Q: What is the history of the company and the fund?
In 2008, we started the Ancora Microcap Fund, which currently has more than $16 million in assets under management and a total of $56 million including institutional accounts.
I have been investing in micro cap stocks since 1991. In 1998, while at Maxus, we launched a micro cap fund that was acquired by Fifth Third Bank and grew to over $300 million. I stayed with the bank until 2005 before rejoining with my original partners from Gelfand and Maxus at Ancora.
The micro-cap segment of the market—companies with market cap of less than $500 million—is generally inefficient compared to the larger and more established corporations. Companies that are in the value category trade at even more inefficient levels.
In general, stocks in the micro-cap value segment tend to be unfollowed, unloved, and unappreciated. We recognize that these are smaller companies and they often have only one product or a simple product portfolio. What is more, they do not have the ability to borrow money whenever they want. Yet, we feel they need to be treated a little differently.
Q: What are the benefits of investing in micro caps?
The micro-cap value segment has delivered the best performance in the long term, according to several recognized academic studies. We think that micro caps are misunderstood in many cases because people think of them as penny stocks or stocks that no one follows. However, this small end of the market also has many companies that are widely known across the nation. Most of our portfolio is consists of these substantive companies.
Another popular myth out there is that investors can have access to micro caps via small-cap funds that also invest in the space. Our findings indicate that the average small-cap portfolio manager only has a few percent of assets devoted to micro caps for a number of reasons. Generally, successful small-cap managers get so big that they cannot maneuver in the micro cap area.
Moreover, some investors think that investing in the sector through an index fund is enough. In fact, nothing can be further from the truth. Different studies have shown that because of the inefficiency in this arena, it is the one market sector where the active manager does have some history of adding value and beating the index.
We see a lot of people making mistakes when it comes to investing in micro caps. Both investors and advisors misunderstand what micro caps are and avoid them because they think micro caps are too risky. Also, investors who do invest in micro caps tend to choose small-cap managers or index funds, which are the wrong ways to get exposure to this asset class.
Q: What is your investment philosophy?
We try to put together a portfolio of stocks that have proven, over time, to have the characteristics of successful micro-cap stocks. These characteristics are the margin of discount in the stock price to the intrinsic business value, a strong balance sheet, and evidence of positive insider activity.
From a technical standpoint, we like stocks that have come down over time and have shown some basing technical pattern. We also look for a potential catalyst. For example, has there been a management change? Have they been working on a new product? Have they cut costs a lot recently? What is going on that could change the trajectory of earnings that has put the stock down?
In value, we are looking for typical valuation metrics, and when screening for ideas we do not use serial screens. A lot of these companies would be screened out if you were to do this. We screen on the valuation metrics separately, and when we come up with the ideas, we put them through our normalized return analysis. We are looking for companies whose current returns are far below what the normalized return should be, and will be, in the future.
There is a tendency in the market for things to revert back to a mean. Companies that earn well below their normal earnings capacity will be under pressure to get back to normal. If management cannot do it, oftentimes that is when they get bought out. The buyout price is often close to the figure that we have calculated for normalized return value.
Q: How do you apply your investment process?
Our diversified portfolio consists of 75 or 80 names that meet our key criteria, which I highlighted earlier. It does not necessarily work every quarter or year, but over time it provides returns that are ahead of other asset classes.
We are looking for opportunity in companies with market cap between $25 million and $500 million, and there are thousands of companies in this market cap range. After screening to get down to a manageable number that meets our key criteria, we look for other intangibles to understand why the company has been earning below normal levels.
Our time horizon is generally about three to five years for each stock. Sometimes it will get bought out the quarter after you buy it, while other names may take longer to turn around. Even after it has been turned around it can take a little time for the market to fully appreciate and reflect the improvement in the stock price. As a whole, our portfolio turnover ranges from 25% to 30%.
Q: What is your research process?
Most of our ideas come from our own screening. We will screen stocks on multiples of earnings, sales, book value and dividend yield, searching for companies that are undervalued on any of those parameters. Then, we apply our normalized return analysis on these companies. At this point we want to see what the company has earned over a long period of time, what the earnings in the industry are, and how that compares to where the company is currently earning. When we do the calculation we want to see 50% upside potential from where the stock is today to what we perceive as its normalized value.
Q: Would you highlight this with some examples?
A relevant example would be Albany Molecular Research, Inc, a provider of contract and research manufacturing services. Historically, the company had earned decent returns, but they have recently had negative earnings comparisons as royalties from Allegra have been going down. At the time the allergy relief product was starting to come off patent.
The earnings have suffered while the company is building other revenues streams, which are still to grow to a sizeable level, so we came to conclusion that the earnings would bounce back once the other parts of the business grew.
We had bought the stock from the high single digits down to its low at around $3. Eventually, the earnings started to improve. The stock then rebounded and has got as high as $25. Although we have sold some of it, we still think that there is room for the stock to grow.
Another example is Hawaiian Holdings, the parent of Hawaiian Airlines. Airlines are not usually thought of as micro cap, and Hawaiian is a leader in the travel to the island from Japan or the U.S. Additionally, they have one of the best on-time records of any airline that travels in the region.
After the airline had added a large number of planes, earnings came under pressure due to this increase in the company’s capacity. In fact, earnings were well below normal earnings in the industry. We felt that if they did not turn around and get earnings back up, there were a lot of airlines that would acquire them at a price that should reflect normalized earnings in the industry.
We had seen a continued consolidation in the airline industry. At the same time we did not feel that there was a lot of risk due to their reputation and routes. We just knew that if management did not get earnings back up, someone else would do it for them.
The stock got hit recently because investors expected earnings to grow last quarter on the back of lower oil prices. However, the way the company accounts for the hedges made earnings look worse than what the market had expected. Our analysis showed that the decline was because of accounting, which had factored in the value of the hedge, and there was just a small benefit of the drop in oil prices that quarter. Over the past six months they have had some good routes awarded to them—something that has helped their capacity utilization.
Another example is Lakeland Industries, one of the primary manufacturers of hazmat suits and protective gear. Their earnings had been weak for a while and the investment in Brail dragged the performance even more. The stock had dropped to a price valuing the company at a significant discount to book value.
Since they are one of the very few companies in this business, we felt the company was in a good market and the stock was trading cheap. At the time they were also starting to take actions to resolve the Brazilian issue. So, in 2014, when the Ebola crisis hit, the stock went from $6 to $20 in just three weeks. We sold 95% of our holding as it went up. The Ebola crisis faded and the stock moved all the way back again to under $10. We felt that it was an even better company with reduced debt and in a better financial shape, so we started buying it back again when it was below $10.
Q: How do you construct the portfolio?
We have found over time that somewhere between 75 and 100 names is a reasonable number of holdings. You need to be diversified enough so that any single mistake, if a company runs into a problem that cannot be solved, will not destroy the portfolio. Too many names would also turn the portfolio into an index fund, limiting the potential of returns that an active manager can provide. We build the portfolio primarily bottom up and look for names that meet our value criteria. In addition to that, we also apply a top-down approach to avoid sector over concentration.
Although we ensure that we limit our total allocation to any one stock to less than 10%, we will rarely exceed the 5% limit. We also limit our holdings to 1.5x the sector limit in our benchmark, the Russell Microcap Index.
Our portfolio construction process begins with the ideas that our research generates rather than with the benchmark. Of course, there is some overlay to make sure that we do not get out of line with the index in terms of total weights.
We tend to buy gradually. Being a value buyer, we are generally early so we step our way in. Generally, if you buy into the lower quartile of the price, you will get a good average price.
The percentage allocation varies with the financial condition of the company, our conviction, as well as some other factors. We may have 2.5% or 3% positions in the companies where we have the most conviction, while the less liquid names may only have between 0.5% and 1.5%.
Q: What is your sell discipline?
In terms of our sell discipline, the most positive aspect of normalized returns and normalized value calculation is that it gives us a sale target. Once a stock starts exceeding what we calculate as the normalized value, that is a clear sign to us to start exiting.
If we see a whole raft of insider selling, and the stock is slightly below its normalized value, we will exit early. We will certainly not stick around when the company has a significant deterioration in their financial condition. If there is a huge loss that changes the financial character, even if there is a bit more value, the value has still changed and we may get out.
Q: How do you define and manage risk?
We think that if you have a diversified portfolio, you have diversified away a lot of the single stock risk. For us, the primary risk is that of losing all your investment in a single stock. You cannot protect 100% against that. Historically, we have had a couple of stocks that have surprised us, but they were not big holdings.
The best way to reduce that risk is through investing in companies with strong balance sheets, and our companies tend to have much better balance sheets than the index. For example, on average the companies in our portfolio have 14% debt to capital ratio compared to 24% in the Russell Micro Cap Index and 35% in the S&P 500 index. Not only do good balance sheets protect you from substantial losses; they also enable you to take advantage of stock price drops because, psychologically, you have much more confidence.
Micro-cap stocks are undoubtedly more volatile than their counterparts across the rest of the market cap spectrum. Sometimes the market takes them down unfairly but you can use that as an advantage if you know the company will survive, especially if you are confident in the fundamentals. This is clearly something that we did with Albany Molecular. We made a lot more money because we had a big position when it was low, which we would not have done had it had a lot of debt.
Strong balance sheets bring more than just ultimate protection—they provide portfolio flexibility and the ability to take advantage of market drops.
