Microcap Investing: Finding Diamonds in the Rough

During their recent episode, Taylor, Carlisle, and Claremon discussed Microcap Investing: Finding Diamonds in the Rough, here’s an excerpt from the episode:

Ben: Yeah. The first thing I hear from people is that this is just pure adverse selection, that anything that was good enough to grow out of microcap has, that it’s compounded its way into small caps, mid whatever, even bigger in certain circumstances. And so, what’s left are the dregs. Businesses that have some reason to exist but don’t have, that aren’t getting more valuable over time, that are often run by people who are not that sophisticated when it comes to either operations or things like capital allocation and corporate governance. So, what you’re looking at is that just a bunch of broken businesses that are public because of some historical accident or historical reason and can remain public, but you’re never going to make any money there. And so, that is the first criticism I hear.

I think the way I would frame it, and I’m not going to talk about any individual companies, but that may be true 85% of the time. That’s a totally arbitrary number. But let’s just say it’s true 85% of the time. That still leaves 15% of the time where it’s not true. If those 15% of companies that don’t fit that characteristics but are tainted by the microcap taint, then you’ve got the opportunity for undervaluation.

So, I think the point is, if you just paint the microcap universe, which is very diverse in terms of earners versus non earners versus industries– You’re looking at, there’s a lot of companies in this space and it’s very diverse. So, to paint them all with the same brush, I think misses a big opportunity to seek out the best companies in this space.

We can talk about why, but we’re starting in the nanocap space, which is we defined as $100 million in enterprise value, because we’re private equity guys now, so that’s more important than [chuckles] market cap. So, we’re are now $100 million in enterprise value and lower. We’re starting with that universe and distilling it down to the handful of the best companies in this space where there’s a significant reinvestment runway which the companies are unable to access in the public markets.

So, if it were true that these companies were broken, then they wouldn’t have a high return reinvestment runway. I think the idea is is to find those ones that are the exceptions to those rules, which I think broadly can be true in the space. But the cool thing about what we’re doing is that we don’t need 200 companies. We just need to be able to find a couple new interesting ideas per year. I think that is an evergreen space for us to make money.

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