SCI Insights: Candid, Off the Record Q&A with an Institutional Investor & Board Member
[Small-Cap Institute regularly interviews highly experienced investors, so that CEOs and board members can benefit from candid, rarely-heard feedback. To ensure the frankness and value of the material, the interviews are conducted on a “no-names” basis.]
Q: How did you get started investing in small-cap companies?
The first manager that I worked for turned me on to small-caps. He said that at small-caps, if you call the CFO to ask a question, he will actually pick up the telephone. He told me you could get a research edge by working like a ‘reporter,’ i.e. getting the ‘story,’ trusting, ‘but verifying,’ as they say.
Q: And do you find that to be the case? How have you worked to hone your senses in order to discern which management teams you’d like to invest in?
It is usually the case, yes. Sometimes it takes a little bit longer to get in front of management. You have to use your interpersonal skills to create an instant connection in order to distinguish yourself from other investors that call and ask lots of mundane questions. Assessing management is kind of part art, part science. It’s not just the operating results of the company, but it’s also how those results are articulated, and any observations you can obtain with respect to how they treat employees (i.e., is the corporate culture ethical and sustainable).
Q: What has compelled you to become an activist in certain positions, rather than simply selling and moving on to a new idea?
Well, a lot of small-cap companies have subpar governance and corporate controls. Sometimes you can effectuate meaningful change in the organization by joining the board. Or by being able to appoint a great addition to the board, pent up value can be unlocked.
Q: Can you expound on the governance and controls you feel most small-caps lack? An example or two would be helpful.
Public company boards, whether they are listed or not, are supposed to be selected predominantly by independent board members that make up the nominating/governance committee of a board. Sadly, in most small-cap companies, it’s the CEO who personally selects board members. Since board members are supposed to oversee the manner in which the CEO and others operate the company, it’s a glaring problem, as friends don’t typically do a great job objectively overseeing their friends. These Boards often allow Management to set the tone, weigh in on their compensation agreements, and influence other important decisions like capital allocation. This is the fundamental reason why the vast majority of shareholder activism is in small-cap companies. There are just far too many boards that are comprised of the CEO and his/her friends.
Q: When you joined your first public company board, having come on as an investor, what was the most eye-opening thing?
Unfortunately, I was struck immediately by how many directors were just unprepared. Sadly, many are there to rubber stamp the CEO’s plan, collect their fees, and hope everything works out so their stock options have value. Boards really require activism on the part of each Board member in order to do their job of overseeing the company on behalf of shareholders. Each member should bring their own specific skill set to the table and look to meaningfully contribute. There shouldn’t be any public company board members who view their participation as “optional.”
Q: And in your view, having served on a handful of boards, what percentage of directors would you venture to guess were up to the proverbial task?
It is hard to give a specific percentage. I would say that I have been fortunate to have at least one other director that truly puts in the time and effort on the boards that I have served. This is not to say that the world is full of bad people. Instead, it is full of busy people. Being effective on a board requires time and commitment. Whether it’s a small-cap or a large-cap, honestly I think most people do not have the time to meaningfully contribute.
Q: As a board member, what are your primary concerns on a day to day basis? Anything that might surprise most management teams?
If you need to think about operations on a day-to-day basis, you probably have a company in distress or the wrong CEO. Day-to-day board members should be thinking about the company’s positioning and strategy, and what relationships (financial, operational, social) you can help the company build.
Q: What is (are) the most troubling issue(s) you repeatedly find among small-caps you come across?
Small-caps have a hard time attracting top talent, are often victims of ill-conceived financings, and are often just too small to actually justify being public.
Q: What two or three key pieces of advice would you give the newly placed CEO of a small public company, assuming they had little to no capital markets experience?
I would say that a good CEO needs to manage investor expectations, be a strong communicator, and relay to investors what the key metrics of the business are. Investors must truly understand the factors that drive business performance and not get distracted by all of the other noise surrounding the company. You can boil down any investment to two or three key factors. Companies that consistently communicate this well will be rewarded when these targets are met.
Q: When doing due diligence on a new investment idea, what do you do first and what are some of the first places you look to assess whether an idea deserves more work?
We tend to be balance sheet investors; i.e., what is the value of this enterprise if we had to get rid of it in a fire sale? What is the solvency risk? Is it being run by competent, motivated management, and overseen by a board whose interests are aligned with shareholders?
Q: How much idea flow comes from other investors vs. fundamental screening?
Almost all of our ideas come from talking to other investors and industry participants.
Q: OK, last question. The requisite “If you could go back and give yourself advice at the beginning of your career, what would it be?”
You won’t have that many great ideas in a year, in five years, or even in a lifetime. Most ideas are average. Focus on your biggest and best ideas and don’t get distracted by the noise.