Going 'micro' for maximum gains

Two years ago, after managing a small-cap institutional fund for First Austin Capital Management, Inc., in Texas, Brian Bares started his own firm, investing exclusively in micro caps, the smallest of small-cap firms.

Investing for friends and family, he developed a track record running Bares Capital Management that led Money Manager Review to name him the top-performing private small-cap equity manager in the US for 2001 – up 68 percent for the year.

Mr. Bares hopes to ride the relative recent strength of small-cap firms with his Bares Micro-Cap fund.

With just $1 million under management so far, the fund has recently been opened to institutional investors as well as wealthy individuals. In a rough second quarter for the market, it fared better than most – down just 1.78 percent. For the year to date, the fund is up more than 22 percent.

Bares's target firms: companies with market capitalizations under $200 million. These, he told the Monitor, offer the largest playing field, the greatest value gaps, and the best opportunities for growth.

What's unique about your strategy?

We run a concentrated micro-cap strategy, holding between 10 and 20 stocks in our total portfolio. There are a lot of concentrated strategies and there are a lot of micro-cap strategies around, but very few venture into that realm.

If we can concentrate our funds in the best investment ideas in the portfolio, we think the performance will reflect that over time.

The obvious downside is that with fewer positions in the portfolio, you're statistically [as likely] to underperform as outperform. But the risk to a lot of managers isn't necessarily in the positions [they] own, it's in the positions [they] don't own, vis-à-vis their benchmark index.

By being concentrated, we can eliminate a lot of the land mines that are out there in the micro-cap universe, and there are a lot. A very large percentage of the stocks in the micro-cap universe are companies going out of business, overly speculative companies that have never made a dime in profits.

What is it you like about the micro-cap universe?

There's no following the Street in micro caps. There's relatively little in the way of investment-bank research [or] analyst coverage. There's relatively little in the way of large institutional portfolio managers paying attention to these stocks.

Therefore, you have a lot of intrinsic "value gaps" out there that are specifically the result of lack of attention.

The other thing that not a lot of people talk about is that companies under $200 million in market cap, which is our ceiling, represent 60 percent of the "investable" stock market, according to Market Guide.

If you've got approximately 10,000 companies on the exchanges, you're looking at 6,000-plus in terms of potential investment. The playing field is just so much larger. Think about the guys who are running $50 billion-$100 billion funds – they essentially have 500 selections where we have 6,000.

How do you avoid the so-called land mines?

We start with the investable universe and whittle that down to a universe of 1,000 to 2,000 companies by essentially taking out all the companies that are under $10 million.

From there, we eliminate companies that are overly speculative. These may be companies ... in natural resources/mining/minerals where we think that through our research efforts we couldn't add any value to the investment process. I don't invest outside what Warren Buffett called his "circle of competence."

From there we actually profile each one of those companies, looking for any unique competitive advantages ... without regard to price.

Once we've whittled that list down to about 200 to 300 stocks, then we monitor those on a price-to-intrinsic-value basis. From there we select the ones we feel provide the greatest potential capital appreciation.

How do you handle your research?

Our research is internally generated. We have some third-party research providers that are independent, and we like to know what the Street is thinking, if they have an opinion on the stock, because we want to know why a competitor would be taking a position contrary to our own.

But in the vast majority of cases there is nothing to compare it to, and we're doing everything from the bottom up, starting, of course, with the [Securities and Exchange Commission] filings.

We obviously have to exercise a lot of due diligence on the individual selections we make, and try to be as accurate as possible in assessing the ability to outperform the market.

We probably pay more attention to the predictability of revenues and earnings than most micro-cap managers because we are concentrated.

What are some companies you like?

One of the names we like is Edelbrock Corp. (EDEL), which makes aftermarket performance auto parts.

Here's a company that, in terms of predictability, is a relatively stable company that is consistently profitable. Their net margins are on the order of twice what a lot of replacement auto-parts manufacturers are.

The reason they can sell their products for higher prices is they have a strong franchise – name brand – as well as reputation for performance and quality among auto enthusiasts.

We've held onto the stock for a long time and feel they have strong upside potential.

Mity Enterprises (MITY), [a] Utah company, makes tables and chairs, which is about the most mundane thing. But they operate in a relatively stable industry. And Mity has a habit of making about twice as much money as their competitors do.

If you examine their financial statements you'll see they have no debt on their balance sheet, so they're in a better capital position than their competitors, and on top of that they have an extremely talented, shareholder-friendly management.

It's a dream to own. The stock price hasn't performed probably as well as the rest of our portfolio, but that just indicates it remains a good value.

Are micro caps, in general, getting overvalued?

We're certainly not finding as many values as we did 18 months ago, when micro caps were overly neglected. But there are still pockets of value we're finding out there.

I think we're still in an environment that favors this asset class, and I think we'll continue to be, only because it's easier for a company that's $100 million in total market cap to double, triple, or quadruple in size than it is for an Intel or a Microsoft or a General Electric.

So you'll continue to see strong performance from micro-cap stocks, but I think that selection is now at a premium.

You really have to be careful about which ones you're purchasing. But the fact that there are so many more of them gives you the opportunity to actually find some of these values.