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Small Cap Opportunities: In Search for Hank Rearden

Aaron Monroe, CFA

As small-cap investors, we are passionate about hunting for and evaluating great overlooked businesses. Smaller businesses offer a rich vein of opportunity for investors like us who love to roll up our sleeves and dig into the fundamentals.

While investing in small-cap stocks is a common strategy to increase diversification and enhance return potential, it remains a much less efficient segment of the market ripe with opportunities. While the hunting ground is important, it is our intrinsic value approach to investing that is our ethos. This is where we believe we can most differentiate ourselves from others in terms of approach and long-term investment performance. This approach is easiest to articulate with an example.

Many of you are likely familiar with Hank Rearden, one of the lead industrialists from Ayn Rand’s “Atlas Shrugged.” As long-term investors executing with what we view as an owner’s mindset, Hank Rearden is the embodiment of the characteristics we search for in our investments — these include his integrity, capacity for excellence, trust of his own judgement, resilient structure of his enterprise, aligned interests and desire to trade value for value. Lastly, one key but often neglected element is his innate attraction to surround himself with other bright and capable people. In our experience as investors, these characteristics are often shared by some of the most successful enterprises that have compounded value for shareholders over the long run.

At times it can be easy to find one or two of these attributes, like a company with strong alignment and insider ownership. Yet, as Rand highlights through the dichotomy of the two main characters in the book, lineage and ownership do not immediately equate to competency. As we scour the universe of businesses, we keep these attributes top of mind and believe we have found intriguing opportunities that demonstrate much of the Rearden disposition.

UFP Technologies (UFPT) is an excellent illustration. CEO Jeff Bailey has been with the company for over three decades and has served as CEO since 1995. The business operates at the intersection of specialty materials, innovative applications and high precision manufacturing. UFPT is an important link in the medical device supply chain as a valued outsource partner to many of the top device manufacturers in the world. The company’s single-use and single-patient devices and components are used in a wide range of medical devices, disposable wound care, infection prevention, minimally invasive surgery, wearables, orthopedic soft goods and orthopedic implant packaging. Bailey has surrounded himself with a team that reinforces many of the key attributes Rearden possessed, resulting in a company that has grown its EBITDA (earnings before interest, taxes, depreciation and amortization) by nearly 15-fold over the last 20 years.

UFPT is now primarily focused on the medical field, which provides excellent opportunities to apply its skills. This has been a thoughtful and deliberate transition over multiple years with nearly 85% of its revenue now tied to the medical industry. The company’s exclusive and semi-exclusive access to important medical grade materials is valued in these industries, and UFPT has taken steps to secure its access. After finding the best lightweight crosslinked foam provider — which is ideal for medical packaging — UFP Technologies acquired five businesses over 2008-2009 to become the largest customer in North America. This paid dividends during the recent global supply chain crisis as it has had few problems procuring what is necessary for its business.

Having great materials is only part of the challenge. UFPT has a team of over 90 engineers and relationships with 25 of the top 30 medical device businesses. These companies partner with the engineering team to innovate and design custom solutions for their packaging, component and advanced material needs. This has resulted in excellent products such as the Site-Scrub needleless injection port cleaner or Bioshell, the single-use bioprocess bag protection. These innovations build lasting partnerships predicated on trading value for value.

While Bailey and team have done amazing work securing top materials and devising custom solutions, they are not immune to the need for value manufacturing. The business found some customers appreciated its innovation, custom tooling and precision manufacturing, but after a program matured and became less cutting edge, it became more susceptible to competitive bids. This drove some of the business’s most recent acquisitions and organic capital expenditures.

In 2022, UFP Technologies brought its Tijuana, Mexico manufacturing facility online, its first organically built ISO 13485 certified and FDA registered facility outside of the United States. It provides the company with 5,000 square feet of cleanroom space and the ability to economically extend many contracts due to its lower cost manufacturing footprint. On top of this investment over 2021 and 2022, UFPT acquired Contech Medical, DAS Medical and Advant Medical. These acquisitions provided medical grade certified manufacturing capabilities in the Dominican Republic, Costa Rica and Ireland. Yet again, UFPT identified an opportunity and executed a plan within a couple years. These investments planted the seeds of the nearly 20% organic revenue growth in 2022.

Much like Ayn Rand’s fictional hero Hank Rearden, Bailey and the UFP Technologies team have consistently looked to build a business centered around excellence and resilience. They have relied on their own business acumen and ingenuity to construct a company of value. As opportunities and issues have arisen, they have adeptly addressed them through acquisition and internal investments. As should be the case, the team has profited along the way due to its ownership stake and alignment with capital providers. This alignment is similar to how we think about our personal alignment with our clients — I have a material personal investment in our small cap strategy to align my interests with those of our clients.

UFP Technologies is not alone among our current holdings. Many of the Rearden attributes are evident in several other positions, whether it is George Gleason and team at Bank OZK (Ticker: OZK), Adam Chase and team at Chase Corp (Ticker: CCF) or Colin Reed and team at Ryman Hospitality (Ticker: RHP). We believe each business has an inner Hank Rearden and an uncompromising drive for excellence, an operation built on honesty and integrity, trust of one’s own judgement and leaders surrounded by highly competent people that share a similar mindset. These are the types of businesses we strive to find and believe will deliver exceptional results over a long period of time.

As of 30 April 2023, the Diamond Hill Small Cap Strategy owned shares of Bank OZK, Chase Corporation, Ryman Hospitality Properties, Inc. and UFP Technologies, Inc.

Securities referenced may not be representative of all portfolio holdings. The reader should not assume that an investment in the securities was or will be profitable.

Small-capitalization issues tend to be more volatile and less liquid than large-capitalization issues.

The views expressed are those of Diamond Hill as of June 2023 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not a guarantee of future results.

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