Discovering Under-Covered Microcap Stocks
on Bloomberg Markets
Guest Jim O’Shaughnessy, OSAM’s CIO/CEO, and Carol Massar1 find much to discuss during his periodic visit to her daily Bloomberg Markets radio program. For more research on this topic, go to the microcap archives.
The interview2 begins 2 minutes into the recording…
“Bloomberg Markets: O’Shaughnessy on Investing in Micro-Caps” transcript:
(Bloomberg Radio, Monday 5:03 pm, June 12, 2017)
0:00 through 2:10 — Bloomberg Radio’s news headlines
2:10 — “Active vs. Passive” intro
Carol Massar (BBR): You are listening to Bloomberg markets right here, on Bloomberg radio. He’s back; he’s gonna rescue you if you need some investment ideas in this interesting market environment. Jim O’Shaughnessy is back with us, Chairman and Chief Executive Officer of O’Shaughnessy Asset Management that has roughly 5.4 billion in assets under management, based in Stamford, Connecticut, back in our Bloomberg 1130 studio. Nice to have you back with us.
Jim O’Shaughnessy (Jim): Great to be back!
BBR: I wanna talk [about Active vs. Passive] then we’re gonna talk about microcaps and small caps which we’ll get to in a moment. But what do you make of — we’ve had fund managers, well known fund managers — big money managers coming out and saying, “Hang on everybody, active management’s gonna be back in style.” You’re an active manager.
Jim: I am indeed.
BBR: What do you say of this ongoing debate between active versus passive? Especially when you see so much money going into index funds, just tracking the S&P 500.
Jim: So I did a full Google Talk [see this Blog article] about what it takes to succeed as an active manager, and it resonated because it’s very difficult to be an active manager. If you’re a passive manager there’s only one point of failure. You freak out when the market goes down and you sell your index fund. With an active manager you have two points of failure. The first is the same freak out when the market dives, but secondly, and more importantly, let’s say you’re invested with an active manager who, over the last three years, has provided 10% per annum, but his benchmark has done 11.5%. You’re very likely to fire that active manager and try to look for greener pastures. But study after study has proven that the managers who get fired outperform the managers who replace them. And, basically, what we have is we have the wrong timeframe when trying to decide whether someone is a good active manager or not. Now I’m very proud to say if you look at our stuff since inception, all but one of our strategies is beating its benchmark since inception. But the fact is there are ups and downs. We have had really bad drawdowns, as active managers, who are very different from the index, and so we’re looking for investors who understand that this is a marathon; this is not a sprint.
BBR: You can’t get emotional.
Jim: You really can’t.
BBR: You talk about this a lot.
Jim: I talk about it until I’m blue in the face.
BBR: What about the movement we’re seeing in tech stocks right now? And I know that’s not your space, certainly where the names have gone up dramatically and the names are getting overvalued, that’s not your thing, but what do you say to investors who are seeing the retracement, if you will, in the tech area, mostly in 5 names.
Jim: Yes, and I was just about to say that. Look, these companies are great companies; no one will dispute that. But a great company is not always a great stock. What you want to find in a great stock is a lot of value for your money, really good financial strength, really good earnings quality, and either some excellent shareholder yield on the large cap side or momentum and value on the small and microcap side. So we are looking for very specific type stocks to fill our portfolios with, and one of the things, if you looked at our portfolios, what you’d see is there’s this concept called active share. What that means is, if you have an Active Share of zero, you are the index, whereas if you have an Active Share of 100%, you don’t share a single name with the index. Any Active Share above 80% says you’ve got a really active manager working for you because basically he or she is very, very different than the index. That can be very good, and it can be bad. It can be very good in that if you want to do better than the index you’ve gotta be different. But, you can also hit a really rough patch where you don’t do so well.
BBR: Jim, do you think though, because, being passive for many years, I mean certainly we saw a lot of asset classes go higher and higher, but being passive has paid off.
Jim: Oh, definitely.
BBR: Does it start to separate, or do we start to see things differentiate themselves because we’re getting back to normal, and because of fed policy getting back to normal? Is it just as simple as that?
Jim: Well, I’ve been in this game for a long time. I remember the cover of Institutional Investor saying the death of value investing and that was right before value investing went on for a seven-year tear. I remember the Business Week article saying the death of equities, basically saying how baby boomers would never put a dime in the equity market. Generally speaking, when the news is all over something, I get very very skeptical. Now I don’t’ know when it’s gonna end…
BBR: Does it make you very nervous then, that so many people are going into index funds, the S&P 500. I mean look at the money and the flows going into vanguard.
Jim: It does, and just think logically about it. At the worst time the S&P 500 becomes a momentum fund. When was tech the biggest percentage of the S&P 500? At the beginning of 2000. Same if true of energy; same is true of many of the industries that did very, very well. They got way over-represented in the S&P 500 right before the downturn, and that adds insult to injury. So, I think a lot of passive investors aren’t really certain about what they’re getting. If you’re buying the S&P 500, especially, you are buying something where the best performers become the biggest percentage of the index, and then when they crash and burn, that makes it extra bad for you.
BBR: We’re gonna talk then about microcaps and small caps. We’re gonna come back with Jim O’Shaughnessy, Chairman and Chief Executive Officer of O’Shaughnessy Asset Management. We’ll get to that space in just a moment.
8:21 through 11:15 — Bloomberg Radio’s news headlines
11:15 — “Active vs. Passive” outro
BBR: You’re listening to Bloomberg markets. Jim O’Shaughnessy is our guest. He is Chairman and Chief Executive Officer at O’Shaughnessy Asset Management, which has $5.4 billion under management and is based in Stamford, Connecticut. We’re in our Bloomberg 1130 [radio] studio. I wanna get on to small caps and microcaps because I know you’ve done a bunch of work but one last thing: that whole flow into all of those S&P index funds, is it becoming a crowded trade? Could it become potentially a dangerous trade for investors, that they’re gonna get caught unaware?
Jim: Yes to both questions. I think that people sometimes seem to think that passive equals no risk. For a long period of time people felt that no load funds were no fee funds, and so they didn’t quite understand what they were getting, and I think that the headlong rush into cap weighted indexes, where, I mentioned earlier, the most overvalued become the largest component of the index, and then when those valuations get right sized, you suffer. So I definitely think that people need to be thoughtful about what kind of investment they’re making; they need to be long term in nature, whether they’re active investors or passive or both. We’ve found that combining our stuff with indexes works really great.
BBR: It’s a combination
Jim: Exactly, and so I think there are a lot of great advisors out there, who do a good job of getting their client to understand. The people I’m more worried about are the people who are just willy-nilly buying the ETF and not getting advice; they don’t really understand but they’ve read about it and everyone says, “Well this is the way it’s going.”
BBR: Everyone else is doing it
Jim: Exactly, and so the bandwagon effect kicks in
BBR: It’s a pure momentum play, or could be —
Jim: Exactly. I’ve often said that, at inflection points, the S&P becomes a momentum index, and you really wanna be very very careful about that because you could find yourself very badly burned.
13:20 — “The Micro Cap Opportunity”
BBR: You mentioned investing in the index with other strategies. Microcaps, small caps; how does that fit into somebody’s portfolio? Because I often think about it as being these under-covered, be very careful, volatile.
Jim: Well, actually, under-covered is one of the things I love best about the microcap space. You know there are 1,100 companies in the microcap space, and we define microcap as 50 million to 200 million at point of purchase. That’s really small. And in our portfolio about 45% of these companies have no analyst coverage. None. If you extend it to one, 75% have one or none. And so, what happens is, few institutions, very limited commercial appeal for guys like me to run a fund like this, because I have to close it soon, even though I love this space so much I’m running one. And what happens then is they get very undervalued and mispriced, because you don’t have the 18 analysts doing the work to say, “Well this is the true price here.” And so, one of the things that we believe and what we’ve seen over the course of this is, really, this is the highest source of alpha, we believe, in the U.S. stock market. And one of the reasons I wanted to talk about it today was because individual investors can look at these names. There’s all sorts of sites: the American Association of Individual Investors has a microcap portfolio, I think it’s actually based on my work. Some of the gurus sites have these portfolios. Go to osamlibrary.com and read a commentary called A True Microcap Strategy [also in Blog format as “9 Reasons to Micro Cap”] and in it I show you, look, yeah there are 1,100 companies — but you don’t wanna own about 800 of them.
BBR: You read through them. You filter through them — a lot — so that you come down to a core group. What do you look at to get to that core group, and remind me how small you whittle it down to?
Jim: Sure. So, specifically, we’ll start with 1,100 companies and then we will eliminate the half that have the highest valuations; we will eliminate the half that have the worst financial strength. That’s things like they have way too much debt or they’re using a lot of external financing. Historically, those have been horrible things for a company to do going forward. They’ll have really horrible free cash flows. So, I wanna emphasize, the majority of these companies are not great companies, but there are so many diamonds in the rough, that, if you can get rid of those companies, and I show you how to do it in this commentary, so it’s not like I want you to do it alone, you’ll see how we do it, and then we believe very strongly in a core portfolio. So, a core portfolio is half value, so we get down to the 50 percent of names that have the lowest, or the best value score, they’re the cheapest. And then the other half is momentum. We buy the companies that have already been excluded because, or any of the bad ones, have been excluded because of bad financial strength etc, and then those with the best momentum. I’ve gotta tell you, we even wrote a paper about how this can be a proxy for private equity.3 And, what’s beautiful about it is it’s liquid every single day. Now, as I always do carol….
BBR: I was gonna say, because it’s like the emerging market area of the stock market to me.
Jim: Yeah, you’re absolutely right. But the other point I wanna make is: there’s one ETF you can buy, the iShares Russell Microcap, but its median cap weight is more than 450 million. That’s double the top price that we’ll pay. We find the greatest value in the $50 million to $200 million names.
BBR: So once it comes up on your screen, then what do you do? Is it an automatic buy? Do you talk to the company? What do you do then Jim?
Jim: We never talk to the company. You know the old Bernard Baruch saying about how he has 10 rules for successful investing, but he can narrow it down to two? Number 1, sell when the shoe shine boy asks about the stock market, and number 2, never believe what a company president tells you, because he’s not gonna give you the honest dope.
BBR: They’re not gonna come in and say, “Hey, let me tell you the bad stuff.”
Jim: “Let me tell you how bad this particular company is…”
BBR: So when it shows up, then what?
Jim: We buy it.
BBR: You just go?
Jim: Absolutely, and we have criteria for selling….
BBR: How actively do you move within the smaller microcap space?
Jim: So we re-run these models on a monthly basis, and we create a weight of confidence index. So let’s say Company XYZ shows up in January, and again in February, and again in March… it will increasingly become a larger portion of the portfolio. Now, conversely, if that company begins to not show up we won’t buy it and then if the company starts to show up as a sell in that particular month we’ll start selling it. So we’re very methodical in the way we buy and sell securities, and we think this gives us the opportunity to be on board for when a company is doing really really well and yet also we have exactly the same sell mechanism that we do on the buy side. So when it starts saying sell we’re starting to move out of it. All completely non-emotional. All completely done by the various formulas that we have perfected for buying and selling these names and, again, just to the space itself, it’s amazing. Finally, the value you get from things like value, is almost double in microcap land from what you get in large cap land. So if you get excess return of 5% in large, you get 11% in micro.
BBR: Jim O’Shaughnessy, this was a fun space to talk about, thank you so much!
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- See BloombergRadio.com/hosts/Carol-A-Massar/
- For other recent interviews with members of the OSAM Research Team, visit our Blog’s interview archives.
- See osamlibrary.com “Microcap as an Alternative to Private Equity” Nov. 2015