Business

Brian Bares On The Small Cap Edge

See Brian Bares’ interview with Manual of Ideas and a small informal transcript excerpt below

Excerpt first

So I started reading the Buffett annual letter when I was in high school. I’m from Omaha originally and so my interest was piqued by basically the geographic proximity of the world’s most famous investor would wait with bated breath each year as the new report came out would tear it apart. Started reading annual letters by their companies. Once the university Nebraska and focused on mathematics and actuarial science but my passion was always in my free time reading and understanding businesses and so knew that I really wanted to be an investor long term the sort of Buffett and Munger mold always felt like I could get an advantage in smaller companies because they’re under followed less professional analysis in the space and thought it would be a great idea to structure a business around that concept. The problem wasn’t that I didn’t really have a good set of operational background for professionally managing money so I found my way to Austin Texas and work for a fellow who has a warrant MBA CFA who was structuring a portfolio around quantitative backtesting for Buffett like characteristics. But he had up and running registered investment adviser with a mutual fund and was professionally managing institutional money at the time and he was very generous with allowing me to get up to speed operationally and understanding how to professionally manage money. I would have stayed with him my entire career because I enjoyed working for him. He was very generous both in time responsibility but small cap hit a real bear market in the late 90s.

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The fund and firms started to hemorrhage money and so I decided to take a crack at it myself and start bears capital in June of 2000. We took a little bit of a departure from the philosophy process that my old firm was using and that we weren't backward looking and quantitative in nature.

Moreover we didn't hold 50 to 100 stocks. I thought the surest path out of performance was being highly convicted about your ideas and manifesting that in terms of the number of positions in the portfolio. So our current process is highly analytical in-depth research and the conviction is reflected in a 10 stock portfolio in the small microcap space. And I also learned that backtesting and quantitative metrics. Well well fund to research and fund to talk about it in books and the Financial Analyst Journal. He was not it didn't make a lot of sense to me to look at backward looking accounting statistics and try and draw conclusions about what would happen in the future. Our process and philosophy is very much about analyzing the qualitative aspects of businesses in particular the factors germane to future out performance in terms of internal business. Compound being so very much a Buffett Munger philosophy. But the search despite my quantitative background despite my mathematics my studies in mathematics is becoming more and more distant from the actual you know computational parts of investment management and is gravitating more and more towards the analysis of people and business models. So the core of our current investment philosophy is really the analysis of the qualitative aspects of businesses from a competitive standpoint and the capital allocation ability and execution ability of management teams. So it's really those two pillars that hold up our investment process.

And you know it's a long answer to your original question but you know that it really comes from this idea that's very much of Buffett Munger idea which is there will ultimately be a convergence between stock prices and the underlying compounding of the businesses at the fundamental level on a per share basis. So if you're a long term investor what that means is that if you want above average stock price performance you really need to be looking for above average internal business compounding. And if if if you take economics 101 you'll learn that if if I'm earning in excess of my cost of capital as a business over time you're probably going to open up a shop across the street and compete away my economic margin and we'll end up earning our cost of capital over well over the long term. That is unless one of us has a unique competitive position in the marketplace. And so it's our job as analysts are a person team and Austin is to run around the country and to find those unique competitive characteristics of small microcap businesses. Moreover we want people that understand the moats around these businesses how to expand them and how to protect our interest outside outside passive minority shareholders. And if we find that that recipe that should drive the quantitative results that we're looking for and I would also add that the wisdom of doing that from my perspective is that we insulate ourselves as capital from competition because it's hard for other managers to replicate the work that we're doing in this space. Anybody can you know get a database of companies and filter it on price to earnings price to cash flow return on equity and come up with quantitative metrics that lead to potentially good stock price performance.

But what they don't realize when they're doing this is that other managers could happen upon that same recipe and through competitive arbitrage in the marketplace by committing significant capital to the strategies nullify their value over time. And you wouldn't even know that your strategy isn't working until it's too late. And by doing it the way that we're doing it hopefully were happening upon these qualitative stories earlier than other managers before the financial results have been outed in 10 ks and 10 Qs and before the screeners have really picked up on the seductive aspects of the business as big so. So that's why we have a sort of qualitative first approach. It's very much grown out of me seeing in my early investing career with what frankly it hasn't worked and it's worked for us for the last 12 years our strategies have done very well versus the benchmark index indices. And I really credit that qualitative first approach as a reason for our sustained outperformance and again I look at our business from a moat basis and and what sort of quarters five forces can we bring to bear on our own business to ensure that another manager with similar capital can replicate the sort of work that we're doing. And I think the answer is really just admitting that we have to do the hard work we have to get on airplanes and in rental cars and go out and visit as many of these small cap companies as we possibly can and catalog a database of qualitative characteristics of companies.