Earnings drive stock prices.
This is the foundation of everything we do. We believe the value of a company is realized over time through the growth of its earnings — and that in the small-cap universe, quality businesses are consistently mispriced until that growth becomes impossible to ignore.
A word on what we mean by true small-cap. Our average holding sits below $2 billion in market cap. We do not automatically sell a winner if it grows beyond our average market cap, but we exclusively buy companies at the small-cap stage.
We tend to avoid businesses with low or volatile returns, weak balance sheets, poor records of organic growth, and management teams that own no equity. To us, falling returns are a warning that a company’s advantage is being competed away.
Growth investors, closest to GARP.
We think of our style as rational, sitting closest to growth-at-a-reasonable-price: GARP. We will pay a fair multiple for a business that is genuinely growing, but not any multiple. We hunt for high-quality companies in the small- and micro-cap range, an asset class where mispricing is abundant.
The smaller the company, the less efficiently it is priced — which is why quality, in our asset class, can often be owned inexpensively. Because so few investors are looking, these businesses trade at reasonable, even modest, valuations despite their growth.
We put heavy weight on earnings growth, and our portfolio tends to trade near a “1 PEG” — meaning the price-to-earnings multiple roughly matches the rate at which earnings are growing, so we pay about a point of multiple for each point of growth (a price we view as very reasonable given the quality of what we own). Rather than selling a quality compounder because it looks expensive on a single year’s earnings, we are comfortable letting the multiple expand.
We manage money the way we do because we believe our asset class is, by a wide margin, the most inefficient. Small caps are mispriced chiefly because of a lack of awareness and discovery. There is a genuine information shortage: without easily accessible research, most investors simply don’t look. That neglect is the cornerstone of our opportunity.
And it is work. Active management of true small-cap investments is not optional. Many of the companies we own have no sell-side coverage at all, and where coverage exists, it tends to be thin, dated, or wrong. Success depends on the willingness to screen the universe methodically, to seek out undiscovered companies in a disciplined way, and then to analyze a business from the ground up. Our edge comes from discovering inefficiencies, so we operate where the most inefficiencies are found.
We want two things at once: growth that already shows up in the results, and a market large enough to absorb a great deal more of it. Usually that means a company that is taking share, growing faster than its industry and its peers, and is situated in a market with a runway measured in years rather than quarters.
Great business models tend to work regardless of geography: when we find one that succeeds in one country, we look for its equivalents elsewhere. We’re wary of businesses whose addressable market isn’t clearly large, and we hold low exposure to markets where we can’t get comfortable that a company’s advantage is durable.
