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Tracking down small-cap winners

Four clues to identifying the small-cap market's strongest management teams
Tracking down small-cap winners

A lot has been written about the best ways to analyse companies, from both a fundamental and technical viewpoint. It is essential of course to look at things such as market share, margins, return on capital employed, and cost pressures to predict the future of a company.

It is also important to be aware of more technical factors (as distinct from technical analysis), which can determine the size, depth, and other characteristics of the applicable investor universe. For example, a sub-£100mn market cap business may not be on the radar of many institutional investors, or the sector (eg, gaming, oil) may exclude it from some investment mandates altogether. Exclusion from institutional pools of capital can be detrimental or even fatal to the prospects of a business if it needs capital for expansion into new products or territories, or to survive difficult times.

But there is another key element to consider, which is particularly important in smaller companies. While the majority try to balance the interests of all stakeholders, there are many instances of companies which are run for the benefit of management rather than shareholders. Being able to find good management is essential to generating good portfolio returns. While the words of the Sage of Omaha, Warren Buffett, are very true – “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” – it is also true that a bad jockey can put even the best horse into a ditch. With that in mind, let’s look at some ways by which you can select better managements. The holy grail is a fast horse and a good jockey.

Marc Cohodes, US short seller and scourge of Wall Street, is a big believer in the idea that investors should bet the jockey, not the horse. What he means is that we should take a good look at the person running a company, and the people around that boss. Cohodes' particular short-selling expertise is in outing what can loosely be called rascals – although his term is stronger. 

Let’s take a look at some factors to consider when deciding whether to 'Bet the Jockey'. In one sense or another, much of what follows has to do with alignment of interest.

 

What business are they really in?

I used to follow a company (Company X) in the finance business, which nearly failed during the last credit crunch. Afterwards, it was carefully nursed back to life by a no-nonsense chief executive, who had a very simple formula – lend the money out and get it back, and do it again. After a few years of success in which the business was stabilised and put back on a growth trajectory, the CEO was replaced by a more ‘dynamic’ boss, who repeatedly made presentations showing a strategic growth plan with a goal of a £100mn market cap, more than four times where it stood at the time. Sounds good, doesn’t it? Maybe not for shareholders. This was to be achieved by a series of acquisitions in adjacent sectors, paid for with significant share dilution. Several acquisitions followed, yet the share price never really rose much, even though the company remained profitable. In fact, it drifted down and down and down, as successive share issues made to fund acquisitions were done at lower and lower prices, nearly doubling the share count yet without a positive impact on the earnings per share. Was it perhaps more about empire building and personal enrichment than shareholder value? One clue is the fact that the shareholding of the CEO was minimal – less than two months’ worth of salary.

A further clue indicating that investors might have done better to be wary is outlined later on in this article. But the point in this case is to keep an eye out for the rising share count and director share sales combination. It’s not good if funds are being raised and are going straight out the door for often-inflated director salaries, or if cheap options are being used as a significant source of cash compensation, which comes below the line.

 

Who benefits?

Alignment of interest is always an important factor to consider when you’re thinking of backing a jockey. In a horse race it’s easy – if the animal wins, I win. But in a company it’s often different. It comes down to three things: salary, shares, and related contracts. Make sure there is no misunderstanding when the CEO says: "We treat the company money as if it were our own".

First comes salary. Is it proportional to the work being done, the skill level, and the size and stage of the business? Of course, your jockey has to be paid for their work, but a CEO taking £250,000 in cash out of a company each year is a lot of money. Is this draining precious liquidity from the company? Is it significant in relation to the profits? I’ve seen the head of an established company taking 7 per cent of revenues as their compensation (shareholders did badly), and a quarter of a million being paid to the boss of a start-up (pre revenue, so just waiting for the next dilutive fundraise here), and a quarter of a million for a part-time job (again, waiting for the other shoe to drop). That is an immediate flag to see fundraising money going out to pay big salaries.

Another company I can think of, since delisted, had a habit of making acquisitions by paying a higher multiple than they themselves were trading at. Not only was this value destructive for existing holders, but they failed to gain much synergy from the businesses acquired. All that happened was the company got bigger, which provided the justification for management’s ever increasing pay packages.

That’s not to say that a salary plus bonus of £250,000 is always unreasonable. It depends on the company and the value added. I’ve just looked up two of my favourite small caps, and both chief executives are in the £250k to £300k range – but one has built an outstanding and profitable business, and the other has been instrumental in building a recurring revenue business which is nearing profitability.

Next comes shares. Does your jockey have a significant stake, either from founding the business or from purchasing shares? By purchasing I mean reaching into their own pocket and buying shares with money, not option awards with a nominal strike price. This is often the best sign of alignment: if a CEO or a finance director (FD) has sufficient confidence in their company to make a meaningful purchase. Meaningful is relative of course – an FD on a £60k salary making a purchase of £20k in the market is a much stronger signal than a CEO on £400k purchasing £50k worth of shares.

Businesses with a large founder participation are also good – not only because of material skin in the game – and if descendants are involved in the business there will be a great deal of family pressure to manage it prudently.

What about share options? Of course they’re a good incentive tool, but bear in mind that even though they may be deducted ‘below the line’, they are still an expense of the business. Options with realistic performance conditions and a strike near the current market price are good motivators, but options with nominal cost strikes or easy conditions are really just a transfer of shareholder funds to management. I've seen one company announce an Executive Incentive Plan (EIP) and a Growth Share Scheme, and at the same time grant a million nil cost share options to the CFO. Vesting conditions? Only that he needs to turn up to work for the next two years; apparently this is also in recognition of three years of past service. This doesn’t seem to be best practice to me. Keep a keen eye out for the proliferation and pricing of share options.

Sometimes big pay and option packages are justified by comparison to private equity (PE) compensation levels. But there are a couple of important differences. As CEO of a PE-backed firm, the executive would often be drawing a lower salary, with big share incentive rewards. But they would also likely have a very significant personal stake in the company, and be much easier to replace in the event of underperformance. Listed companies, by contrast, offer greater job security and a less painful downside if things go wrong.

I promised you another clue on Company X above – they tried to put in place an EIP plan which was ridiculously generous to management, including what were effectively free options. Key shareholders kicked up a big fuss and the plan was modified to something more reasonable. If the chief executive wanted more shares, he could either buy them to supplement his minimal holding, or earn them; they weren’t going to come for free.

There are many companies who put in place much more shareholder friendly plans, with material performance hurdles linked to return on equity, earnings per share growth, and total shareholder return. Let’s call one of them Company Y. Can you guess from the graph below which is which? Note that both companies remained profitable throughout the nearly five-year period shown, and respective CEOs remained in situ.  

 

Company X

Company Y

Shareholder friendly LTIP

Easy performance conditions, nil strike

25 per cent compound growth in EPS and TSR

Significant management shareholding

No

Yes

Less common, but also worth watching out for, are related party contracts. These can take the form of significant supplier relationships, or as a major customer. Sometimes it’s genuinely helpful to a company, but more often than not the principal beneficiary is the relevant director.

Sometimes a company takes firm and decisive action to address a problem. On 17 December, Litigation Capital Management (LIT), announced that it had sacked its executive vice-chairman, Nick Rowles-Davis, for gross misconduct. The company stated that the reason was the “identification of certain expenses claims which have been made in contravention of LCM’s global expense guidelines and policy”. While it would be perfectly reasonable for investors to have questions about what happened and whether the underlying problem was fully resolved, the board should be applauded for its frank disclosure, rather than sweeping the matter under the carpet with a bland statement that he ‘left to pursue other interests’.

 

Promises, promises, or ‘this time next year, Rodney…’

Keep an eye on the company over time, and compare what was promised with what was delivered. Okay, Covid-19 was a major event for every business, but we’re two years into this and it’s no longer really an excuse.

You can follow companies much more easily now using some excellent online resources. You can search a back catalogue of presentations to see how things panned out compared with the plan. And David Stredder’s Mello events (https://melloevents.com/) also offer an opportunity to meet companies either online or at face-to-face events. Over time, you’ll be able to see which chief executives overpromised and underdelivered, and which underpromised and overdelivered. And, of course, at all of these events you can ask questions to better understand why the goals might not have been met.

A friend with a superb investment track record created this matrix which he’s allowed me to share with you:

It’s useful to see if you can slot your CEO into one of these boxes. The best quadrant of course is where management is both honest and realistic. Things won’t always go the way you’d like, but you’ve got the best chance in the top right. Dubious realists may end up enriching themselves rather than shareholders from the success of the company, and honest dreamers usually end up with a pot of mud at the end of the rainbow. Worst of all are the dubious dreamers, where even if the company gets lucky, you won’t.

 

What other races is your jockey in?

Have a look at any other races your jockey is in. Companies House is an excellent resource for this: you can search at no charge, either by director (including the CEO, as they are usually on the board), or by company. Clicking through allows you to build networks of companies where they and/or associates are active. In addition to seeing where your jockey is active, you can often see associates who work with him/her and move from company to company. (You chair my company, and I’ll chair yours.) Marc Cohodes was particularly keen on building networks of rascals from which he used to find shorting candidates. While this may be a bit specialist and time consuming for most of us, if you see directors A, B, and C from a failed company reappear in similar roles at a new company, beware – the same thing may happen again.   

David Webb, the legendary Hong Kong investor and longstanding corporate governance advocate, took a slightly different approach to links between listed companies, when in May 2017 he published “The Enigma Network: 50 stocks not to own”. Through painstaking research, he highlighted cross shareholdings in 50 Hong Kong companies. One of his key insights was that cross shareholdings, which themselves were often small (and below the 5 per cent disclosure threshold), would often aggregate to provide significant voting power. This aggregation would then allow the companies to do things which were not necessarily in the interests of smaller shareholders. 

There is also a positive side to this coin. If you see what you believe is a high calibre manager, have a look at other businesses they are involved in, as well as other directors they work with. I was impressed with Andrew Brode’s long-term value creation at RWS (RWS), and learned that he was also chairman of a then small listed company providing talent and learning solutions, Learning Technologies (LTG). He and Jonathan Satchell (who became chief executive) had reversed the EPIC Group into a cash shell in November 2013 when the shares stood at 9p, and they declared a buy-and-build strategy. I met with Satchell in 2015, and his ambition and capability were easy to see. I first invested at 23.5p and today, the shares sit at more than five times that level, having nearly touched 240p before the recent tech sell-off.

Brode holds 117mn shares, and Satchell owns 73mn shares, so it’s clear that they both have significant skin in the game. While the buy-and-build strategy has required some share issuance, the alignment of interest from these large personal shareholdings has meant dilution has been kept to a minimum. A recent deal to buy workforce training programme provider GP Strategies saw most of the acquisition paid for with cash and borrowings – a tripling of revenue was achieved with just a 6 per cent dilution. The series of acquisitions made under the Brode/Satchell stewardship has meant that the share count has tripled. But what really matters to investors is that the share price has increased from 9p to the current 117p.

You’ll often see FDs or other key staff moving from one company to another. While it’s always worth asking why they left company A, it’s often worth taking a look at the business he joins; there may be something interesting happening there.

What does management do when there is a spin-off or business sale? Ippplus was a business providing call centre services and technology, with a nascent payment card industry (PCI) compliant business. In late 2016, the board sold the main business, paid a very large special dividend from the proceeds, retained the very small but fast growing PCI business, and renamed the company PCI-Pal (PCIP). Interestingly, the jockeys elected to stay with the rump business, in particular James Barham, who has since stepped up to chief executive. Revenues for 2022 are expected to be 40 per cent higher than those made in 2016 – and more than five times greater than those produced by the rump business in 2018. While the business is not yet profitable, its gross margins, revenue growth rate, and customer retention make it a company well worth watching. 

Elektron Technology, now known as Checkit (CKT), is another example. In September 2019 it sold its profitable Bulgin business, delivering the great majority of revenues, to focus on one of the smallest bits of the group which was a real-time operations management software business. It returned £81mn of cash to investors, and renamed the business Checkit. Once again, executive chair Keith Daley remained with the small but fast-growing portion of the business, which he clearly felt had greater potential to create value. 

It’s not always possible to follow the jockey, though. David Hornsby was an immensely popular CEO with private investors, no doubt because he took Ideagen (IDEA), an information management software business from about 8p a share in June 2009 up to 282p by the time he stepped back in May 2021. I’m sure investors are keeping a keen eye out in case he returns to the public arena.

And, of course, successful leaders often attract high calibre directors and managers to work with them. By watching their movements over time you can build a web of colleagues of successful chairs and chief executives and follow them to their new ventures.

Careful selection of the jockey can help improve your investment returns. Take a look at what business your board is really in, and who benefits from their actions. Keep an eye on how well they deliver on their promises over time. Knowing what other races they are in can tell you if they are distracted, but also give clues in finding other good businesses. If you follow these four steps, the chances increase that you’ll be drinking champagne in the Winner’s Circle.

Mark Lauber holds shares in Learning Technologies, Ideagen and PCI-Pal.