Q:  What is the history of the company and the fund? 

The FAM Small Cap Fund was launched on March 1, 2012; however the strategy has been in place since the fourth quarter of 2008. Although our roots were in small- and micro-cap, Fenimore Asset Management has now grown to incorporate investment in mid-cap companies too. 

The Small Cap Fund was launched to refocus on small- and micro-cap companies with the goal of leveraging our experience and time-tested process. Often, when we were doing research on mid-cap companies, we would find an opportunity that was attractive but too small for our mid-cap portfolio. 

Through the Small Cap Fund, which has just marked its three-year anniversary, we now benefit from investing in these attractive opportunities. Today we have $100 million in the small- and micro-cap strategy, of which $70 million is in the public mutual fund and the remaining $30 million in the original private placement structure.

Q:  How do you differ from other small-cap funds in the marketplace? 

We are unique in a sense that we focus on the smaller end of small caps. Our average market cap today is in the $500 million to $600 million range. Up to this point we have focused on the segment smaller than $1 billion in market cap primarily because there is less competition to invest and there is even lesser amount of research available. 

In addition, we focus on a smaller number of holdings in our portfolio and we are quite concentrated, unlike other managers in the space who may have hundreds of names in a portfolio resembling a quasi-index. 

We also focus exclusively on quality companies. We do not look at start-up companies that are bleeding money. Instead, we are investing in established businesses that are profitable and, in most cases, have been around for years and carved out specific niches. 

Q:  What is your investment philosophy? 

We are a value investor, and our overall investment philosophy is the same firm-wide. We take the same investing approach whether we apply it to small, mid or large caps.

Value can mean many different things to different people and we are not deep value investors. We prefer companies that are growing with a bias towards quality companies, meaning profitable businesses. We prefer companies that generate excess free cash flow and we prefer strong balance sheets. Among other key criteria are our trust in the management team and our confidence that the company will reinvest its free cash flow wisely.

While we want all key criteria to be met, we are also price sensitive and that is where the value component comes in. Being followers of Warren Buffett and other prominent value investors, we have paid close attention to their processes and our team has attended the annual meeting of Berkshire Hathaway for decades. 

We believe that over the long term stock prices tend to follow the intrinsic value of a business. In line with this conviction, our focus is on analyzing businesses and figuring out what that intrinsic value is. We are then going to purchase a security as long as it meets the quality criteria and we can buy it at a discount to the intrinsic value.

Q:  What is your investment process? 

We have an open mind when it comes to where ideas are generated. We read and listen to the latest news and we also talk to other value investors. In addition to that, we do our own criteria-based screening.

Furthermore, we read all the government filings, listen to conference calls and talk to management to get to know a company better. We seek to invest in understandable businesses with conservative management teams who are good capital allocators. Once we find an idea that is interesting enough because we like what management is saying and how the stock and the company meet our quantitative criteria, we will dig deeper. 

If we make it through those initial hurdles, the next step is to bring the idea to the entire research team of seven analysts. The analyst who came up with the idea will begin their work by writing up a detailed report and defending questions from other analysts on the team. 

At this stage, we will attempt to find weaknesses in the idea by questioning what could go wrong or what we might be missing. Is this a good business with a good management team and, above all, is this a business we should own?

We take the entire feedback to the analyst, who will gather answers for a list of questions, often including an additional meeting with management. If it makes it through that rigorous process, the idea will finally go into our inventory. At that point we will wait for the right price to add it to the portfolio.

Once a company does make it into the portfolio we have regular meetings with the management team each year. We prefer to do that at their headquarters or one of their manufacturing facilities and by doing that year-in year-out, we get a very good grasp on these smaller businesses.

One of the metrics that we primarily focus on is return on invested capital, which is one of the ways of gauging the performance of management and their ability to be prudent capital allocators. Any business has to be at least generating the cost of capital in order to be creating value. That is why we prefer companies that have double-digit returns on invested capital. We also like companies that have the ability to grow their earnings over time. As they are growing earnings, we like to see that the management team can maintain that return on invested capital, so that for every dollar the management is putting back into the business they are getting an adequate return on it. 

Free cash flow generation, as opposed to earnings reported by standard accounting process, is another area of interest for us. We want to understand what cash we could take out and put in our pocket if we owned the entire business. Warren Buffett coined a valuation measure years ago, which we use in our process, called “owner earnings.” This is the cash that an investor could take out of the business if they were the sole owner of that business. 

Going through the balance sheets, we pay attention to net debt to cash operating earnings and the interest coverage of the business, which means that we do not like companies that are overleveraged. For a typical operating business we are going to look at companies that have a net debt to cash operating earnings of less than three times. 

We look for about 15% return on invested capital. In terms of the leverage of these businesses, a lot of companies we own in the portfolio have cash on the balance sheet. Even though cash can drag down an investor’s return on investment capital, we see it as something prudent, especially if the business is cyclical. There is a lot to be said for management teams who are willing to survive through rough times. Naturally, if you have cash on your balance sheet, you can survive. In 2008 and 2009, the businesses that we were invested in were the survivors, perhaps because they were more conservative and had cash on the balance sheet.

Q:  Would you share some examples of holdings to highlight your research process?

One of our holdings, John Bean Technologies (JBT), was a company spun-off from FMC Technologies, an oil services company, back in 2008. The company had two unique businesses generating strong cash flow and solid returns on invested capital. One was a food processing equipment company; the other was an airport equipment operation including Jetway Passenger Boarding Bridges. In fact, about 80% of the time when you board a plane in the U.S. you walk across a Jetway.

These two businesses were cash cows, but they were not the sexy, exciting businesses that the parent oil services company had back in 2007 and 2008 when oil prices were rising higher seemingly every day. As a small-cap name, JBT did not attract a lot of investor attention even though it had a strong balance sheet and generated a 15% plus return on invested capital and considerable free cash flow. For several years JBT stock was available to buy for around 10 times earnings. So far, the investment thesis has played out well and the intrinsic value gap has closed over time. 

Another part of our investment process is evaluating what the business can do from here and how intrinsic value can grow. New management has been in place for almost two years and we feel they have a credible path to continue to grow intrinsic value. They are putting in pricing initiatives and value-based pricing—they never priced their products appropriately considering how much value they offered. It will not be easy with large customers like FedEx and Tropicana sitting across the table, but so far the initiatives are taking hold.

With regard to food manufacturing equipment, they have highly technical components to them with a lot of moving pieces. They could be pricing the new equipment more efficiently, but they also need to capture more of the aftermarket and services. In the past they were not successful enough in capturing the high margin aftermarket. This is also true on the airport equipment side of the business. Management has a new plan in place and we think this is another way they can continue to grow and improve margins from current levels. 

On the cost side, leadership has taken a knife to the business and we think they will become much more efficient operators. We see a potential path to continued margin expansion and a higher return on invested capital, coupled with growth, as they capture more of the aftermarket over time.

Q:  Would you share another example? 

Patriot Transportation is a company that recently split into two units—FRP Holdings and the new Patriot Transportation. We became interested when the management team from a business we had owned in our Value Fund for years, Florida Rock, sold their business and then went on to manage Patriot Transportation.

We knew that the management team was conservative and they were good capital allocators. In fact, they sold Florida Rock in 2007 at the peak of the market. We thought Patriot Transportation was undervalued and we saw it as a three-headed monster with a petroleum hauling trucking business, commercial properties in Baltimore and Washington D.C., and mining royalty properties. 

In our opinion, the company always traded for a cheap valuation versus the sum of the parts. Just this year, management finally completed a spin-off, which we consider to be a positive development for the businesses. Now there are two pure play companies—the trucking business and the real estate business, which includes the high free cash flow mining royalty properties.

Not only do we think that it will be easier for the market to evaluate the two businesses separately, but we also believe that each management team will now be incentivized properly on their own. We are still invested in both pieces of the business since the spin-off, but we think there could be more opportunities to buy their stock at cheap prices. Some of the index funds and ETFs may be selling either one of these pieces, especially the small trucking business that has under a $100 million in market cap today, which is a range that we can own but a lot of larger funds cannot.

Interestingly, the mining piece is aggregates. Construction volumes have come down a lot and although activity has picked up—Patriot could still use the Transportation Bill to increase the funding for building of highways—the pricing for these aggregates, throughout the whole downturn, has continued to increase. In the meantime, volumes have gone down so much that at a lot of the mines they own are only collecting the minimums right now. If we ever see volumes pick up in a meaningful way, there is certainly a lot of latent earnings power there. 

Q:  How is your research team organized? 

We have a research team of seven people, all of us being generalists. We can look wherever we want to find value, but most of us gravitate to, and have expertise in, one or another area. Historically, at Fenimore we have always had a lot of expertise in the financial area, beginning with the Chairman and Founder, Thomas Putnam. Two of our analysts, John Fox, our director of research, and Andrew Boord, carry on this tradition with an impressive track record of finding small regional banks and small Property & Casualty insurance companies, which constitute a significant part of our portfolio.

It is important to mention how our research has contributed in this fascinating area. After a difficult period through 2009, large banks are still dealing with a lot of fallout from the financial crisis even today. Some of the really small community banks have also struggled. We found a sweet spot in small regional banks from a few hundred million dollars up to a billion dollars in market cap that had been able to take market share from the larger players due to their problems. At the same time they were also able to buy some of the tiny banks that were failing. As a result, these banks have been able to grow their assets very nicely, growing their loan book at double-digit rates in the past year or two while having 15% plus return on tangible capital. They are well capitalized and trade at a very reasonable valuation. 

Q:  What is your sell discipline? 

Our sell discipline is that if stocks trade at a premium to intrinsic value that may be a sign that we are going to sell. We will also sell if we make a mistake in misjudging management or if they have made a big acquisition which can be perceived as an unwise capital allocation decision. In other words, if management changes the balance sheet, recapitalizes the company, and we are no longer comfortable with the debt load.

Our companies are growing revenues, and hopefully they are growing earnings faster, but even as you get to intrinsic value you could still make money from there. Being conservative on our intrinsic value levels, we think that we can get an 8%, 9%, or 10% return compounded from there. Since we buy at a discount, we hope we can get as much as 15% plus compound. 

We will not necessarily sell if a stock gets to intrinsic value as long as we deem the company to be a high quality business. 

Q:  What is your portfolio construction process? 

When it comes to the number holdings, we stick to a range of 20 to 30 names, although in recent years we have been staying closer to 30. We think that it is much harder to find value in the current environment and, as a result, we have less conviction and fewer big positions, respectively. For us, one of the ways to have conviction is through a big margin of safety. We do not think that having more than 30 names is the right way to diversify. We would rather put more money into our top 20 ideas than buy the hundredth name. 

When it comes to sector allocation, our portfolio is fairly diversified. Even in our largest sector, financials, we have a diverse group of financials, from real estate to P&C insurance, to small regional banks. For benchmarking purposes, we use the Russell 2000 Index.

Our smaller positions are around 2% and our larger positions, in this fund, could be 5%, 6%, or 7%. The position size is determined by how big of a discount it traded at to intrinsic value and how much of a quality business we consider a particular stock to be. 

Q:  How do you define and manage risk? 

To our way of thinking, risk is not beta or volatility. We would much rather think of risk as the permanent loss of capital. You can do a lot for your portfolio in terms of performance if you avoid the losses in the portfolio, but risk can also come in terms of valuation. Valuation risk is when a company’s stock trades at a big premium to its intrinsic value. 

There are certain areas of the market that we are avoiding at the moment because of unfavorable valuation, especially in the small-cap space. If you look at the Russell 2000 Index, some of the biotech or smaller tech startup companies, such as social media and other smartphone app driven businesses, are getting stratospheric valuations. 

These companies are valued on the multiples of revenues, not earnings. It is possible that the next Facebook is in there, but that is certainly not the game we are trying to play because we cannot predict which technology is going to be the next big winner. As these companies are burning through cash, we do not feel confident we can pick the survivors. For every one winner there are most probably 10 losers.

We have even backed our exposure away in the REIT space. A lot of investors are reaching for yield, whether it is a high dividend paying consumer staple, or a utility, or REIT. There may not be a lot of business risk in those types of companies, but we think there is a lot of valuation risk. 

We monitor the macroeconomic developments but believe we cannot predict the short- and medium-term events. That is another reason why we like to focus on good quality businesses.