“Charlie and I believe that those entrusted with handling the funds of others should establish performance goals at the onset of their stewardship. Lacking such standards, managements are tempted to shoot the arrow of performance and then paint the bull’s-eye around wherever it lands…”

Warren Buffett – 2010 Berkshire Hathaway Shareholder Letter

Over the past several months, I’ve literally looked at thousands of different companies in the microcap space. The stocks that made my watch list were ‘cheap’ by one metric or another.

Often it’s the balance sheet that catches my eye – a stock trading at a large discount to book value. Or sometimes the company trades at a low multiple to its long-term earnings power – a low EV/EBIT ratio as one example.

But in microcaps – more than any other asset class – one indicator sticks out above the majority:

Quality of management is key.

The logic makes sense – in a tiny company, strong management has a huge influence on strategy and corporate decision-making. A good CEO remembers that their duty is to the shareholders, and even institutes practices to reward long-term holders (see ADVC).

A great CEO is able to turnaround a struggling company.

As a general rule, I invest in companies where insider ownership is very high. If insiders have a financial stake in the stock, then the idea is that they are financially motivated to make smart, value-creating decisions.

Control Shareholders

Investing in this space also requires an evaluation of ‘control shareholders,’ usually a family or founder that controls more than 50% of shares outstanding.

In such circumstances, it is much harder for activists to push for change, and therefore value investors – attracted to a low P/B or excess cash balances – are left with fewer options if management starts acting irresponsibly.

In these control situations, an unexpected acquisition – my favorite type of value unlocking situation – is less likely, but it is usually counteracted by a stable share count and potential to be taken private at a premium.

Usually, the greatest danger is if management is satisfied with the status quo and does nothing while the stock price lingers and excess cash sits on the balance sheet (or even worse, is blown on a dumb acquisition).

Management Compensation

High insider ownership is one part of the scenario, but I also firmly believe in another maxim:

People respond to incentives so compensation must be properly aligned.

I check the insider ownership position in the proxy statement, but also spend time understanding the performance targets and bonus structure for company management.

I’ve been around enough bonus and commission plans to know that people will exploit the bonus structure to its fullest extent, so care must be taken to ensure that management and shareholders’ interests are properly aligned.

Recent Examples

The importance of these two concepts is not confined to microcaps however.

Just ask Microsoft’s shareholders after the company’s recent acquisition of Skype – “Microsoft Buys Skype: I Feel Poorer”

As Warren Buffett said, management must not move the bulls-eye in tough times and also be willing to forego a bonus if results are not up to par.

In critiquing the bad compensation practices at Kraft, My Investing Notebook summed up the ideal scenario.

If only more companies followed this advice:

“Setting compensation is not that difficult. Pay people well for things they control, don’t reward them for things they don’t. Think on a per-share basis. Avoid tying compensation to share performance. Avoid stock options. Pay very well for operating performance and return on incremental invested capital.”

Empirical Finance just released a detailed research study that backtested a simple Ben Graham strategy for investing in stocks.

Backtesting Ben Graham

The backtest is based on a 1976 article in Medical Economics magazine, where Graham was interviewed and provided some tips on stock selection.

From the article,

“Graham believes that a doctor handling his own investments should be able to utilize those same principles to achieve an average return of 15 percent a year or better”

According to Graham, investors should look for two defining characteristics when picking stocks:

• P/E ratio of 7 or less
• Shareholder Equity ratio of > .50

Graham also goes on to recommend a portfolio of roughly 30 stocks and a holding period of two to three years.

Empirical Finance has done an amazing job of running the study based on these criteria. Here is the explanation:

“We decided to keep it simple and backtest the low P/E (<10), shareholder equity > .5 strategy from 1965–2010. We also backtested the results in accordance with the “trading rules” alluded to by Graham: stocks entering the portfolio are held for 2 years, or if they appreciate >50%. For robustness, we tested a variety of P/E and shareholder equity combinations–all results are very similar.”

It turns out that Graham was spot on with his return estimates:

Both the small and mid-cap backtests eclipsed the 15% CAGR metric for the study period.

It looks like the large-cap portfolio did not fare as well.

The study is great confirmation that Graham’s methods work, especially for the smaller stocks that are the focus of this blog.

And probably proof that many investors badly over-complicate their stock picking strategies – myself included!

After reviewing the rationale behind closing my investment in SYK, this is the second part of my series on recent stock sales.

iParty (IPT)

While the investment in SYK turned out well, iParty (IPT) is an example of how several errors can compound to change the attractiveness of a position.

Through the first two quarters of this past year, IPT had turned in better than expected results.

In the initial writeup on IPT, I thought that the company was poised for a big year. Same-store comps were up 1.3% and 1.4% on a quarterly basis, putting the company on a strong path going into its busiest time of year – the Halloween season and fourth quarter.

Third quarter results showed a boost in the number of temporary Halloween stores – from 4 to 11 – that caused a  $1.9m loss in the 3rd quarter compared to $1.4m in the same quarter in the prior year, setting back the company’s progress.

Then, fourth quarter results did not show the expected jump. While the balance sheet improved, the company reported full year earnings of only $254k compared to $1.1m in 2009.

I try to avoid putting too much attention on quarterly results, but do keep a close eye on investments and evaluate them when appropriate.

Investment Review

With IPT, I made a mistake in this analysis on two fronts:

1) In the DCF valuation, I placed a much heavier weight on 2009 results – a high water mark for the company – vs. using the long-term averages. My upper estimates were predicated on a growth rate that was not supported by the historically lumpy results (as opposed to a company like SYK, where the trend line has continued upwards more or less in a straight line)

2) I did not include the significant number of preferred shares in my original EV calculations. Not my finest moment, but one of the consequences of learning on the job.

With this new calculation using the preferred shares, total EV comes out to $27.5m. This translates into an EV/EBIT multiple of 30x (!) using 5 year averages.

EV/FCF is slightly better due to the large depreciation expenses, but still high at 21x.

While the company has the backing of top tier investors, continues to expand its retail footprint and clean up its balance sheet, it probably doesn’t qualify as a value investment at these levels.

Conclusion

Warren Buffett said,

“When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.”

Retailing is a tough business, and IPT is in an especially tough part of the retail market. 5 year average ROE of 4.06%, CROIC of 9.25%, and ROIC of 2.54% reflect this challenge.

My investment methodology has gotten more conservative, with a heavier focus on long-term averages, which therefore changes the viewpoint of IPT as a viable value investment.

With this in mind, I closed out my position at $0.30 per share on Feb 24 – I’ll take the gain and move on.

Final Thoughts

To be clear, my preference for long-term investments hasn’t changed (despite the whirlwind of sales in recent months).

It is important to grow as an investor, and I feel like my approach has changed significantly from some of the early analysis on this blog. As my philosophy matures, I’ll continue to make adjustments to the portfolio.

Learning from mistakes is a big part of that process.

Disclosure

I still own a small remaining position in IPT (1%) in my personal account.