An Inside View on Small Cap Value Investing

Interview with Tom Kerr of Rocky Peak Capital Management, LLC

We are frequently asked by our small cap clients and prospects what they can do to build investor and analyst support. We recently had the opportunity to speak with Tom Kerr, founder of Rocky Peak Capital Management, a 25-year veteran of small cap investing, about how stocks are selected for his Rocky Peak Small Cap Value Fund (RPCSX). Tom actively seeks opportunities to invest in small cap stocks, and we expect you’ll find his commentary interesting. His comments are followed by some top line advice from Financial Profiles for any small cap company that is seeking to build Wall Street support.

What is your small cap investment philosophy? What sets you apart?

Our philosophy is based first and foremost on preservation of capital and avoiding undo risk. If you don’t lose your money, you can do well over time.

One of our main points of differentiation is our focus on fundamental research. We do our own fundamental research for a few reasons. First, sell-side research doesn’t pay a lot of attention to our universe of small cap companies. Second, to find value in undiscovered or neglected stocks, you have to take a contrarian approach – you can’t run with the herd. We also take a highly concentrated approach to investing. At any one time, we want to know 30 to 40 stocks very well, and that takes a real commitment to doing our own homework.

Another key differentiator is that we balance our portfolio among three small cap value segments:

Quality value Blue chip, small cap companies with good balance sheets and good yields that have outperformed in down markets.

Contrarian value Good companies that have fallen out of favor.

Microcap Companies with market caps between $100 and $500 million that are widely unknown. There is a significant information gap in the microcap world and that’s another reason we do our own research.

Which characteristics or financial metrics do you use to identify good investments?

Our three lines of inquiry focus on the business, the value of the business, and the value of the people running it. If one of those characteristics does not meet our criteria, we avoid the stock. If all three line up, then the stock has good portfolio potential for Rocky Peak.

Business Is it a good business? What does the industry look like? How has the business performed in good and bad markets? How will the business perform in the future?

Valuation What is the company worth? Is it trading at a discount? We utilize many different valuation processes to determine an appropriate intrinsic value for the companies we buy.

People We look for great management teams. You have to have good people who can allocate capital. We look for teams with a strong CFO who can challenge the CEO. Management teams at smaller companies are eager to talk to investors, and direct access to them is a real advantage for Rocky Peak in making an investment decision.

How do you source investment ideas?

That’s a good question since with 6,000 small cap public companies there is no shortage of ideas. Our approach combines a quantitative and qualitative approach.

First, we use a screening process that includes a dozen metrics such as EBITDA strength versus the industry, insider buying, and others. Our screens generate hundreds of potential investments, and then we dive into the ones that look most promising.

There’s also a creative aspect to our investment process that leverages anecdotal evidence. For example, we listen to what competitors are saying at one-on-one meetings or at investor conferences and we think about what we’re reading in the news and trades. We put together these bits and pieces of information to get a more complete picture.

What are the biggest obstacles of small cap value investing?

The size of the universe is enormous; there are 6,000 stocks with market caps of $100 million to $3 billion. Many of these are smaller, out of favor penny stocks, so you need to be able to screen your list down to find great ideas.

The recognition factor, or lack thereof, of these stocks is also a challenge. If nobody knows about the company, the stock won’t go up. A company’s challenge is getting the word out. Companies need to take their stories to the buy-side directly because in most cases the stock isn’t going to be picked up by the sell-side.

Is illiquidity in small cap land a benefit or a detriment?

For many firms, illiquidity is a huge problem, but for Rocky Peak it’s an advantage. Whether illiquidity is a detriment or not usually depends on the size of the investment firm and its assets under management (AUM). Managers with portfolios under $500 million can be patient. For managers with portfolios of more than $1 billion in AUM, it can be tougher. The larger the AUM, the harder it is to buy the illiquid stocks.

How has sell-side coverage changed over time?

We all know that since the dotcom bust, sell-side coverage has declined substantially. Some of the void has been filled by smaller, regional firms that do a great job. Still it’s tough for small cap companies to get coverage. Smaller firms like Barrington in Chicago and B. Riley in Los Angeles are less short-term focused than the larger sell-side firms. They look at the long-term potential over time.

Do you have any lessons you’d like to share about small cap value investing?

The essential thing is to have patience and discipline. This is not the place to be if you are looking month to month or quarter to quarter. Investors have to realize that small cap value stocks can be undervalued and underfollowed for quite a long time, but can also be very rewarding over time. And of course, I’m talking about quality companies that have a chance to emerge over time. I also suggest carefully evaluating highly leveraged small cap companies. Equity can be wiped out if you aren’t very careful. That’s what I mean about preserving your capital by limiting risk.

Financial Profiles has worked with dozens of small cap companies that have successfully transitioned to the next level – with broader buy-side support and sell-side coverage. As Tom notes, small cap investors have over 6,000 stocks to choose from, so the competition is stiff. The following are a few top line recommendations for successful small cap marketing campaigns

• Articulate a clear and compelling investment story that speaks to your target audience – small cap generalist investors. You need to explain your business, your strategy, your competitive strengths and your plans for creating shareholder value, including your capital allocation strategy.

• Make it easy for investors to understand your story without having to dig through SEC filings. Develop your own communications materials – fact sheet, corporate profile, presentation, website copy and Q&As. This is critical for small cap companies with no research coverage or no recent initiating coverage reports that tell the whole story.

• Don’t wait for the investors to find you. There are lots of firms like Rocky Peak Capital that are searching for good small cap stock ideas, but you have to find them, meet with them and convince them that your stock is the one to buy. As Tom notes, meeting face-to-face with company management is a critical part of his investment process. In our experience, small cap companies that are serious about building investor support should dedicate 2 or 3 days each quarter to meeting with investors in company sponsored meetings and/or conference presentations and one-on-one meetings.

• Given the significant decline in analyst coverage for small cap stocks, we recommend leveraging all capital markets activity to build relationships with investment banks that can provide research coverage, conference presentation opportunities, non-deal roadshow assistance and trading support. Many companies miss the mark on this critical strategy which can catapult a small cap company from one level to the next with some careful coordination.

Rocky Peak Capital Management, LLC based in Calabasas, CA, is a SEC-registered investment advisor founded in 2011 by Tom Kerr, CFA. Most recently, Tom was a Portfolio Manager and Partner for a $4 billion investment firm in Los Angeles where he was co-manager of the Small Cap Value strategy and the CNI Charter RCB Small Cap Value Mutual Fund.

Rocky Peak Small Cap Value Fund (RPCSX) is a mutual fund following a small market capitalization focused value strategy. The firm employs fundamental bottom-up analysis to create its portfolios and conducts its own research to arrive at security selection.

Tom Kerr can be contacted at 310-963-8009.