then, one of the hardest questions for me is when to put on a total position. Like how much work is enough because you’re never done researching position, you’re never 100% there. Maybe you get to 90% in an extreme scenario, maybe not, but there’s always more work, more checks that you can do. And so, typically it will start out as something like, “I’ve read the filings, I think it’s really interesting. I’ve built an initial model, I’ve done some supplier, X employee check, et cetera. My hypothesis is turning out to be likely correct based on my diligence. I’m going to start it out with say, three to 4% position and then I’m going to keep doing work.”

Connor Haley: And over time maybe the price goes down on non fundamental news and the IRR approves or maybe the IRR gets better because my fundamental estimates go up as I do more diligence, but I’m always trimming, adding, et cetera based on my projected view of IRR, which is really the summary of all my fundamental work.

Tobias Carlisle: And then you have a monitoring process as well, as you’ve discussed, looking at the potential inclusions in the portfolio against the existing ones. Is that what that process is?

Connor Haley: Exactly. Yeah, in addition to bear bass and bull, IRRs spitting out an expected value for the current portfolio. I’m also always working on doing that same exercise for the watch list, some of which already have IRRs, some of which I’m still building up the models, building up the scenarios. And so in updating those in a typically quarterly basis. There’s some businesses on my watch list that I really like, but the price just isn’t quite right. If we were to get a sell off and I felt like the fundamental views didn’t really change, they might find their way to the portfolio or if something really runs up in my portfolio and I feel like the fundamental earnings and free cash lists haven’t really changed, then I might trim that or exit entirely and swap into something on the watch list that maybe has gotten more attractive.

Connor Haley: It’s always a tetris exercise and moving things around and trying to optimize. But I try to really make all the decisions based on my fundamental views of typically three to five year forward normalized earnings and free cash flow.

Tobias Carlisle: How many positions do you have on at any given time? How many positions you have on now?

Connor Haley: Yeah, it’s typically about 15 positions on the long side and a handfuls, one to five on the short side with the shorts being considerably smaller in allocation. But it can vary a lot because one position could be up to 15%, if you have a couple of high conviction positions that work out for example and you trim, then that’s a pretty significant gross allocation. Positions range from typically 3% to 12. 15 is rare, I don’t have any at the moment, and then on the short side, they’re typically one to 5%

Tobias Carlisle: And how big do you let them grow before you start trimming them back before they start making you nervous?

Connor Haley: Yeah, it is a good question. There’s no strict discipline rule on that like there’s at cost. With the reason being, if something is really phenomenally working out, I don’t want to be forced to sell. That being said, I do have a soft idea in my mind. I’ve been fortunate to have a couple big winners that were either 12 or 15% cost and I started basically trimming once it got to around 20% of the portfolio. And if a position is running in your favor and I’m after way and you’re continually trimming at 20% that’s still a big position. It’s still a big position, you’re still very much participating in the upside, but you’re also locking in some gains as the position appreciates. And so that’s the approach I’ve taken in the past and I have some flexibility there because every situation is different. But that’s generally how I approach it.

Tobias Carlisle: Let’s talk about edges. This is an interesting part of your presentation. You said there are three forms of edges or you have three forms of edges, informational, analytic and institutional. Can you just take us through those edges and how they apply to you?

Connor Haley: Sure, sure. The first being informational. This is the Holy Grail of investing. It’s very difficult to have an informational edge, but it’s not impossible. And this is really scouring all of your fundamental work for unique data points basically. It could be … Right now, all the region, buy-side investing is like data sets. Hedge funds will buy really expensive credit card data sets. Some of these data sets costs seven figures a year. Sometimes I’ve seen more and they’ll have a team of PhD’s and Quants behind them. And so that’s an example. They’re trying to get an informational edge. That’s the Holy Grail, but it doesn’t necessarily require that, particularly in smaller companies. And frankly, my experience there’s been a lot of those data sets, because they’re consumed by multiple funds, tend to be commoditized over time.

Connor Haley: And so, they’re incorporated in the price over time. But that being said, there could be unique data points and edges. It could be a supplier check. You could build up a network of suppliers, you can talk to them on a monthly or quarterly basis. You can build up your own data set how a business is performing based on some of the businesses they sell to. And then you have your own data point and if you’re getting both qualitative and quantitative inputs on a regular interval basis, that’s unique data point. Whether it has significance or not, you have to see. But that potentially, can lead to an informational edge. But it’s basically just going out there and talking to a bunch of people and trying to ultimately have some quantitative, unique data point that no one else has or very few have, that can allow you to find or spot inflection points in the business, positive or negative.

Connor Haley: The second one will be analytical edge. This is the edge where you don’t have different information than anybody else, but you’re processing it in a different way, which gives you an advantage. I think the most common is time horizon, time arbitrage particularly in small growing businesses. If everyone else is valuing it on a one year forward basis, but you’re trying to understand the drivers on a three to five year basis, that really can be an edge. And I think it’s often talked about, but often applied. But I think it really matters is, how are you viewing your time horizon? And I think it’s a delicate balance and every investor has to find their own style for time horizon. For me, I found in general, three to five years it’ll be a pretty good sweet spot just because I feel it’s short enough where I can estimate with some reasonable degree of accuracy, the drivers, the risks, et cetera.

Connor Haley: But it’s not so short that everyone’s looking at it like a one year forward basis. Everyone’s got to find their own sweet spot and it depends on the business as well. And then finally institutional, I think this really relates to, what types of factors are influencing your decision making on a daily basis? And are those rational or not? And the reality is, I think a lot of professional managers have forces that influenced them negatively, whether it’d be … They don’t have a lock up, they don’t have the right investors, they are trying to make up for poor historical performance or whatever. They don’t have the right incentives for both themselves and for the three of their investors. And I think having the right investor base really is a competitive advantage and having the right investor terms that is consistent with both your investing style and your strategy.

Tobias Carlisle: Let’s talk a little bit about risk management. I think that there are three ways that you approach risk management. One of the first things you look at is, you just risk averse in your security selection.

Connor Haley: Correct. Particularly within the small caps, I find that a lot of other small cap investors tend to … Including some very successful ones and unsuccessful ones, tend to have a different approach to this subset of the universe. Not all, but many are always looking for these small caps that have tremendous upside and they’re always looking at the upside first. That’s one of the alerts of the small caps, is they’re small therefore they can grow many times the value. Well, that’s true and nice, they often look at the upside to the detriment of the downside. And I tend to be pretty downside focused for the most part. It’s always a balance of course, but I’m really looking for very high quality business models that can weather most economic climates. And also not dependent on a lot of external factors for success.

Connor Haley: If you can control your own destiny as a business, that’s a much better position to be in than requiring a really strong economy or requiring a really attractive trade relations I should say. You don’t want to be subject to all these other risks and look, every business has some external risks and factors. And sometimes there can be positions in a portfolio that it’s okay to take on economic sensitivity, but you got to be really cognizant of what percentage of your portfolio that is and be really objective with yourself. I love finding businesses that can control their own destiny and succeed in any economic climate. I think some of my biggest winners this year have to fit that description.

Tobias Carlisle: You also talk about risk averse position sizing, I think we’ve covered that in some data. Let’s talk about risk averse portfolio construction. What do you mean by that?

Connor Haley: Yeah, I think that can mean a couple of different things, but one is making sure you understand what risks you’re taking on from each of your positions and what that looks like on an aggregated basis. It’s okay to have an economically sensitive restaurant stock in the portfolio, but if you have that along with a boat manufacturer and a motorcycle manufacturer, suddenly, maybe those are all three attractive fundamental ideas based on what we know about the economy today. But now your portfolio is fundamentally highly sensitive to high end discretionary spending, highly sensitive to changes in trade or these other things and I think it’s really important to understand those factors when you’re building up your portfolio.

Connor Haley: Because ideally you’d have 10, 15 names of highly idiosyncratic fundamental bottom up these that are largely immune from economic sensitivity. That’s an unrealistic expectation for the entire portfolio, but at the same time, I think if you’re not thinking about how those things intertwine, you think you’re betting on the brand of Harley but in reality your portfolio is a high beat bet on high end discretionary spending. I think that’s really important to think about as well.

Tobias Carlisle: In your presentation, you make the case for small and micro-cap. And there are a few really interesting data points for this one. I want to take you through it. First of all, let’s discuss the returns and all the studies that you included.

Connor Haley: I think it’s generally accepted that small and micro-caps have outperformed other indices over time on a very long time series. We’re currently in a period of pretty dramatic under performance, which I think is pretty interesting in and of itself. But I think the idea is, historically you’ve been paid to take on a little bit of a liquidity premium, I guess as some people would say. Small and micro-caps have outperformed. But even more than that I think micro-cap, I believe are the only segment of the market where historically active managers have actually added value, which is pretty interesting.

Connor Haley: It’s like you could pick an average micro-cap manager and you would still come out ahead, which is pretty interesting and certainly cannot be said about the other subsets of the equity market. My goal is to obviously be well above average manager, but it’s a little comforting to know that even if I do okay, maybe my investors will still come out ahead

Tobias Carlisle: It’s like Lake Wobegon, every manager is above average.

Connor Haley: Yeah, exactly.

Tobias Carlisle: Or above the median. Talk about diversification a little bit.

Connor Haley: I think, talked about risk limits, which I think is important, not having any position above 15% at cost. But within that I think it’s also important to … What I was saying earlier about structuring your bets and understanding what you’re betting on. An example of that would be, I wrote up a company in a previous quarterly letter called XPEL, which basically provides Paint protection Film, PPF called for new cars. And so it’s basically an expensive adhesive tape that goes over a car, which protects it that you can’t even see, unless you really up close, which protects it from rock chips and other things like that. I really liked the fundamental bottom up thesis and I wanted to make it a large position, but at the same time I was a little bit concerned about how tight it was to new car sales and how that might get hit in a trade war, recession, et cetera.

Connor Haley: And that was a debate about how important that was between bulls and bears, but it was a concern if there was going to be a big position portfolio. From my perspective, I had two options, one was, you liked the bottom up thesis, so invest in a very small allocation so that if these macro risks actually materialize, you’re not hurt too poorly because I’m a pretty risk averse investor in terms of not trying to prevent capital loss. That’s one option, but the problem is then you don’t get as much of the bottom of thesis as one. The alternative is you make it a bigger position and then you find some other shorts that are standalone attractive shorts, but also share some of that high end discretionary spend exposure so that if that segment of the market, that factor rolls over, you can outperform on that basis through your shorts, doing worse than XPEL would.

Connor Haley: That’s an example where I’m trying to think about factor exposure. I’m trying to think about how the portfolio will respond in a variety of economic scenarios. I’m trying to position it for success regardless of the … I’m really trying to bet on bottom up thesis not macro variables.

Tobias Carlisle: The small and micro-caps also add some diversification to an allocator’s portfolio. I think that this is part of your case for small and micro-cap that you have the benefits of diversification through exposure to that part of the market?

Connor Haley: Yeah, certainly. Historically micro-caps have been much less correlated to other subsets of the equity market, and I think that’s for fairly obvious reasons. They tend to not be included in many of the main indices. They don’t have the same fun flow, impacts, often don’t have coverage or much coverage. I think broadly speaking, investors are very much under allocated to micro-caps and part of that’s because they’re not really indexable. There are indices, the Russell micro-cap index. I don’t think it does a very good job of capturing what micro-caps are. It has a super wide range of micro-caps. The entire premise of micro-caps is somewhat capacity constraint strategy and that doesn’t suit well for indexing, that’s the subset of the equity markets.

Connor Haley: I think it’s this fascinating structural market that has persisted for a long period of time and is somewhat immune to the indexing factors, and most people don’t know about. And it gets a bad reputation for the bad actors. One thing I tell investors that talk to me about my philosophy is, my perspective, despite being a small and micro-cap investor is that, the majority of small and micro-caps are low quality garbage businesses. The majority management teams are also low quality and garbage.

Connor Haley: That being said, I still focused the majority of my time in that space because the reward for sifting through that garbage and finding what are called the gems is so asymmetric to the upside. You’re rewarded for doing that work, for doing good fundamental work. And that’s why there is an opportunity, if all these micro-caps were high quality, and you could just index them, then I don’t think the same opportunity would exist.

Tobias Carlisle: What’s your definition of small and micro cap in terms of market cap.

Connor Haley: Everybody seems to have their own definition. I think of a small cap as … It changes by the day, but under 750 million. Call it 300 … A billion maybe, it might be a reasonable way to look at it. And that’s really a range where most reasonably large funds can’t really invest. And then micro-cap would be more in the sub 300 million.

Tobias Carlisle: Why do you think that, that sector has … Or that part of the market cap has underperformed over the last three or five years, whatever it’s been?

Connor Haley: It’s a really fascinating question and I’m not sure I have the perfect answer. I try not to be too confident and on large, big picture questions like these. But I will say I think it definitely creates an opportunity along with just the dynamics in the buy side industry. In general the data’s pretty clear. The biggest hedge funds are getting bigger, they’re attracting more dollars, there’s a variety of reasons for that. But it’s been a tough environment for small funds from a capital raising perspective, from an index performance perspective focused on small caps. But I think this really creates an attractive set up over the next five years because ultimately, I’m excited about having launched this last year in an environment where it was difficult to launch. Because I think there’s just less competition looking for these names and I think small and micro-cap investors should be excited about the opportunity set over the next five years.

Tobias Carlisle: Have you seen compression in valuations through the period of under performance?

Connor Haley: Yeah, I’d have to pull the aggregate data and I think it’s difficult to pull the aggregate data for things like the micro-caps because so many of them are garbage and lose a lot of money. Anytime you’re mixing profitability metrics or whatever, you’re mixing in a lot of highly loss-making companies. There’s a lot of noise in the data. That being said, from my own perspective, certainly I’m see things that are getting more interesting for sure. And things on my watch list that I was waiting for the right price that are now almost there.

Connor Haley: I’m being patient but in general, I think the opportunity set for small and micro over the next five years is pretty attractive, both from a bottom up following the perspective from companies and valuations and growth prospects, but also just from a competition stand point. I think it’s been a difficult environment for small and micro-cap funds and I think that the funds that are able to buck the trend, outperform, survive and thrive will have an opportunity set available to them that is pretty attractive based on historical standards.

Tobias Carlisle: What do you think the average small and micro-cap investor tends to outperform or the median tends to outperform the median return there?

Connor Haley: I think it’s because there are so many garbage, small and micro-cap companies. If you just ignore promotional scummy management teams, and that’s all that you did and you invested in everything else, that should probably do okay. You should do better than investing in the scummy promotional manager teams. And there are a lot of them. If you just don’t void the all hype, all sizzle and no substance names, you should probably do better than the guy who’s buying the management to the moon, a bullish case. If you just take a well-grounded common sense approach to investing in quality businesses at reasonable prices. I think you can do pretty well and outperform.

Tobias Carlisle: One of the interesting parts of your presentation, you say that there are some unique risks and opportunities in small and micro-caps. Just take us through what some of those unique risks are. And for instance, I think you probably just discussed one then, management, but please.

Connor Haley: No, I definitely think it’s true. I think in a similar way like biotech investing or energy investing or financial investing is often considered like a specialty field. Generalists don’t normally want to get in the weeds on some energy producer. It’s just this prior special analysis, you might end up being the dummy at the table, the part of the day. Well, I think in micro-caps, that can sometimes also be the case. You can have a set of assumptions that are generally true and applicable and you’ll be okay with and say mid to large cap investing, like, “This management team isn’t outright lying to me.” Obviously there are exceptions, but in general that’s probably it’ll the case. They’re going to be professional.

Connor Haley: All their data is going to be factually correct. They’re going to be generally competent people. They’re not going to engage in super illegal activity. There’s all these different things and of course there are exceptions and frauds, all aspects of micro-caps. But within small and micros, you get some really crazy stories often surrounding management teams that either they don’t care at all about shareholders or sometimes it’s not even a nefarious. Sometimes they don’t know, sometimes management teams don’t know how to run a public trading company because they’re new at it. And particularly companies that were really small have gone from super small to small, there’s often a lag in their approach to the public markets and communicating with investors, which can often create an opportunity frankly, because they haven’t gotten out and told their story yet.

Connor Haley: There are opportunities there, but there are also risks there that are very much unique to small and micro-cap investing, which personally I think makes it more fun. In addition, they’re doing this for job, I really have a passion for investing and I like the hunt investing, I like talking to new businesses, management teams, business models, and analyzing them. There are plenty of investors that make a very good living, investing in the same 40 large cap restaurants and building very detailed models and changing quarterly basis. And that’s fine more power too. But I really enjoy the hunt of investing in small and micro-caps. It’s like the wild West, you never know what you’re going to find, but you always got to be ready

Tobias Carlisle: And you say sometimes you’re the first analyst to visit the company.

Connor Haley: Absolutely, yeah. There was one of my bigger winners over this past year. I tried to get a visit with the company and they were hesitant and it was clear they had no IRR function. The CEO who’s the founder owned a lot of stock but didn’t … It just wasn’t very comfortable talking to investors that it wasn’t his personality. There was this lag and they had been on a really nice run in terms of stock performance and fundamentals but … I basically had to convince them to let me fly out and meet with them for an hour and I said, “Look, I’ve spoken to these 10 X employees, I’ve spoken to these suppliers, I’ve done all this work. Here’s what I’ve done. I’d love to come meet with you for an hour at your headquarters any day in the next month. Just tell me, I’ll fly out there.”

Connor Haley: And it was funny, the only reason I got the meeting was, they were interested in speaking to the one of the people that I had listed and they didn’t know how I had contacted them. I was able to add some value to them and at the same time learn a lot more about the business. And since then they’ve really improved their investor relations work and the stock’s done very well. That just doesn’t happen in mid and large caps. They typically have a professional investor relations team. It’s just a totally different situation.

Tobias Carlisle: You say that you need a different approach to valuation and small and micro. What do you mean by that?

Connor Haley: Yeah, well because they’re so small, there’s a bunch of different factors that you have to take into account that are often not as important and say mid or large cap. We talked about fixed cost. That’s a big thing. Really understanding the cost structure and how much is fixed? How much is variable? How does this develop over time? Is particularly important for small and micro-caps. I think understanding the industry structure, this is something I spend a lot of time on because I’m taking a view of, I want to invest in high quality names, leaders in their industry, but I’m investing in small companies. How does that reconcile together? And industry structure is really important as a result. If you want to invest in best in breed and really high quality companies, but you’re investing in small companies, it means one of a couple things.

Connor Haley: One, it could be a really fragmented industry where they may be the biggest player or close to the biggest player, but everybody else is really small. And so, it’s a really fragmented industry and maybe they’re best in breed. It could be that it’s a really niche industry, they’re the leader, but it’s a small industry. It could be a really new industry, which has just come on the horizon, so there aren’t any other big established players, and they’re trying to be that guy. But I try to spend a lot of time on that industry structure because I want to be invested in best in breed, really high quality and only certain industry structures suit that. I don’t want to be the 12th largest player in a really competitive industry where two massive large caps are investing a ton of money. That type of setup generally, there are always exceptions but generally is not something I’m going to be that interested in.

Tobias Carlisle: Do you want to go through two case studies that you included in your presentation? The first one is 3PEA and I think it’s TPNL. Let’s start with that, how did you find it? How do you analyze it? Where do you see the opportunity?

Connor Haley: Yes. 3PEA International. They’ve since changed their name to PaySign, P-A-Y-S. And that was actually the company I was referencing earlier where they wouldn’t meet with me and I had to convince them to. It’s a pretty fascinating story, I found it on a screen, it seemed really interesting from a fundamental perspective, but it was hard for me to figure out exactly what they did. Then I went on their website, I searched a bunch of things, but basically they made a majority of their revenue over 90% from basically facilitating payments to Plasma donors through prepaid debit cards and really niche industry. And yet the word plasma did not show up in their 10k even one time, really crazy. This is a plasma payment company and plasma doesn’t show up in the 10k.

Connor Haley: And there just was so little out there, they didn’t speak to any investors they were pretty new. And this got me intrigued because it’s lik, “Wow, these fundamentals are really attractive.” It’s right in the ballpark of size that I’m looking for. And no one seems to know what they do. I started doing digging, starting to figuring out more stuff, started doing my whole process of calls and checks, et cetera. And develop this view that, “Wow, this is like actually phenomenal business.” Plasma groves about 10% a year, it has for the last decade. It’s projected to grow at 10% for the next decade. It has basically zero sensitivity to macro factors whatsoever. These are life sustaining donations, they go into drugs that are life-sustaining drugs for people. There’s zero sensitivity.

Connor Haley: Financial crisis you can go look … Guess what? Plaza donations actually grew in the financial crisis. And that the actual dollar growth was pretty similar. It’s double digit. It’s really rare to find an industry that can grow double digit, secondly with no macro sensitivity. Then also has basically zero foreign competition. The U.S is a net exporter of plasma. They supply basically 70% of the world’s plasma. And the reason is FDA drugs are required to use U.S soft plasma for a variety of safety, quality control reasons. And so, there’s no synthetic substitute. Basically you have to have human plasma and the way you pay these donors is prepaid debit cards, and there’s only two players, Wirecard and 3PEA international now called PaySign.

Connor Haley: It’s a duopoly and PaySign is out innovating the larger player. It was a hundred percent basically if their business at the time no longer is. They were investing a lot more in it. They were much more focused on it. They were much more responsive to their plasma customers. You have this amazing industry backdrop. You have a leader that’s part of the duopoly that set the gain, significant share. You have basically no price sensitivity because the customers are paying the fee, not the Plasma donation centers. And so it’s like this phenomenal industry set up, and it was about to leverage it to fixed costs in a remarkable way. It’s been basically doubling its EBITDA on revenue in excess of 50% just from Plasma. Now they’re leveraging that into some other industry verticals as well. But it was a pretty unique setup.

Tobias Carlisle: Why do you need a specialized payments service for plasma?

Connor Haley: There’s a couple of reasons for it. But one, you have to pay them via prepaid debit cards basically because there’s no other way to pay them. You can’t really do cash or check because a large percentage of these donors don’t have bank accounts that are part of the unbanked. And then two, there’s a lot of fraud and theft that goes along with when you’re dealing with cash. And so, basically 99.9% of the industry uses prepaid debit cards now. And you need somebody to be the program manager of that to be able to reload cards, have it hooked up to the donor management system within the plasma center. There’s regulations around how often you can donate, how much you can donate, all these kinds of things.

Connor Haley: You need somebody who is … And also there’s significant amount of customer service required for people calling in with issues on their car or questions about the car and et cetera in multiple languages. And so you need someone who is focused on that market, who can provide a seamless service to ultimately these vertically integrated large plasma companies that don’t really care so much about the preservation, they’re in the business of selling really expensive lifesaving drugs and they need the plasma as I raw ingredient for that. And so they just want to make sure it’s smooth, easy, let somebody else handle it, or the customer service, et cetera. And they’re not even really paying for it because the customers are. Make it seamless and the switching costs are super high.

Connor Haley: That’s why there’s really only two players, and the company has never lost a single center in their corporate history and they’re typically signing … I think it’s like three to five year contracts. It’s a really phenomenal industry.

Tobias Carlisle: Is it a position you still have on?

Connor Haley: It is, I actually … I profiled in about in the mid two’s about 250 in my quarterly letter and on Value Investors Club as well. It ran up to a peak at 18, I think I was out in the mid teens. But it recently fell on lower and the revenue fell to 13 and below times. I’ve been actually nibbling on it a little bit recently. Just because I think the business is really phenomenal. I think there’s still some aspects as part of their newer growth that aren’t well appreciated. It’s not nearly as big as it was, but I’ve started to nibble again because I think the valuation is getting somewhat attractive if you’re willing to look at a few years.

Tobias Carlisle: What was the market cap?

Connor Haley: Today, it’s in the like 500 million range or so. It’s started at … Today it’s 495 million market cap.

Tobias Carlisle: Right. How does something like that go public? How long has it been public?

Connor Haley: That’s a great question too. Because this company was as an interesting background. They started a very long time ago in the advent of the internet trying to become a basically a hardware/software option for facilitating online payments. Somewhat like a PayPal with this hardware component. Now obviously that failed. But as a result, they became a payment processor. They have all the technology and the payment processing side. They are hooked up with the Visa, MasterCard, et cetera.

Connor Haley: They applied that technology to pharma copay industry basically facilitating various, typically debit cards to help with copays for patients to make drugs more affordable, working with pharma companies. And then they stumbled their way into the plasma industry. Wirecard was almost a hundred percent of the industry at the time. Wirecard didn’t really care about small centers. While the majority of the plasma industry is run by a few very large publicly traded players, there are small mom and pops that may have a center here, a few centers there.

Connor Haley: And Wirecard didn’t really want to work with them. 3PEA now PaySign had the opportunity to work with those guys and they did well and eventually they won some bigger centers. And eventually Wirecard stumbled in servicing the larger players, and they were able to win centers with the really big guys. Now they have over a third of the industry. I think they’ll get to two thirds over the next several years. They’re just a much better option than Wirecard and as a result they’re winning significant share.

Tobias Carlisle: That’s very interesting. Let’s talk about XPEL, which we discussed a little bit earlier. That’s the wrapping and the cars. Can you tell us a little bit, how did you find it? And how do you assess the opportunity there?

Connor Haley: Yeah, I can’t take credit for finding that originally it’s been pretty well documented on MicroCapClub by a lot of very smart investors for many years. And I’m a member of the club that stumbled upon it and it’s based in San Antonio and I’m based in the Dallas Fort Area, it’s not that far away. It has phenomenal growth, it was a very niche industry. I would categorize this in … If we’re talking in industry structure, this would be similar to PaySign a very niche. In the case of XPEL pretty new, this is not an industry that’s been around forever in a meaningful way. But XPEL’s definitely the leader. They’re purely focused on it versus some of their competitors, which it may be a subset of a much larger company.

Connor Haley: And so they’re very much the leader, the thought leader, the brand leader in the industry growing very quickly with a niche product that many people don’t understand. Before I started reading about XPEL, I’d never heard of Pay Protection Fill, I didn’t know anything about it. That interested me, and then I went and visited the CEO, Ryan Pape at the headquarters in San Antonio and really impressive guy, has done a phenomenal job with the business. And started doing my whole process, developing three to five year view and ultimately decided it was a pretty attractive industry and growth for the price and invested.

Tobias Carlisle: Did you go and wrap your car when you’re-

Connor Haley: You know what? It’s funny, I actually had an appointment at their headquarters to wrap my car. But they were so busy at the time, which was obviously a great sign. But they were so busy, I was going to have to wait like a couple hours. I was with my wife at the time, I didn’t want to get a rental car and then have to come back. I didn’t get it wrapped on fortunately. But hopefully that will change. [inaudible 01:01:34].

Tobias Carlisle: … What’s the reason for getting it wrap … It protects the car at a low price. Is that the idea?

Connor Haley: Yeah, basically the idea is, you can make a new car, stay looking new for long periods of time. Which can help the resale value but also if you’re just really into your car, you want it to look good, look new, look shiny and not having like rock chips all over it. Some people put Xpel on part of their cars, some people put it all over, but a very, very high percentage, I think like over 80% of high end cars like Ferraris and Lamborghinis will get film put on it. This isn’t like some ticky tack product. People are putting this on $300,000 cars. And increasingly putting it on other cars as well. It depends on the model and whatnot, but a full wrap for the entire car may cost a few thousand dollars. But relative to the price of the car, making it look new for several years is worth it to a lot of people, particularly car enthusiasts.

Tobias Carlisle: And is it manually applied? How does it get put on?

Connor Haley: It is manual applied. There’s a software that basically helped cut the film to be applied to a specific model of the car. So it’s fairly complicated software for cutting, but then it’s manually applied by a professional installer who’s fairly well compensated because it’s not easy to do and you need a lot of training to do it. Because if you apply the film in a haphazard … If I tried to apply the film, I’d look terrible. You wish that you didn’t have the film on your car. You need somebody who’s well trained, has a lot of experience.

Tobias Carlisle: And this is distinct from the colored reps that you see, there’s a lot of colored reps in LA on expensive cars and less expensive cars. It’s different from that?

Connor Haley: Yeah. This is typically a transparent film, you can’t even really see it. But it protects. Its primary goal is aesthetics and also protecting it against various forms of harm.

Tobias Carlisle: And that’s super interesting. I think we’re coming up on time. If folks want to get in contact with you, what’s the best way of doing that?

Connor Haley: Yeah, the first way would just be my website. It’s www.altafoxcapital.com. I’ve got a lot of information on there. You can sign up for my distribution list there as well. Read some of my past quarterly letters and occasionally I will post a high conviction investment thesis there. And then also my Twitter handle, which is @AltaFoxCapital. I tweet there occasionally, that’s a good way to follow me. I would say those are probably the two best ways.

Tobias Carlisle: Oh, that’s fantastic. Connor Haley, Alta Fox Capital, thank you very much for spending some time with us today.

Connor Haley: Thank you very much. Enjoyed it.

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