[In the asset management universe, there exists a vast array of strategies and approaches to investing money. Many fall into relatively distinct groups like growth, value, income or quantitative. Each approach is steered by one or more portfolio managers and their respective investment teams that have their own specific view of the market, what elements of the investment landscape are most important to focus on, and which signals to use when deciding to strike or retreat from the chess board.
From this diversity of efforts, certain investment strategies exist that do not adhere to the established, traditional parameters and patterns of investment thinking and portfolio management. These asset managers do their own thing, knowingly snubbing their noses at the traditional investment world, and decisively following their own path. Fortunately, and unfortunately, these approaches create both opportunities and challenges.
Atypical stock portfolios often generate performance that differs drastically from benchmarks. These approaches offer investors and asset allocators a public-market approach to diversification versus continuing portfolio overlap with standard investment options or illiquid alternatives such as private equity. These types of nonconforming portfolios tend to exhibit their own dynamics with episodic performance, rather than just following the greater market forces, which requires both patience and a different investor mindset.
These ideas and ponderings come to mind whenever I speak with Institute members 180 Degree Capital Corp — a Montclair, NJ-based publicly traded, closed-end fund (NASDAQ: TURN). Speaking of “following your own path”, they apply an atypical mix of seemingly disparate investment elements in the construction of their portfolio including microcap stocks, Graham & Dodd valuation analysis, concentrated portfolios and constructive activism. Investing from this multi-level perspective helps them isolate opportunities from a very different point of view than is commonly found in public-market investing as they also add a touch of a private equity approach to their public investing strategy.
I reached out to Kevin Rendino, CEO and portfolio manager and Daniel Wolfe, president and portfolio manager to ask them deep dive questions into the nature and process of managing a stock portfolio that follows its own unique dynamic rather than that of the masses.]
Bill Hortz: Key elements of your investment strategy revolve around microcaps, Graham & Dodd valuation, concentrated portfolios, activism, and having a private equity mindset. What do you see as the key benefits of each area in your investment strategy?
Kevin Rendino: Our Graham & Dodd approach allows us to identify undervalued companies whose stocks we believe provide the opportunity for 100% appreciation over a one-to-three-year cycle. Focusing on microcaps means we are participating in a market where there are significantly fewer sophisticated investors, which we believe means there are more opportunities for us to unearth than would otherwise be available amongst larger market capitalization companies.
Daniel Wolfe: We also believe that being concentrated allows our investors to have the potential to achieve higher returns, if we get our stock picking right, than could be generated from diversified funds. Of course, the converse is possible if our stock selections do not perform as we believe they can and their stocks decline in value. This risk is why we first ask ourselves, “How much do we believe we can lose?” on each investment so that we manage risks appropriately. We are not afraid to walk away from an investment at a loss if the investment thesis is no longer applicable.
And, lastly, by being constructive activists, we think and act as engaged owners, like principals, in a hands-on working relationship with managements, which is unlike most traditional, passive institutional investors. We are able to work hand in hand with our portfolio companies in order to unlock the value that we believe we have identified through our analysis.
Hortz: Can you explain what is in your guiding investment thesis that helps you have patience to weather volatility and periods of relative underperformance in your portfolio companies?
Rendino: We apply a number of traditional “value” investor screens to the publicly traded microcap market. All of the other pieces of our investment approach (in particular, our concentration and constructive activism) are predicated on first identifying companies that we believe are undervalued relative to other comparable companies in the marketplace as well as undervalued relative to that company’s longer-term earnings power.
This initial screening is followed by a deep dive into their management, the strength of their current and prospective business, and a rigorous analysis of their financial statements. If this analysis yields a catalyst that we are able to identify and that we believe, should it occur, will lead to a sharp increase of the stock price of a target company, then we will initiate a position. As mentioned earlier, we run a concentrated portfolio of 10 to 15 names. Of those, 4 to 7 are targeted to be core positions that ultimately determine our performance.
Wolfe: Because we are concentrated, we own material stakes in many of our portfolio companies of often more than 5% and sometimes more than 10% of outstanding shares. This outsized stake in each company we invest in typically provides significant leverage in working with company management. After identifying areas where we can be helpful to management and the board, we will bring our constructive activism to the process and, in so doing, aim to help the company to unlock the catalyst(s) that we have identified.
Hortz: Kevin, you used to invest in large-cap companies. Why have you shifted to investing in micro-cap companies?
Rendino: We believe the micro-cap market provides a number of advantages for us as investors relative to larger markets. One of those is that there are significantly fewer investors picking over the many stocks that make up this market. So, while we may be “fishing in a fairly small pond”, we believe we are one of a limited number of institutional investors that actually has a pole in the water. This characteristic provides us with the opportunity to try and find investment opportunities before their businesses turn and attract the interest of more investors.
A second advantage is that because these companies are relatively quiet and small and additionally often lack experience with the public markets, they often are open to working with us constructively to find ways to increase investor interest in their companies. Also, due to the size and the fact that many microcap companies should probably not be stand-alone public companies to begin with, there is significantly more merger and acquisition activity than in the larger public markets.
Hortz: Why do some of your portfolio companies in this market environment not move in lockstep with their improving fundamentals?
Rendino: One downside to the micro-cap market is that in a bearish environment, these stocks are often more out of favor than the market as a whole. This underperformance can be exacerbated by how thin the trading can be in many of these stocks. It is not unusual for microcap names to grind down in price on very little trading volume and without any news or information that would be a cause for triggering a selloff. However, it is worth noting that in a bullish environment, the same factors have historically caused micro-caps to outperform relative to larger market cap companies.
Wolfe: We purposely focus on a small number of companies so that we can understand the business of each one in as much detail possible. This level of understanding is important particularly at times where overall market declines can lead to weakness in the face of improved fundamentals in our businesses. When we believe it is appropriate, we can use such weakness to add to our positions ahead of the catalysts that we believe can unlock value in the position regardless of what is transpiring in the overall market at the time.
Hortz: What are some examples of the difference between public versus private activism and how do those actions potentially reap rewards for the stock price and your investors?
Rendino: At 180, we strongly prefer private activism where we work behind the scenes with both the board and management. These actions can range from smaller items like directly working with management to engage a new investor relations firm, or it can be significant such as helping management to rework difficult capital structures and boards to improve corporate governance.
Sometimes we will join the boards of our portfolio companies. To date, we have only done that when asked by the company and never in an acrimonious setting. Typically, our joining the board has been part of a strategic alternatives initiative where we are able to use our expertise to help generate a more positive outcome for the company in question.
Wolfe: In rare instances, we have had to resort to a more confrontational style of public activism. To date, this has not included proxy contests (although it is certainly possible it could at some point), but rather has been focused on public letter writing campaigns with the goal of getting management and/or the board to take steps to create value for common shareholders. This type of campaign would only follow an extensive initial effort to effect these changes behind the scenes.
Our current public activism effort is focused on SCOR, a data measurement business for advertisers and broadcasters that has had issues with regard to board governance. SCOR’s common stock price has languished in the face of an improving business because SCOR’s Board has failed to take action addressing investor concerns about a potential special dividend to preferred stockholders and a general misalignment of interests. Furthermore, SCOR’s Board has managed the company to the benefit of its preferred shareholders at the expense of employees and common stockholders. We will continue to hold SCOR’s Board accountable to its fiduciary duty under Delaware law to all stakeholders of the business, not just itself and SCOR’s preferred stockholders.
Hortz: How do you help translate the particular story of your non-correlating style of investing with the larger market to an investor looking at quarterly performance numbers?
Rendino: Many traditional equity managers seek to produce quarterly returns that beat their particular benchmark. Private equity managers, on the other hand, focus on providing longer-term (seven to 10 years) returns that significantly beat the market over that timeframe. The advantage of the traditional manager is the liquidity and transparency that investing in the public markets allows them to provide, while a private equity manager’s goal is to offset the lack of transparency with superior returns.
At TURN, we are somewhere in the middle. Our goal is to generate at least a 100% return on our individual investments in a one-to-three-year timeframe. Clearly some of our investments will not meet this target for one reason or another, but our goal is to be correct on our investment thesis and return targets at least two-out-of-three times. This blended return profile, if successful, would generate meaningful alpha, or absolute returns, for our investors in a vehicle that provides both liquidity and transparency.
Wolfe: I think the other point investors need to understand is that while we provide quarterly performance, and monitor it, we are generally not investing with quarterly timelines in mind. Sometimes our investment theses play out sooner than expected and others take longer to occur. For a fund like 180, it is important to look at performance over an investment cycle of three to five years rather than any given quarter.
Hortz: Why do you believe an investment such as 180 is an important part of an investment portfolio, especially today?
Rendino: Following a period of above-trend inflation resulting from the COVID pandemic, we have entered a phase whereby interest rates are at and likely to remain closer to historical norms rather than the periods of low rates that investors have become accustomed to since the financial crisis in 2008/9.
That said, we also believe that the Fed has either finished hiking rates, or nearly finished, which should provide some stability to interest rates for the near term. Historically speaking, it is just that type of financial condition that has resulted in significant outperformance for the small/micro-cap sector of the market. While past trends may not be indicative of the future, we believe there is significant upside for investors in TURN simply from what we believe will be a strong bull market for small caps over the next two to three years.
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