Speaker 1: Welcome to Inside Active podcast about active managers that goes
Speaker 1: beyond sound bites and headlines and looks deeper into their processes,
Speaker 1: challenges and philosophies in security selection. I'm David Cohne, i
Speaker 1: lead mutual fund and active research at Bloomberg Intelligence. Today
Speaker 1: my co host is Michael casper, Us, small cap and
Speaker 1: sector strategist at Bloomberg Intelligence. Mike, thank you for joining
Speaker 1: me today.
Speaker 2: Thank you, David.
Speaker 1: So you've recently published a note on the Russell two thousands.
Speaker 1: I guess we should say not so great December. Can
Speaker 1: you give our listeners a brief overview of just what
Speaker 1: went wrong last month?
Speaker 2: Yeah, pretty much everything. So the Russell two thousand and
Speaker 2: December down about eight percent or so a little bit
Speaker 2: over eight percent for the month. Every single sector in
Speaker 2: the red, led by declines and materials, healthcare and financials,
Speaker 2: so some behemoths in their healthcare and financials obviously two
Speaker 2: of the bigger sectors in the in the index, Tech
Speaker 2: and consumer staples actually fell the least, but still everything down.
Speaker 2: What was interesting though from our standpoint is we have
Speaker 2: a sentiment indicator called the bi Market Pulse Index. It
Speaker 2: looks at risk taking across equities and bond markets, and
Speaker 2: it actually ticked higher, kind of led by low volatility
Speaker 2: outperforming high volatility stocks for them, or high volatility stocks
Speaker 2: performing low volatility stocks for the month caused the market
Speaker 2: Pulse index to tick a little bit higher. So we're
Speaker 2: still watching that it is showing a little bit of concern.
Speaker 2: Especially some of these factors that we look at are
Speaker 2: smooth out over a three month timeframe, so picking up
Speaker 2: some of that November rally, but still moving higher. But
Speaker 2: I think really what wereent wrong under the surface was
Speaker 2: the moving rates. We had highlighted at the end of
Speaker 2: last year that the Russell two thousand was pretty fairly
Speaker 2: priced on the multiple given where consensus expected rates to
Speaker 2: go over the next year. And obviously what we're hearing
Speaker 2: from the FED and what we're seeing from the Tenure
Speaker 2: is that there's a healthy dose of skepticism that the
Speaker 2: original rate cut intention will actually be followed through in
Speaker 2: twenty twenty five. So a lot of that volatility I
Speaker 2: think was driven on the multiple side from Fed unease
Speaker 2: or unease about where rates might go. Obviously, consensus for
Speaker 2: revenue growth not going to change too much on a
Speaker 2: month on month basis. So it was really driven a
Speaker 2: lot by the multiple in sentiment and where rates are
Speaker 2: expected to go over the next year.
Speaker 1: Well, hopefully the next few months will be a little better.
Speaker 1: But on the topic of small caps, I'd like to
Speaker 1: welcome our guest, John Barr, Managing director and executive vice
Speaker 1: president of need and Funds, portfolio manager for the Needam
Speaker 1: Aggressive Growth Fund tickern eag X. John, thanks for joining
Speaker 1: Inside Active.
Speaker 3: Great. Thank you, David, it's great to be here.
Speaker 1: Well, let's start off by talking about your career. You
Speaker 1: know we've met and so I you know you've got
Speaker 1: an interesting career trajectory. Can you tell our listeners how
Speaker 1: you got your start in the investment business.
Speaker 3: Yeah, they're really three parts to my career, And the
Speaker 3: first is that I had a whole first career in industry,
Speaker 3: and it was predominantly in electronic design automation, which is
Speaker 3: CAD software used to design semiconductors and printed circuit boards.
Speaker 3: And so fourteen years in that industry at marketing, sales,
Speaker 3: sales management, product management. I lived in Japan and set
Speaker 3: up distribution, so lots of industry experience, and I also
Speaker 3: worked for or predominantly small companies but been through small
Speaker 3: venture backed companies, conserving cash through an IPO, through friendly merger,
Speaker 3: hostile takeover, white night layoffs being and then finally being
Speaker 3: the last person out the door. So I've kind of
Speaker 3: been in the shoes of the companies that I look
Speaker 3: to invest in. So yeah, lots of industry experience, and
Speaker 3: then just mentioned the second part is other financial industry
Speaker 3: experience and leaving industry, I had the chance to go
Speaker 3: to the cell side and follow the industry that I
Speaker 3: came out of for a number of years, so had
Speaker 3: that additional experience. And then also venture capital has been
Speaker 3: something that has been a strong interest for a long time.
Speaker 3: And as on the cell side, I worked with sourcing
Speaker 3: ideas for Needham's Venture Fund at the time, and then
Speaker 3: I was on the board of a private company that
Speaker 3: successfully sold and have maintained that interest and involvement since.
Speaker 3: So significant other financial industry experience too, and now been
Speaker 3: a portfolio manager slash analyst for over twenty years.
Speaker 1: So you know that brings us to the Aggressive Growth Fund,
Speaker 1: which is, you know what we really want to focus
Speaker 1: on for this episode. Can you kind of walk us
Speaker 1: through the investment process for that fund?
Speaker 3: Yeah, so it we look for I call it hidden
Speaker 3: to quality compounders, and when we look to purchase a company,
Speaker 3: it's in a stage that I call a hidden compounder,
Speaker 3: and then we look to hold it while it transitions
Speaker 3: to strong to strong financial performance, and then hold on
Speaker 3: even more while it becomes a quality compounder. And I
Speaker 3: like to joke that even the quants can find it
Speaker 3: when it's a quality compounder. But in the early stages,
Speaker 3: we're looking for some specific characteristics that aren't readily apparent,
Speaker 3: so that that's the process from a high level. Some
Speaker 3: of the characteristics of it are very long term holding,
Speaker 3: so turnovers about ten percent, so averaging a ten year
Speaker 3: holding period. And so we're looking to find those small
Speaker 3: cap companies that the market hasn't yet discovered, hold them
Speaker 3: through that transition, and then hold them even longer to
Speaker 3: point where some of them become mid and even even
Speaker 3: large caps and we were able to hold on to them.
Speaker 3: So I might just mention the criteria that we look
Speaker 3: for when we first purchase one of those companies, and
Speaker 3: they're four key criteria. The first is that the company
Speaker 3: has an established business, but then is investing in something
Speaker 3: new that the market doesn't yet recognize, and it can
Speaker 3: be a product or a service, and the established business
Speaker 3: maybe not so exciting, not growing rapidly, but profitable or
Speaker 3: generating cash to support the new thing. So while we're
Speaker 3: growth investors, we're not growth at any price. We're not
Speaker 3: looking for companies that just have the new thing. We're
Speaker 3: looking for companies that have that established business and that
Speaker 3: helps us with downside protection as well. And we're prepared
Speaker 3: to look beyond the typical Wall Street model of a
Speaker 3: year or two to give the new thing time to develop,
Speaker 3: and that can be a year or two or even
Speaker 3: three or four. And so that's the first thing that
Speaker 3: we look for. And then secondly a big market. Can
Speaker 3: the company grow to be five to ten times its
Speaker 3: current size, because if we're going to be invested for
Speaker 3: ten years, the company with success needs to grow. And
Speaker 3: then third, great management. Every investor says they invest in
Speaker 3: great managers. To me, the shortcut is founders, family or
Speaker 3: long tenured, because they tend to think long term. Like
Speaker 3: we want to be invested, we need to be careful
Speaker 3: that they're not just self dealing and controlling management team.
Speaker 3: But we've had great success with that class of management
Speaker 3: and then the final criteria is investing in a margin
Speaker 3: of safety price and that can come from the balance sheet,
Speaker 3: it can come from the value of the established business
Speaker 3: or other areas as well. So ideally it's it's it
Speaker 3: looks like a boring stock, it's got a flat stock chart,
Speaker 3: the market's not excited about what they're doing. But it's
Speaker 3: also not something that's been cast aside. That's a that's
Speaker 3: a falling knife. So that's that's what we look for,
Speaker 3: and then we look for the for the transition, and
Speaker 3: then then the further transition.
Speaker 2: And what do you think might be in store for
Speaker 2: small cap stocks as a whole going into twenty twenty five.
Speaker 2: Do you see any catalysts on the horizon that might
Speaker 2: help narrow the gap with the S and P five
Speaker 2: hundred Michael.
Speaker 3: That's a great question. I tend not to pay much
Speaker 3: attention to the macro side of things and very focused
Speaker 3: on on the companies and a few specific tailwinds sector tailwinds.
Speaker 3: I think there's one thing that we can point to,
Speaker 3: which is small companies have have typically benefited from M
Speaker 3: and A and with the change potential change at the FTC,
Speaker 3: there may be more opening for small companies to be acquired,
Speaker 3: and it's been even our small companies that really it's
Speaker 3: hard to imagine any kind of market dominance or monopoly
Speaker 3: kind of situations. The M and A has just been tough.
Speaker 3: But I think that that's one element that could could
Speaker 3: help small small caps. But we see lots of opportunity,
Speaker 3: plenty of companies that meet our criteria that we think
Speaker 3: will provide great returns over time.
Speaker 1: What did have a follow up? You know, one of
Speaker 1: the things you mentioned was, you know, having kind of
Speaker 1: that margin of safety in terms of valuations. Are there
Speaker 1: are specific metrics you use when you're looking at valuations.
Speaker 3: There are many things that we look at. So we
Speaker 3: will when we first enter, we'll look at the balance
Speaker 3: sheet and potentially we can find hidden real estate value
Speaker 3: or something that's not recognized. I'll look at some of
Speaker 3: the parts because we'll have the established business and then
Speaker 3: project what we think the new thing can look like.
Speaker 3: We will look at enterprise value to EBIT. Enterprise value
Speaker 3: to revenue, particularly useful for a company that's under earning,
Speaker 3: which many of ours will be. When we first purchase
Speaker 3: enterprise value to EBITDA. But then as Charlie Munger says
Speaker 3: about EBITDA. It is something bulld ebit DA, and you
Speaker 3: have to be very careful that it's not all just
Speaker 3: getting plowed back into to stock comp or cap X.
Speaker 3: But a unique thing that I look at is a
Speaker 3: Berkshire Hathaways, a form of Berkshire Hathaways owner's return on
Speaker 3: capital which takes into account capital spending, maintenance capital spending,
Speaker 3: and expansion capital spending, and major movements in cash flows.
Speaker 3: So we're not so much looking at an annual cash
Speaker 3: flow as cash flow over the cycle of this investment
Speaker 3: that we're looking at.
Speaker 2: Did the election or any of the proposed policies of
Speaker 2: the incoming administration change any of your investment thesies.
Speaker 3: I mean, we're really looking out longer term, and I
Speaker 3: think this changed in the FTC maybe something, but other
Speaker 3: than that, not really so much. I might just mention
Speaker 3: though that. So I described the strategy tactically for I've
Speaker 3: managed the fund now for fifteen years, and we've really
Speaker 3: been focused on infrastructure broadly defined. And yes we're growth,
Speaker 3: so we have some elements of physical infrastructure concrete, roads
Speaker 3: and construction companies, small bit of that, but lots of
Speaker 3: technology infrastructure and that has meant data centers and semiconductor
Speaker 3: manufacturing going back for fifteen years and even before that
Speaker 3: in my previous experiences, those have been important areas, and
Speaker 3: I just mentioned data centers. It was a good business,
Speaker 3: somewhat cyclical, we really liked the business. And then in
Speaker 3: twenty seventeen the hyperscalers started to build out, and then
Speaker 3: in twenty twenty one came AI and we think we're
Speaker 3: still in very early stages of data center build out
Speaker 3: and semiconductor manufacturing has lots of tailwinds and it happened.
Speaker 3: It also somewhat cyclical still but major tailwinds for leading
Speaker 3: edge and for regionalization and really helping the data center
Speaker 3: build out too. So infrastructure broadly defined, and then we
Speaker 3: have some labs and fabs for other industries too, but
Speaker 3: that's a major area of focus. So it's the companies
Speaker 3: that are behind the scenes supplying the engineering tools and
Speaker 3: the manufacturing tools and manufacturing services that we're invested in,
Speaker 3: which means we're going to miss the hot new consumer
Speaker 3: app but we've found that the cap X and where
Speaker 3: we invest there's there's more durability to it and it
Speaker 3: matches what Needham is strong at and it also remembering
Speaker 3: my background for chip design software matches my background too.
Speaker 2: And what do you see is maybe the biggest risk
Speaker 2: of stocks or maybe your portfolio and some of the
Speaker 2: calls that you have in there in the coming year.
Speaker 3: We really try to look beyond a year. So uh,
Speaker 3: we're currently I mean, what has what what hurt a
Speaker 3: bit last year? Two elements. First, the industrial economy is
Speaker 3: not robust and UH, you know we've we've seen weakness.
Speaker 3: There's housing and autos are two areas that then ripple through. UH.
Speaker 3: And then the other element is consumer and UH in
Speaker 3: particular killer the lower income consumer has also been suffering.
Speaker 3: And I don't know that either of those is there's
Speaker 3: tailwinds in the next six months. So those those are
Speaker 3: those are probably the biggest concerns. UH. And then if
Speaker 3: you want to if you do want to look at macro,
Speaker 3: you probably have to look at the increasing the tenure
Speaker 3: as it's creeping up at four seven and potentially heading higher.
Speaker 3: There's there's a lot of depth to to to refinance.
Speaker 3: But I try to look forward now the five to
Speaker 3: ten years and assume that everything that things will be
Speaker 3: normal when you look out there.
Speaker 2: Yeah, and are there any sectors you find particularly compelling.
Speaker 2: I was looking through a little bit of your portfolio characteristics.
Speaker 2: I know you're you're have you into tech, So maybe
Speaker 2: outside of tech, are there any you know, sectors that
Speaker 2: that you really like at the moment?
Speaker 3: I like so as I described infrastructure, broadly defined picks
Speaker 3: and shovels that enable the big, high profile industries. An
Speaker 3: area where we added a few new investments last year
Speaker 3: relates to skilled labor, and I can highlight a couple
Speaker 3: of companies that were new additions in the last couple
Speaker 3: of quarters. One is Lincoln Tech and the others Universal
Speaker 3: Technical Institute UTI. And these are the skilled labor trade
Speaker 3: schools and small market penetration, big big need for the
Speaker 3: country and strong growth prospects, and they were kind of
Speaker 3: thrown away in the mid two thousands when with all
Speaker 3: of the for profit institutions. But these companies provide a
Speaker 3: real service and value. They could also benefit from a
Speaker 3: change in administration. So those are a couple. And then
Speaker 3: we have a small company that provides hazardous gas detection
Speaker 3: companies called black Line Safety that has strong growth, gaining
Speaker 3: market share and provide safety for those for those workers.
Speaker 3: So that's that's one area, as you earth. Yeah, just briefly,
Speaker 3: I'll mention another that's related to that, which is construction
Speaker 3: services and a data center of semiconductor manufacturing, life sciences manufacturing.
Speaker 3: Lots of we in the country need a lot of
Speaker 3: new manufacturing facilities. So we have invested in a couple
Speaker 3: of spinouts from utilities. One is the Everest Construction Group,
Speaker 3: which spun out of the Montana Dakota Utility MDU, and
Speaker 3: another is Century which spun out of Southwestern Gas. And
Speaker 3: so these these are construction services companies. Jacob's Solutions is
Speaker 3: a third. Matrix Services is another. So I think that
Speaker 3: construction services are an important area that we've invested in
Speaker 3: the last year.
Speaker 1: Earlier, you kind of alluded towards, you know, helping kind
Speaker 1: of protect the downside, and so I'm just curious if
Speaker 1: you had any processes in place to, you know, in
Speaker 1: terms of handling risk or volatility.
Speaker 3: Yeah, it's it's really around the companies. When we buy them,
Speaker 3: we're buying them with that margin of safety and and
Speaker 3: that that has helped. This leads to the question of
Speaker 3: portfolio construction too. So when we first purchase, we will
Speaker 3: buy a fifty thirty to fifty basis point position, and
Speaker 3: we can take a year to build a position small cap,
Speaker 3: maybe not so liquid. If they run away from us,
Speaker 3: it's unfortunate, but oftentimes we have that time to take
Speaker 3: and so we'll get our entry price, and that will
Speaker 3: those entry level those hidden compounders may grow up to
Speaker 3: two hundred basis points, and then in the transition they
Speaker 3: may go up to three to four hundred. And we'll
Speaker 3: be adding purchases in the late hidden and early transition phases,
Speaker 3: and once they're into the quality they may be a
Speaker 3: larger market cap, so we're not purchasing anymore, and the
Speaker 3: market is more recognizing, so we're not purchasing more. So.
Speaker 3: The risk protection comes from the valuation sensitivity at the beginning,
Speaker 3: and then the portfolio construction, which keeps those early stage
Speaker 3: companies small in the portfolio so damage is limited. About
Speaker 3: half of the hidden make it to the next stage,
Speaker 3: and then we do have some doozy of losers in
Speaker 3: the tail of those hidden that don't make it, but
Speaker 3: most of them we're getting our money back or a
Speaker 3: significant portion of it, or making a small game. But
Speaker 3: the real returns from the portfolio come from those half
Speaker 3: that make it to transition and then the twenty five
Speaker 3: to thirty percent of those that make it into the
Speaker 3: quality stage. And over half of the outperformance has come
Speaker 3: from about twenty companies that we've invested in over this
Speaker 3: fifteen years. It ranged from five to one hundred baggers
Speaker 3: based on the first purchase. So the risk control really
Speaker 3: comes from that valuation sensitivity, but then letting the real
Speaker 3: winners go and produce outside the returns.
Speaker 1: So how do you handle CELL decisions? You know with
Speaker 1: both you mentioned you know there are some losers, but
Speaker 1: also when you have a company that hits that quality stage,
Speaker 1: how do you determine when to sell those?
Speaker 3: Yeah, and sometimes valuation can seem stretch. But for me,
Speaker 3: I've learned its best not to pay that much attention
Speaker 3: to it because sometimes, and in these twenty or so cases,
Speaker 3: the fundamentals catch up with that valuation that seems stretched.
Speaker 3: So Cell discipline. Once they hit ten percent of the portfolio,
Speaker 3: and we've had a few that have, we will we
Speaker 3: will trim and hold it back there. When we're also
Speaker 3: a diversified industry fund, so we're limited to you can
Speaker 3: have position. Once a position is over five percent, you
Speaker 3: really don't buy more of it, so that provides risk
Speaker 3: control as well. And then when we are a small
Speaker 3: cap fund, categorized as a small cap fund, so when
Speaker 3: they cross eight to ten billion in market cap, we
Speaker 3: can still hold them, but we're not buying any anymore.
Speaker 3: And so that's Those are some of the main elements.
Speaker 2: And do you have any major takeaways from the third
Speaker 2: quarter earning season or what are you watching maybe as
Speaker 2: the fourth quarter results roll in? Are there any concerns there,
Speaker 2: you know, anything specifically.
Speaker 3: I mean, as I mentioned before, we're looking for any
Speaker 3: type of turn in industrial economy, specifically autos chemicals, and
Speaker 3: any relief for the for the lower income consumer. So
Speaker 3: any any green shoots that we see there we're watching
Speaker 3: for in the portfolio and out of it, of course.
Speaker 2: And we talked a little bit about M and A
Speaker 2: already and how that might pick up a little bit
Speaker 2: in twenty twenty five and beyond. Do you see maybe
Speaker 2: the same happening for I POS or track I POS
Speaker 2: kind of as a long term Yeah, so flow into.
Speaker 3: Russell I love to me so my interest in the
Speaker 3: ventures side. We love to meet private companies. We like
Speaker 3: to get to know them when they're private. So we
Speaker 3: know what to do when they when they go public,
Speaker 3: and it also helps helps you understand what's going on
Speaker 3: in the market if you're actively in interested in private
Speaker 3: companies and then taking them into the public market. It
Speaker 3: has been it's been a tough time in particular. We
Speaker 3: love a great small cap I PO that the big
Speaker 3: guys aren't focused on and the headlines aren't focused on,
Speaker 3: and doesn't run away from you. We're optimistic that the
Speaker 3: new year will will bring some Yeah, and you know, Michael,
Speaker 3: just to add further on that, I think we're also
Speaker 3: probably in a good position for some more high profile
Speaker 3: I pos the of the larger caps, and we will
Speaker 3: follow them and be interested in them. But that no,
Speaker 3: that's not what we do. But freeing up the mag
Speaker 3: seven to to do M and A would be a
Speaker 3: good a good thing for small caps.
Speaker 1: So we you know, we still have a little bit
Speaker 1: of time left. So there's one question I wanted to
Speaker 1: ask as well as you know, if we talk about
Speaker 1: market caps, one of the things I've looked at with
Speaker 1: small cap funds is there are a lot of companies
Speaker 1: with larger market caps than we've seen historically. If you
Speaker 1: go back ten twenty years do you think small cap
Speaker 1: companies are just generally getting bigger compared to historical market
Speaker 1: caps or is this kind of, you know, the way
Speaker 1: things are going to be until there's more m and
Speaker 1: a activity in small caps.
Speaker 3: Yeah. I think Socks Sarvey inz Oxley when it was implemented,
Speaker 3: put extra expenses which made it hard to go public
Speaker 3: as a smaller company. And then this rise of capital
Speaker 3: that's available for late stage venture and private equity allows
Speaker 3: companies to stay private longer. So it's definitely a trend.
Speaker 3: But we still there's plenty of small caps. And the
Speaker 3: other element is that funds have gotten larger. Pools of
Speaker 3: capital are just larger, so they can't afford to spend
Speaker 3: the time to get to know the small and micro
Speaker 3: caps like we can. And so I think there's still
Speaker 3: great opportunity in small caps, despite the fact it's very
Speaker 3: different than when I started on the buy side over
Speaker 3: twenty years ago. And you'd have plenty of one hundred
Speaker 3: to two hundred million dollar market cap companies and at
Speaker 3: this point those are considered micro caps. But we'd love
Speaker 3: fishing in that pond because those are the ones where
Speaker 3: you can get the fifty to one hundred x if
Speaker 3: you get the right ones.
Speaker 1: Definitely. Well, we just have one question before we let
Speaker 1: you go. We'd love to know what some of your
Speaker 1: favorite financial books have been.
Speaker 3: Great question. I love that question. Well, so I'll start
Speaker 3: with the Berkshire Hathaway Letters, and I think they're essential
Speaker 3: reading for anyone interested in breaking into this business. And
Speaker 3: then I'll go with any of the Warren Buffett and
Speaker 3: Charlie Munger biographies, and I'll just highlight a couple of
Speaker 3: amonger ones because there aren't quite so many. One is
Speaker 3: Poor Charlie's Almanac, and then the second is Damn damn right,
Speaker 3: and there is only a third. So I would read
Speaker 3: as much about Charlie as about Warren. I think Seth
Speaker 3: Klarman's margin safety is important. But you can't buy the
Speaker 3: book because it is only an original print and they
Speaker 3: cost a thousand dollars, but you can find the PDF
Speaker 3: out there. I think Christopher Meyer's one hundred Baggers is
Speaker 3: a good one. And then there's a book called the
Speaker 3: Art of Execution by Lee Freeman Shore which was put
Speaker 3: out about four or five years ago, and it's developed
Speaker 3: He looks at investors in different archetypes and it's looking
Speaker 3: at performance at underlying and more than just alpha outperformance
Speaker 3: and attribution coming from allocation and selection. It's looking more
Speaker 3: at decision making within the investment process. I think that's
Speaker 3: an area that is right for research and understanding. And
Speaker 3: then I just point one more which is not an
Speaker 3: investment book, but I think a great book and it's
Speaker 3: called Outlive by Peter Attia, and it deals with the
Speaker 3: importance of, well, what we can do to fight the
Speaker 3: four horsemen of disease, cardiovascular disease, Alzheimer's cancer, and metabolic
Speaker 3: type two diabetes, and what you can do from nutrition
Speaker 3: and exercise perspective to live a long, healthy life. And
Speaker 3: I will add that that helps me helps inform me
Speaker 3: in investing in healthcare companies which are more sick care
Speaker 3: than healthcare, and I really look for things that are
Speaker 3: on the right side of that nutrition and exercise model.
Speaker 1: Oh this is great, John, Thank you for joining us today.
Speaker 3: David, thank you very much, and thank you, Michael.
Speaker 1: Thank you both and Mike thanks for serving as my
Speaker 1: co host today.
Speaker 2: Thank you, David.
Speaker 1: Un till our next episode. This is David Cohne with
Speaker 1: Inside Out It two Stars of the Old Town