Welcome to Inside Active podcast about active managers that goes beyond sound bites and headlines and looks deeper into their processes, challenges and philosophies in security selection. I'm David Cohne, i lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Michael casper, Us, small cap and sector strategist at Bloomberg Intelligence. Mike, thank you for joining me today.
Thank you, David.
So you've recently published a note on the Russell two thousands. I guess we should say not so great December. Can you give our listeners a brief overview of just what went wrong last month?
Yeah, pretty much everything. So the Russell two thousand and December down about eight percent or so a little bit over eight percent for the month. Every single sector in the red, led by declines and materials, healthcare and financials, so some behemoths in their healthcare and financials obviously two of the bigger sectors in the in the index, Tech and consumer staples actually fell the least, but still everything down. What was interesting though from our standpoint is we have
a sentiment indicator called the bi Market Pulse Index. It looks at risk taking across equities and bond markets, and it actually ticked higher, kind of led by low volatility outperforming high volatility stocks for them, or high volatility stocks performing low volatility stocks for the month caused the market Pulse index to tick a little bit higher. So we're still watching that it is showing a little bit of concern.
Especially some of these factors that we look at are smooth out over a three month timeframe, so picking up some of that November rally, but still moving higher. But I think really what wereent wrong under the surface was the moving rates. We had highlighted at the end of last year that the Russell two thousand was pretty fairly priced on the multiple given where consensus expected rates to
go over the next year. And obviously what we're hearing from the FED and what we're seeing from the Tenure is that there's a healthy dose of skepticism that the original rate cut intention will actually be followed through in twenty twenty five. So a lot of that volatility I think was driven on the multiple side from Fed unease or unease about where rates might go. Obviously, consensus for revenue growth not going to change too much on a
month on month basis. So it was really driven a lot by the multiple in sentiment and where rates are expected to go over the next year.
Well, hopefully the next few months will be a little better. But on the topic of small caps, I'd like to welcome our guest, John Barr, Managing director and executive vice president of need and Funds, portfolio manager for the Needam Aggressive Growth Fund tickern eag X. John, thanks for joining Inside Active.
Great. Thank you, David, it's great to be here.
Well, let's start off by talking about your career. You know we've met and so I you know you've got an interesting career trajectory. Can you tell our listeners how you got your start in the investment business.
Yeah, they're really three parts to my career, And the first is that I had a whole first career in industry, and it was predominantly in electronic design automation, which is CAD software used to design semiconductors and printed circuit boards. And so fourteen years in that industry at marketing, sales,
sales management, product management. I lived in Japan and set up distribution, so lots of industry experience, and I also worked for or predominantly small companies but been through small venture backed companies, conserving cash through an IPO, through friendly merger, hostile takeover, white night layoffs being and then finally being the last person out the door. So I've kind of been in the shoes of the companies that I look
to invest in. So yeah, lots of industry experience, and then just mentioned the second part is other financial industry experience and leaving industry, I had the chance to go to the cell side and follow the industry that I came out of for a number of years, so had that additional experience. And then also venture capital has been something that has been a strong interest for a long time.
And as on the cell side, I worked with sourcing ideas for Needham's Venture Fund at the time, and then I was on the board of a private company that successfully sold and have maintained that interest and involvement since. So significant other financial industry experience too, and now been a portfolio manager slash analyst for over twenty years.
So you know that brings us to the Aggressive Growth Fund, which is, you know what we really want to focus on for this episode. Can you kind of walk us through the investment process for that fund?
Yeah, so it we look for I call it hidden to quality compounders, and when we look to purchase a company, it's in a stage that I call a hidden compounder, and then we look to hold it while it transitions to strong to strong financial performance, and then hold on even more while it becomes a quality compounder. And I like to joke that even the quants can find it when it's a quality compounder. But in the early stages, we're looking for some specific characteristics that aren't readily apparent,
so that that's the process from a high level. Some of the characteristics of it are very long term holding, so turnovers about ten percent, so averaging a ten year holding period. And so we're looking to find those small cap companies that the market hasn't yet discovered, hold them through that transition, and then hold them even longer to point where some of them become mid and even even large caps and we were able to hold on to them.
So I might just mention the criteria that we look for when we first purchase one of those companies, and they're four key criteria. The first is that the company has an established business, but then is investing in something new that the market doesn't yet recognize, and it can be a product or a service, and the established business maybe not so exciting, not growing rapidly, but profitable or generating cash to support the new thing. So while we're
growth investors, we're not growth at any price. We're not looking for companies that just have the new thing. We're looking for companies that have that established business and that helps us with downside protection as well. And we're prepared to look beyond the typical Wall Street model of a year or two to give the new thing time to develop, and that can be a year or two or even three or four. And so that's the first thing that
we look for. And then secondly a big market. Can the company grow to be five to ten times its current size, because if we're going to be invested for ten years, the company with success needs to grow. And then third, great management. Every investor says they invest in great managers. To me, the shortcut is founders, family or long tenured, because they tend to think long term. Like we want to be invested, we need to be careful that they're not just self dealing and controlling management team.
But we've had great success with that class of management and then the final criteria is investing in a margin of safety price and that can come from the balance sheet, it can come from the value of the established business or other areas as well. So ideally it's it's it looks like a boring stock, it's got a flat stock chart, the market's not excited about what they're doing. But it's also not something that's been cast aside. That's a that's
a falling knife. So that's that's what we look for, and then we look for the for the transition, and then then the further transition.
And what do you think might be in store for small cap stocks as a whole going into twenty twenty five. Do you see any catalysts on the horizon that might help narrow the gap with the S and P five hundred Michael.
That's a great question. I tend not to pay much attention to the macro side of things and very focused on on the companies and a few specific tailwinds sector tailwinds.
I think there's one thing that we can point to, which is small companies have have typically benefited from M and A and with the change potential change at the FTC, there may be more opening for small companies to be acquired, and it's been even our small companies that really it's hard to imagine any kind of market dominance or monopoly kind of situations. The M and A has just been tough. But I think that that's one element that could could
help small small caps. But we see lots of opportunity, plenty of companies that meet our criteria that we think will provide great returns over time.
What did have a follow up? You know, one of the things you mentioned was, you know, having kind of that margin of safety in terms of valuations. Are there are specific metrics you use when you're looking at valuations.
There are many things that we look at. So we will when we first enter, we'll look at the balance sheet and potentially we can find hidden real estate value or something that's not recognized. I'll look at some of the parts because we'll have the established business and then project what we think the new thing can look like. We will look at enterprise value to EBIT. Enterprise value to revenue, particularly useful for a company that's under earning,
which many of ours will be. When we first purchase enterprise value to EBITDA. But then as Charlie Munger says
about EBITDA. It is something bulld ebit DA, and you have to be very careful that it's not all just getting plowed back into to stock comp or cap X. But a unique thing that I look at is a Berkshire Hathaways, a form of Berkshire Hathaways owner's return on capital which takes into account capital spending, maintenance capital spending, and expansion capital spending, and major movements in cash flows.
So we're not so much looking at an annual cash flow as cash flow over the cycle of this investment that we're looking at.
Did the election or any of the proposed policies of the incoming administration change any of your investment thesies.
I mean, we're really looking out longer term, and I think this changed in the FTC maybe something, but other than that, not really so much. I might just mention though that. So I described the strategy tactically for I've managed the fund now for fifteen years, and we've really
been focused on infrastructure broadly defined. And yes we're growth, so we have some elements of physical infrastructure concrete, roads and construction companies, small bit of that, but lots of technology infrastructure and that has meant data centers and semiconductor manufacturing going back for fifteen years and even before that in my previous experiences, those have been important areas, and I just mentioned data centers. It was a good business,
somewhat cyclical, we really liked the business. And then in twenty seventeen the hyperscalers started to build out, and then in twenty twenty one came AI and we think we're still in very early stages of data center build out and semiconductor manufacturing has lots of tailwinds and it happened. It also somewhat cyclical still but major tailwinds for leading edge and for regionalization and really helping the data center
build out too. So infrastructure broadly defined, and then we have some labs and fabs for other industries too, but
that's a major area of focus. So it's the companies that are behind the scenes supplying the engineering tools and the manufacturing tools and manufacturing services that we're invested in, which means we're going to miss the hot new consumer app but we've found that the cap X and where we invest there's there's more durability to it and it matches what Needham is strong at and it also remembering my background for chip design software matches my background too.
And what do you see is maybe the biggest risk of stocks or maybe your portfolio and some of the calls that you have in there in the coming year.
We really try to look beyond a year. So uh, we're currently I mean, what has what what hurt a bit last year? Two elements. First, the industrial economy is not robust and UH, you know we've we've seen weakness. There's housing and autos are two areas that then ripple through. UH. And then the other element is consumer and UH in particular killer the lower income consumer has also been suffering. And I don't know that either of those is there's tailwinds in the next six months. So those those are
those are probably the biggest concerns. UH. And then if you want to if you do want to look at macro, you probably have to look at the increasing the tenure as it's creeping up at four seven and potentially heading higher. There's there's a lot of depth to to to refinance. But I try to look forward now the five to ten years and assume that everything that things will be normal when you look out there.
Yeah, and are there any sectors you find particularly compelling. I was looking through a little bit of your portfolio characteristics. I know you're you're have you into tech, So maybe outside of tech, are there any you know, sectors that that you really like at the moment?
I like so as I described infrastructure, broadly defined picks and shovels that enable the big, high profile industries. An area where we added a few new investments last year relates to skilled labor, and I can highlight a couple of companies that were new additions in the last couple of quarters. One is Lincoln Tech and the others Universal
Technical Institute UTI. And these are the skilled labor trade schools and small market penetration, big big need for the country and strong growth prospects, and they were kind of thrown away in the mid two thousands when with all of the for profit institutions. But these companies provide a real service and value. They could also benefit from a
change in administration. So those are a couple. And then we have a small company that provides hazardous gas detection companies called black Line Safety that has strong growth, gaining market share and provide safety for those for those workers. So that's that's one area, as you earth. Yeah, just briefly, I'll mention another that's related to that, which is construction services and a data center of semiconductor manufacturing, life sciences manufacturing.
Lots of we in the country need a lot of new manufacturing facilities. So we have invested in a couple of spinouts from utilities. One is the Everest Construction Group, which spun out of the Montana Dakota Utility MDU, and another is Century which spun out of Southwestern Gas. And so these these are construction services companies. Jacob's Solutions is a third. Matrix Services is another. So I think that construction services are an important area that we've invested in the last year.
Earlier, you kind of alluded towards, you know, helping kind of protect the downside, and so I'm just curious if you had any processes in place to, you know, in terms of handling risk or volatility.
Yeah, it's it's really around the companies. When we buy them, we're buying them with that margin of safety and and that that has helped. This leads to the question of portfolio construction too. So when we first purchase, we will buy a fifty thirty to fifty basis point position, and we can take a year to build a position small cap,
maybe not so liquid. If they run away from us, it's unfortunate, but oftentimes we have that time to take and so we'll get our entry price, and that will those entry level those hidden compounders may grow up to two hundred basis points, and then in the transition they may go up to three to four hundred. And we'll be adding purchases in the late hidden and early transition phases, and once they're into the quality they may be a larger market cap, so we're not purchasing anymore, and the
market is more recognizing, so we're not purchasing more. So. The risk protection comes from the valuation sensitivity at the beginning, and then the portfolio construction, which keeps those early stage companies small in the portfolio so damage is limited. About half of the hidden make it to the next stage, and then we do have some doozy of losers in the tail of those hidden that don't make it, but most of them we're getting our money back or a
significant portion of it, or making a small game. But the real returns from the portfolio come from those half that make it to transition and then the twenty five to thirty percent of those that make it into the quality stage. And over half of the outperformance has come from about twenty companies that we've invested in over this fifteen years. It ranged from five to one hundred baggers
based on the first purchase. So the risk control really comes from that valuation sensitivity, but then letting the real winners go and produce outside the returns.
So how do you handle CELL decisions? You know with both you mentioned you know there are some losers, but also when you have a company that hits that quality stage, how do you determine when to sell those?
Yeah, and sometimes valuation can seem stretch. But for me, I've learned its best not to pay that much attention to it because sometimes, and in these twenty or so cases, the fundamentals catch up with that valuation that seems stretched. So Cell discipline. Once they hit ten percent of the portfolio, and we've had a few that have, we will we will trim and hold it back there. When we're also a diversified industry fund, so we're limited to you can
have position. Once a position is over five percent, you really don't buy more of it, so that provides risk control as well. And then when we are a small cap fund, categorized as a small cap fund, so when they cross eight to ten billion in market cap, we can still hold them, but we're not buying any anymore. And so that's Those are some of the main elements.
And do you have any major takeaways from the third quarter earning season or what are you watching maybe as the fourth quarter results roll in? Are there any concerns there, you know, anything specifically.
I mean, as I mentioned before, we're looking for any type of turn in industrial economy, specifically autos chemicals, and any relief for the for the lower income consumer. So any any green shoots that we see there we're watching for in the portfolio and out of it, of course.
And we talked a little bit about M and A already and how that might pick up a little bit in twenty twenty five and beyond. Do you see maybe the same happening for I POS or track I POS kind of as a long term Yeah, so flow into.
Russell I love to me so my interest in the ventures side. We love to meet private companies. We like to get to know them when they're private. So we know what to do when they when they go public, and it also helps helps you understand what's going on in the market if you're actively in interested in private companies and then taking them into the public market. It
has been it's been a tough time in particular. We love a great small cap I PO that the big guys aren't focused on and the headlines aren't focused on, and doesn't run away from you. We're optimistic that the new year will will bring some Yeah, and you know, Michael, just to add further on that, I think we're also probably in a good position for some more high profile I pos the of the larger caps, and we will follow them and be interested in them. But that no,
that's not what we do. But freeing up the mag seven to to do M and A would be a good a good thing for small caps.
So we you know, we still have a little bit of time left. So there's one question I wanted to ask as well as you know, if we talk about market caps, one of the things I've looked at with small cap funds is there are a lot of companies
with larger market caps than we've seen historically. If you go back ten twenty years do you think small cap companies are just generally getting bigger compared to historical market caps or is this kind of, you know, the way things are going to be until there's more m and a activity in small caps.
Yeah. I think Socks Sarvey inz Oxley when it was implemented, put extra expenses which made it hard to go public as a smaller company. And then this rise of capital that's available for late stage venture and private equity allows companies to stay private longer. So it's definitely a trend. But we still there's plenty of small caps. And the other element is that funds have gotten larger. Pools of capital are just larger, so they can't afford to spend the time to get to know the small and micro
caps like we can. And so I think there's still great opportunity in small caps, despite the fact it's very different than when I started on the buy side over twenty years ago. And you'd have plenty of one hundred to two hundred million dollar market cap companies and at this point those are considered micro caps. But we'd love fishing in that pond because those are the ones where you can get the fifty to one hundred x if you get the right ones.
Definitely. Well, we just have one question before we let you go. We'd love to know what some of your favorite financial books have been.
Great question. I love that question. Well, so I'll start with the Berkshire Hathaway Letters, and I think they're essential reading for anyone interested in breaking into this business. And then I'll go with any of the Warren Buffett and Charlie Munger biographies, and I'll just highlight a couple of amonger ones because there aren't quite so many. One is Poor Charlie's Almanac, and then the second is Damn damn right, and there is only a third. So I would read
as much about Charlie as about Warren. I think Seth Klarman's margin safety is important. But you can't buy the book because it is only an original print and they cost a thousand dollars, but you can find the PDF out there. I think Christopher Meyer's one hundred Baggers is
a good one. And then there's a book called the Art of Execution by Lee Freeman Shore which was put out about four or five years ago, and it's developed He looks at investors in different archetypes and it's looking at performance at underlying and more than just alpha outperformance and attribution coming from allocation and selection. It's looking more at decision making within the investment process. I think that's
an area that is right for research and understanding. And then I just point one more which is not an investment book, but I think a great book and it's called Outlive by Peter Attia, and it deals with the importance of, well, what we can do to fight the four horsemen of disease, cardiovascular disease, Alzheimer's cancer, and metabolic type two diabetes, and what you can do from nutrition
and exercise perspective to live a long, healthy life. And I will add that that helps me helps inform me in investing in healthcare companies which are more sick care than healthcare, and I really look for things that are on the right side of that nutrition and exercise model.
Oh this is great, John, Thank you for joining us today.
David, thank you very much, and thank you, Michael.
Thank you both and Mike thanks for serving as my co host today.
Thank you, David.
Un till our next episode. This is David Cohne with Inside Out It two Stars of the Old Town