Small Company Investing — Resiliency Is Key
We recently sat down with portfolio manager Aaron Monroe, CFA, to discuss his views on investing in small companies and where he’s finding the most attractive investment opportunities in today’s market.
Diamond Hill is known for its intrinsic value approach to equity investing. Can you start us off with a brief overview of how you think about intrinsic value?
Aaron Monroe, CFA: At Diamond Hill, we believe intrinsic value investing is the most logical and prudent way to deploy capital for our clients. There are some core principles that I believe all intrinsic value investors agree upon. First, what we are buying is truly a stake in a business. Second, the business has a value that can be reasonably approximated. Lastly, we purchase our stake in the company with a margin of safety.
However, it is also important to note that not all intrinsic value investors are alike, with a lot of the nuance coming from where one derives their personal margin of safety to keep them rational during difficult times. It may be best to visualize the concept on a spectrum, all falling under the intrinsic value umbrella — on one end you have investors who derive their comfort quantitatively from valuation or a low multiple. One sleeps better at night the less expensive the stock, as they believe that price is the solution to all risks. On the other end you have those who focus on the qualitative elements of a company such as how the business is built, the industry structure in which it operates, the depth of its competitive moat, the franchise durability and its ability to compound value over time. Personally, I heavily tilt toward the qualitative side of the spectrum — appreciating the aspects of the business itself with an ownership mentality. If a company has the resilience and durability to grow its value over time and is trading below what I believe is a reasonable long-term valuation, it puts patience on my side and allows me to stay rational during challenging environments.
When applying that intrinsic value approach to the small cap universe, is there anything unique that you focus on?
Aaron Monroe, CFA: As one goes down the market cap spectrum, individual business risk naturally increases while liquidity naturally decreases. I believe most investors appreciate that markets and industries cycle and that there will be both good and challenging times. Because of these factors — heightened business risk, less market liquidity, and natural cycles — I want to own companies that I believe can navigate the challenging times well and ideally come through stronger on the other side. So, I tend to place a heavier emphasis on understanding how the business is built, the way cash flows are generated, the inherent culture of a company, the secular trends of an industry, and both the financial and operating leverage a business is utilizing.
I tend to break down the small cap universe into different segments. On one end, you come across many highly distressed companies. These tend to be super inexpensive but come with a lot of leverage, typically have a lot of industry risk, and tend to be more path dependent. These opportunities have wide ranges of outcomes despite highly attractive valuations. On the opposite side, you can find many innovative businesses in the small cap universe — these tend to have exceptional, often market disrupting, technologies but tend to trade at rather expensive valuations and come with equally wide, often binary, ranges of outcomes. Within both segments, I have found it difficult to prudently deploy capital due to the extremely wide range of outcomes. Because we define risk as permanent impairment of capital, when zero is within the realm of possibilities, there is not enough of a margin of safety for me to comfortably invest.
At the end of the day, we want to buy good, resilient businesses that we can understand. We want to have a good handle on the industry structure and appreciate what a company will look like 5, 10, 20 years into the future.
The definition of small cap can range depending on who you talk to. What market cap range do you typically consider as your universe?
Aaron Monroe, CFA: Our typical range is $100 million to $3 billion or anything below the top of the Russell 2000 Index, which has been as high as $7 billion to $8 billion. That said, I want to maintain the integrity of running a small company focused strategy, and I want to allow sufficient runway for the portfolio to compound before I consider managing the position sizes due to market cap. Therefore, I tend to like new positions below $4 billion and have fortunately been finding a lot of our more recent opportunities below $2 billion.
A lot of small-cap investors emphasize quality but that can mean different things to different people. What is your perspective?
Aaron Monroe, CFA: When I think of a quality company, I would typically define that as one with a deep competitive moat, steady revenue stream, reasonable growth and solid return on equity, combined with a narrow range of outcomes. If I can find businesses with those characteristics trading at a discount to what I think they're worth, they are fantastic additions to the portfolio. But I find a lot fewer of those as I go down the market cap spectrum.
I find that companies with more cyclicality can present equal if not more intriguing investment opportunities. Even though these types of businesses can experience more ebbs and flows through a market cycle, I think they can still have strong competitive advantages, solid market share, and earn good returns on invested capital over long periods of time. Plus, their industries have natural cycles that can create opportunities for the businesses that are prepared to invest countercyclically.
For a business to have the capacity to make these investments, I believe it has to be built with some inherent resilience or capacity to suffer during a downturn. These companies can often find ways to organically grow market share, inorganically consolidate the industry by taking out weak competitors, or build an even greater competitive advantage, ultimately growing the intrinsic value of the business often at an outsized pace than other companies.
As a portfolio manager, I want to make rational decisions about any potential investment. So, identifying companies that are resilient gives me confidence to put additional capital into that investment during the dark days of that industry.
What are some of the key attributes that you like to see in the management teams of businesses? Any examples?
Aaron Monroe, CFA: Ideally, we want to have a patient and thoughtful, long-term focused management team that is aligned with the long-term interests of shareholders. We do appreciate insider ownership as it aligns with our ownership mindset. We want the management team to reap the benefits and suffer the consequences of their decisions just as we do as passive shareholders. I also like individuals who surround themselves with other competent people, independent thinkers who are comfortable being different and stand in the face of the short-termism of the world today.
One management team that I believe is exceptional is George Gleason and the team at Bank OZK. For those who are unfamiliar, Bank OZK is a regional bank based in Arkansas with a broad southeast presence and a major focus on commercial real estate (CRE) development. Despite being in the middle of a challenging banking environment, the Bank OZK team has built the business to thrive in this environment. CRE development can be highly risky, but the company has developed specific underwriting standards that it adheres to that provide a large buffer in terms of covenants, loan to value and capital seniority, to name a few. They have also partnered with what I would say are high-quality equity sponsors on their commercial real estate projects providing good capital to support projects to completion. Additionally, the company delivers attractive high teens returns on tangible capital employed while maintaining a low teens tangible common equity ratio, resulting in a conservative balance sheet which makes their industry-leading returns all the more impressive.
CEO George Gleason still owns roughly 5% of the company, aligning his interests with those of its shareholders. He and the management team lead a conservative culture and have built a business that demonstrates significant resiliency in one of the more trying times for banks.
Speaking of banks, how do you think about banks today in terms of resiliency given what we’ve seen happen with some of the regional banks.
Aaron Monroe, CFA: While the crisis that we witnessed in mid-March isn’t something an investor ever wants to experience, I still find banks to offer a compelling investment opportunity. In fact, I think challenges like this can allow banks to galvanize their competitive position. In my opinion, banks are in much better shape today than 20 years ago. Following the 2008 global financial crisis, banks modified their underwriting standards, moving a lot of the challenging-to-underwrite things off the balance sheet. Ultimately, that crisis made banks more structurally viable.
This latest crisis is now testing how the regional institutions are built from the deposit side. As we get to the other side of this latest crisis, I think investors will come to appreciate those companies that have always recognized the various risks within the industry and have structured their businesses accordingly.
I think the banking dynamic is going to be different in 5 to 10 years from now — there will be a heightened level of regulation, higher capital requirements, and more competition for quality loans. So, I think there will be margin compression broadly speaking, but I also believe the best institutions will still be able to earn returns that are attractive relative to their cost of capital.
Today, many banks are trading around tangible book value, if not below. So, if you can identify those that have a conservative structure, like Bank OZK, I believe they will be able to survive any future storms and provide investors with attractive long-term returns.
Looking forward what other areas of the market are you excited about?
Aaron Monroe, CFA: Our largest holding right now is Red Rock Resorts. It is the market share leader in the Las Vegas locals casino market.
Legislation in Las Vegas restricts where casinos can be built within the off-strip region, and Red Rock has over 50% share and controls many of the viable land development areas around the valley. So, they're basically in control of the supply that will exist over the next 10 to 20 years. In fact, they have a new project coming online at the end of this year that should address a portion of the Las Vegas valley that doesn't have a casino within a five-mile radius. In addition to a strong market position, the business is supported by a zero-income tax state where you're seeing significant population growth from migration, sports teams and business transfers, and investment into the community and infrastructure. This has created an even more diverse and vibrant economic region. It isn't the same Las Vegas of 20 years ago. I believe the company enjoys a wide economic moat, attractive tailwinds, a reasonable balance sheet, and is still trading at an attractive valuation. All of this with a management team that I believe is highly competent, strongly aligned with shareholders and has demonstrated their ability to execute.
As of 31 May 2023, Diamond Hill owned shares of Bank OZK and Red Rock Resorts Inc.
Margin of safety is a principle of investing in which an investor only purchases securities when their market price is significantly below their intrinsic value. In other words, when the market price of a security is significantly below your estimation of its intrinsic value, the difference is the margin of safety.
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.