20
25
30
35
40
45
7.7%
8.2%
8.7%
9.2%
9.6%
10.2%
10.6%
10.9%
11.1%
11.2%
13.3%
12.7%
11.6%
10.6%
9.9%
9.3%
9.0%
8.8%
8.6%
8.9%
Stocks S&P 500; Bonds Lehman Government Corporation; Microcaps WilshireMicrocap.
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overall portfolio volatility. As shown Table 4.1, the return contin-ues to increase and volatility begins to drop as each incrementalunit of micro cap is added. The volatility of the portfolio contin-ues to decline until micro caps reach 42 percent of the allocation,at  which  point  the  volatility  begins  to  rise.  Thus,  from  a  purelytheoretical point of view, returns increase and volatility declinesup to a 42 percent allocation. From a practical point of view, it isunlikely that any institutional investor with responsibilities as afiduciary would recommend that a client carry an allocation of 42percent  micro  cap  stocks.  However,  it  is  relatively  simple  todemonstrate in most allocation studies that a 5 percent to 20 per-cent allocation in micro caps can increase overall portfolio returnwhile lowering volatility.
CONCLUSION
In the world of equity-based returns it is easy to conclude, basedon the data presented, that micro cap stocks offer an attractiverisk/reward trade-off. With a volatility profile slightly higher thanthat of both large cap and small cap stocks, but with significantlyhigher return opportunities, it is logical to consider micro caps asa part of the overall portfolio allocation strategy. A low correla-tion of returns to bonds and other asset classes helps reduce riskand increase overall returns in most portfolios. With many of thefundamental characteristics of venture capital and a return pro-file  that  looks  more  like  venture  capital  than  plain  commonstocks, it is reasonable for the small investor to consider microcaps as a logical substitute for the venture capital asset class.
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CHAPTER 5
Using theInformationAdvantage
This chapter will attempt to answer the following questions:
• Can principal agent theory help to identify micro cap oppor-
tunities?
• What company-specific items should an investor consider?
METHODS TO EVALUATE PRINCIPAL AGENT ACTIONS
If the principal agent theory holds true, there are two groups ofinvestors whose actions should be watched closely when you arelooking for micro cap opportunities. Company insiders who arethe  principals  of  the  transaction  are  the  first  group  to  watch.Knowledgeable institutional investors who are the agents in ven-ture  capital  theory  are  the  other  group  to  watch.  Observing  theactions of these groups is very difficult to do within the venturecapital  community.  Venture  capital,  being  private  in  nature,allows only limited transparency with regard to investment activ-ities. However, the public capital markets are much more trans-parent, and therein exists the opportunity to gain an informationadvantage.
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Management, Management, Management
As in any business, the quality of the management is a key factorin determining the success of the enterprise. In most cases, theskill and vision of the key management team will determine thelong-term success of an enterprise. And the smaller a company,the larger the impact of the top management team. In a micro capcompany, the top tier of key management people has a dispropor-tionately large influence on the success or failure of the company.Unlike large companies, in most micro cap organizations the keymanagement  people  also  have  direct  responsibility  for  actualbusiness execution. This is an important difference between thebig  and  the  small  enterprise.  Success  in  the  micro  cap  worldrequires a certain management skill set that merges big corporatevision with a high level of entrepreneurship. So in micro cap com-panies,  for  practical  purposes,  the  single  largest  contributingfactor  in  corporate  performance  is  attributable  to  the  top  man-agement  team.  This  suggests  that  finding  opportunities  in  themicro cap world requires a complete and careful evaluation andanalysis of key management.
Because the micro cap universe is so large, there is some levelof basic screening that is required to arrive at a working universeof companies to consider for investment purposes. In the microcap world, there are very few sell-side research analysts to pro-vide ongoing research support and evaluation of micro cap com-panies. In addition, those analysts who do cover these companiesare often more junior members of the research team and not asexperienced  or  as  insightful  as  their  more  senior  counterpartswho cover larger companies. In addition, the analysts who covermicro  cap  companies  often  focus  their  attention  on  the  profes-sional  portfolio  managers  that  specialize  in  micro  cap  stocks.This makes it more difficult for the average investor to get high-quality research on micro cap companies.
However, there is one key group of people who are very closeto the company whose actions can provide a leading indicator ofinvestment opportunity in the micro cap sector. They are the mate-rial  insiders  of  the  company  who  make  up  the  top  managementteam  along  with  the  officers  and  directors  of  the  company.  Thiskey group should be studied very closely when looking for microcap  opportunities.  An  evaluation  of  the  corporate  management
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team  is  often  the  key  to  detecting  and  discovering  potentialchanges at a company before they are generally fully reflected inthe valuation of the underlying stock. There are some very effec-tive methods to monitor the ongoing actions of the managementof a large group of micro cap companies for patterns that couldindicate positive future events for the company.
The buying and selling patterns of the key management teamcan  be  a  stunning  leading  indicator  of  a  company’s  futureprospects. Who else is in a better position to make a critical eval-uation  about  the  future  business  prospects  of  a  company?  Thekey management team will have firsthand knowledge of the day-to-day operations of the company and how they are progressing.In  addition,  the  insiders  have  a  keen  awareness  of  the  currentvaluation of the company. Who better to make an informed prin-cipal agent decision about the current value and future prospectsof  the  company  than  the  existing  key  management  personnel?The  pattern  of  their  buying  and  selling  can  be  a  very  powerfulindicator of future stock performance. Also, these material insid-ers are required to disclose their purchase and sale decisions tothe  public  at  large  in  a  timely  manner  through  filings  with  theSEC. The review of these filings can be a powerful tool for screen-ing the micro cap universe for investment opportunities.
WHO’S DOING WHAT: INSIDER INFORMATION
Public  companies  are  required  to  file  a  number  of  documentseach year with the Securities and Exchange Commission in Wash-ington, D.C. These filings are required by statute to promote fulland  fair  disclosure  about  company-level  information.  A  set  ofthese  same  filing  requirements  extends  beyond  the  company  tocertain shareholders of the company. The largest groups of theseshareholders are the management insiders of the company. TheSEC defines an insider as an officer or director of a public com-pany. In addition, an insider can be a legal entity or individual whodirectly or indirectly owns 10 percent or more of any class of acompany’s shares. These are presumed by the SEC to be peoplewho possess a much higher level of knowledge about a companyand its current and future prospects. Once an individual or entity
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meets the criteria to be considered an insider, the SEC becomesinterested in monitoring how you traffic in the buying and sellingof your company shares. To monitor the activity of insiders, theSEC  has  certain  specific  reporting  requirements  that  apply  toinsiders. These requirements come in the form of certain disclo-sures about stock ownership that must be made on Forms 3, 4,and 5 as detailed in the federal regulations concerning the SEC.
The rules require that an insider must make an initial filing ofhis or her holdings of the company stock within 10 days of becom-ing  an  insider.  Form  3,  disclosing  those  holdings,  must  be  filedwith the SEC within that 10-day period. The form must be filedeven if the insider owns no shares.
After the insider files Form 3, any changes in his or her stockholdings of the company must be filed with the SEC on Form 4.The  SEC  must  receive  this  form  not  later  than  the  tenth  of  themonth  following  the  insider  activity.  For  example,  any  insidertrades made during March must be filed on Form 4 and receivedby the SEC no later than April 10.
All insiders must file Form 5 within 45 days of the company’sfiscal  year-end.  Form  5  details  certain  transactions  that  are  notrequired  to  be  reported  on  Form  4,  such  as  dividend  reinvest-ments. Any person or entity who was an insider during the fiscalyear, but is no longer an insider, must also file Form 5 for the prioryear. So any insiders who left during the fiscal year must reporttheir  subsequent  share  activity  through  the  fiscal  year-end  onForm 5.
Although  Forms  3  and  5  can  be  helpful  when  studying  theactivities of a company and its insiders, the Form 4 data is usuallythe  most  useful  and  important  to  outside  investors.  It  can  fre-quently be a treasure trove of information for analyzing the futureprospects of a company. Form 4 discloses to investors on a con-tinuous  basis  how  insiders  regard  their  company  and  its  futureprospects.  As  this  book  discusses  later,  having  a  managementteam  with  meaningful  share  ownership  is  a  good  indicator  thatthe  interests  of  shareholders  and  management  will  be  betteraligned. But knowing when insiders are buying and selling mean-ingful amounts of shares in the open market is normally a strongindicator of current share value and a barometer of management’sopinion of future company prospects.
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When examining insider trading data, it is important to focuson open-market trades. These are the buys and sells of manage-ment that are done in the open market at the then current marketprices. They are the most important trades because they reflectthe actual outlook of the insider with respect to the market valueand  future  prospects  of  the  company.  Insiders  who  are  activelybuying or selling shares without linkage to options are sending astrong indication of their insider knowledge to the market. If thetransactions are not related to the exercise of options connectedto  the  company’s  option  benefit  plan,  then  the  insider  believesthat  the  price  of  the  stock  is  high  or  low,  or  that  the  futureprospects are improving or declining.
This is much more important when considering buys versussells. There are often a possible myriad of reasons why people sellstock  over  and  above  the  belief  that  the  shares  are  overpriced.Buying houses, paying taxes, funding tuition for children, and soforth, are all valid reasons to liquidate holdings in an asset. Theone exception to the general notion that selling is not as impor-tant is that of selling after a large stock price decline. And this ismore important when groups of managers are selling in clustersafter a large share-price decline. It is logical to assume that mostrational investors would not sell shares after a large share-pricedecline unless they felt that the shares were going to decline fur-ther in price. Thus, management clusters selling after a significantshare-price decline is a very negative indicator of share valuationand future outlook for a micro cap stock. Conversely, insider buy-ing is often a good indication that share valuations are low in theopinion  of  management  or  that  business  and  industry  perfor-mance is improving. Why else would management shell out realcash to buy shares in the open market? It is a place for the shareprice  to  move  higher.  And  in  the  case  of  insider  buying,  size  isimportant. Size is relative, but it is much more significant to see acorporate insider buy $100,000 of stock versus $10,000. Both pur-chases  are  significant,  but  the  message  is  much  stronger  in  thelarger transaction.
Although size is important, there are some qualifiers to con-sider. It is worth taking a look at the track record of the insider’sprevious open-market share purchases. Does the insider display a  strong  track  record  of  making  open-market  purchases  that
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translate into gains? Or is the insider less insightful in the timingof purchases? When making this analysis, it is important to reviewthe  data  over  a  longer  time  horizon.  All  the  data  show  that  theinsiders who buy, and particularly those who do it well, are oftenearly with their share purchases. It is best to look at a period of atleast  nine  months  to  a  year  when  analyzing  insider  purchases.Also, as in insider selling, it is often worthwhile to look for groupsor clusters of management activity. It is significant when the chiefexecutive officer buys $100,000 of stock, but it is more importantwhen  management  and  directors  as  a  team  buy  $1  million  ofstock, particularly when this happens during a concentrated timeperiod. This is often an indicator of very substantial events aboutto take place.
A  complete  evaluation  of  the  management  could  require  anumber of meetings at several different times. However, it is pos-sible to select the most relevant ideas for whatever company youare researching and in a short period of time form a reliable firstimpression  of  the  quality  of  management.  The  payoff  from  thisfundamental research is the ability to come to a conclusion aboutthe quality of management. An uncommon company is likely to berun by uncommon people. It is important to conclude from youranalysis that you have a strong confidence level in the manage-ment of a micro cap company prior to owning its stock.
However,  the  evaluation  of  management  should  be  twofold.First, it enables the investor to form an opinion about the qualityof  the  company’s  management.  Second,  it  allows  investors  tobuild important lines of communication with the top managementteam of the micro cap company. In communicating with manage-ment, there are a number of facts that you will want to discover asyou get to know the management and assess the company. Num-ber one, who are the top managers? The key management peoplewho actually make the decisions about the long-term strategy ofthe company are the top management people. It is typical for thehighest titles to be given to the same people who carry out thosetop  functions.  However,  there  are  times  when  titles  are  mis-placed. At some companies, the reality may be that the CEO is thetreasurer of the company, or the true leader of the company maybe  the  chief  production  officer.  The  title  of  president  and  chiefexecutive officer may reside with somebody else; however, thatperson may not in fact be the true top decision maker within the
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company. Although that chief executive may have the final wordon major decisions, the other executives may in fact be the braintrust of the company.
Most  companies,  both  big  and  small,  proudly  publish  theresumes of their key operating people. It is worthwhile to obtainthese from the company if they are available and save them in acompany file. It’s useful to look for a broad pattern of facts in theresumes  of  the  executive  management  teams.  The  resume  canalso help you judge the scope and pattern of outside connectionsa given key manager may have. In some instances, a clear patterncan  be  seen  among  the  members  of  the  key  management  team.They may have worked together previously at other companies,or  they  may  have  the  same  educational  background,  havingattended  the  same  university.  In  addition,  it  may  be  possible  tospot subtle nuances of a management team’s historical outcomes.For example, it is not unusual to see a chief executive officer whohas engineered the sale of the last few companies where he or shewas also the CEO. This can be an indication that the CEO has a“fix  it  up,  dress  it  up”  outlook  that  often  leads  to  the  near-termsale  of  the  company,  hopefully  at  a  higher  price.  After  a  while,these executives become worth tracking if they have done a goodjob in the subsequent sale of other companies. As discussed, inmany cases the ultimate outcome at the corporate level is in largepart related directly to the key management team. If the manage-ment team has a history of selling companies, this may be of inter-est to you as an investor. In fact, people who have come from aninvestment banking background often transform themselves intothe role of chief executive with the express goal of dressing upand fixing up a company for sale. It is worthwhile to take specialnote of key management people who have a background or his-tory in the investment banking area.
It  is  also  worthwhile  to  know  and  understand  how  a  com-pany’s key activities are organized. To best understand the busi-ness,  it  is  worth  taking  some  time  to  study  the  organizationalchart of the company. The way the organizational chart appearson paper may not actually reflect the way things function at thecompany. It’s worth attempting to make this determination whendiscussing  the  company  with  management.  It  is  also  helpful  tostudy  an  organizational  chart  of  the  affiliated  companies  thatmight be owned by the micro cap. These affiliated and subsidiary
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companies can often lead to discoveries about hidden technolo-gies and hidden value within the micro cap company. Studying theorganizational chart can also help you to understand how pivotalbusiness decisions flow through the organization.
For example, a retail company that is in a growth and expan-sion  mode  may  be  required  to  select  dozens  of  potential  retailsites each year to continue an expansion. These decisions are keyto the future success of the retail organization’s growth. In thatscenario,  it  would  be  important  to  know  and  understand  whoultimately makes the real estate location decisions for that retailmicro cap company. In some instances, such as finding retail loca-tions, it may be better to have a single person with the appropri-ate  skill  set  focused  on  that  activity  rather  than  attempting  toselect  sites  by  committee.  It  is  important  to  determine  that  thekey person in question has been successful in the past at execut-ing  the  job  and  continues  to  execute  successfully  in  the  future.There  are  other  situations,  however,  that  may  benefit  from  abroader, more structured team approach to decision making. It isimportant to look for companies where the members of the keymanagement  team  seem  to  have  the  ability  to  communicateamong one another effectively rather than having a single execu-tive surrounded by a group of executives who are afraid to dis-agree  or  discuss  openly  the  issues  surrounding  a  particulardecision or strategy.
It is useful to understand that at times key decisions may havelittle or no impact on the long-term outlook for the company. Insome circumstances, companies may have little control over theirown destiny, and even the most thoughtful decisions will have lit-tle or no major effect on the ongoing profitability of the concern.For  example,  in  commodity-oriented  companies,  where  manyprice decisions are driven by supply and demand in the market-place, few operating decisions may have a large relative impacton the company. In many instances, these companies are highlyleveraged  to  market  pricing,  and  their  operating  earnings  arehighly leveraged to those market prices.
Frequently, these very companies are not of much interest tothe broader investing community. However, it is often possible toforecast with a relatively high degree of competence the direc-tion  of  some  of  the  external  market  factors  that  impact  these
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companies.  We  will  discuss  in  greater  detail  these  highly  lever-aged operating companies and simple ways to try to capitalize onoperating cycles within specific industries.
MANAGEMENT STYLE
It is often important to try to make an assessment of managementstyle.  Does  management  have  certain  prejudices  or  theoriesregarding  the  appropriate  method  of  conducting  the  particularbusiness?  Is  the  management  approach  very  centralized,  with  adistinctive top-down style, much like a military organization? Ordoes  it  appear  that  the  management  style  is  more  collaborativewith regard to the decision-making process? Is there an open flowof  information  in  both  directions,  or  does  information  seem  toemanate mostly from the top down or from the bottom up? It’s dif-ficult to assert that either management style is more or less appro-priate. Because it is a highly subjective area, it is often anecdotalindications  that  lead  to  a  conclusion  about  the  effectiveness  ofmanagement. Do employees seem engaged and interested? Howdo employees treat potential clients and how does that compareto  the  manner  in  which  they  treat  existing  clients?  Talking  torank-and-file workers within the company can lead to very inter-esting  comments,  both  positive  and  negative.  It  is  important  toweigh these anecdotal factors when evaluating the managementculture.
STRATEGY AND PLANNING SYSTEMS
Long-term  planning  and  strategy  are  the  key  to  management’sability to grow and maintain a business. A strategy and planningsystem creates a framework within which information is gatheredand processed inside the business. It sets a fundamental basis forhow future plans and expectations are formulated and related toone another. In addition, the way the corporate structure is builtto gather operating data and relay those data back to management,
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where  the  management  team  can  compare  the  information  totheir  framework  of  expectations,  is  particularly  important.  Flatorganizational  structures  that  have  very  quick  feedback  loopstend to be able to adjust operating strategies much more quicklythan larger, more hierarchical organizations.
It is useful to discuss with management its internal reportingrequirements and procedures. Find out how often data are gath-ered and transmitted to key management personnel. In addition,attempt to determine how those data are evaluated relative to thestrategic and operating plans and try to determine what actionsare prescribed to be taken and by whom when the data are notconsistent  with  the  operating  plan.  A  good  organization  willhave  many  planning  and  control  systems  in  place  to  evaluatemany levels of corporate data. However, it’s not just the quantityof data gathered but rather the quality of data that is importantin a successful feedback loop. In addition, good timely data thatare not used effectively are also of no benefit to management. Itis  worth  spending  some  time  to  learn  the  ways  that  these  sys-tems  were  developed.  In  addition,  it’s  worthwhile  to  ask  man-agement about the internal checks and balances that are used toensure the quality of the data and that the information is beingused and evaluated correctly. Does it seem that management hastoo many or too few reports? Does management have one com-prehensive  enterprise-level  information  system,  or  are  there  anumber of systems operating independently that require integra-tion  of  data  in  order  to  get  sufficient  reports  for  management?These are all key questions that should be discussed and analyzedwith management.
It is important to discuss with management how compensa-tion is related to the planning system. What are the consequencesof deviating from the plan? What actions are taken as a result ofvariances within the plan, and how much latitude does manage-ment have with regard to these variances? How far off budget cana  manager  get  before  running  into  trouble?  Is  compensationrelated to simply making sales numbers, or are margins and prof-itability  factors  when  evaluating  compensation?  These  are  allimportant  issues  that  have  no  simple  answers;  however,  theyneed to be reviewed in the context of the business plan to deter-mine whether in fact there are effective controls.
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MANAGEMENT CHANGES
Changes in key management personnel are often a leading indica-tor of a change in company performance. It is worth investigatingvery  carefully  the  reasons  and  rationale  behind  any  recentchanges in the top management team. In addition, it can be verybeneficial to speak with any top managers who have recently leftthe company. It is important to try to understand the context ofthese management changes.
It can be very tempting to buy shares in a company that hasrecently had a major change in management. However, it’s impor-tant to remember that if a company has problems of the magni-tude that required a change of management, it is likely they willnot be solved quickly. The replacement of a handful of key oper-ating people is often an early indicator that major changes at thecompany  may  be  about  to  take  place.  In  many  cases,  this  newmanagement  team  must  not  only  assess  the  company  itself  butalso  change  the  fundamental  management  culture  within  thecompany.  In  most  instances,  the  real  tangible  impact  of  a  man-agement change is not reflected in the operating performance ofthe company until several years have gone by. It is very commonfor  the  new,  incoming  management  team  to  make  substantialfinancial adjustments including writing off every single question-able item on the books in order to clear the decks for the financialreporting going forward. In addition, it is likely that there will besubstantial turnover within the middle management ranks of thecompany as the new management team evaluates the quality ofthe existing management structure and begins to make changesto  that  structure.  Finally,  the  new  management  team  must  thenconvince  the  existing  workforce  to  embrace  the  new  operatingstrategy  and  work  under  a  new  management  culture  going  for-ward. It can easily take two or three years for these changes to bereflected in the operating performance of the company. However,these  early  changes  are  a  good  indicator  and  generally  suggestcloser  scrutiny  of  the  operating  performance  of  the  companygoing forward. That additional scrutiny can often lead to excel-lent  opportunities  as  new  management  begins  to  improve  theoperating performance of the company.
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MANAGEMENT REPUTATION
Does management have a clear strategy or plan? And how is thisplan  received  by  members  of  the  investment  community?  Ofcourse, it is not uncommon for any management team to want togive  you  a  positive  story  about  their  future  expectations  forgrowth  and  profitability.  Whatever  the  current  plan,  it  is  impor-tant to evaluate how management has executed similar plans inthe past. Do they have a history of disappointing their sharehold-ers and analysts? Have they overpromised and underdelivered inthe past? Or have they met the expectations as promoted in theirforecasts and outlook? This goes to the very important issue ofmanagement credibility.
A  management  team  that  has  consistently  disappointedshareholders and investors and has come up short repeatedly ona historical basis will often see the price of their shares at a dis-count  to  their  industry  peers  as  a  result  of  their  poor  perfor-mance. Conversely, management teams that have been honest intheir  future  assessment  of  operating  conditions  and  relativelyconsistent  in  meeting  the  expectations  as  laid  out  in  their  fore-casts will often carry a premium to the valuation of a group. Oncethe reputation of a management team has been established, it ishard to change the opinion on Wall Street, whether that be nega-tive or positive.
HOW THE COMPANY DEVELOPS AND PROMOTES EMPLOYEES
As  a  long-term  shareholder,  it  is  important  to  know  and  under-stand what provisions are being made to attract good people whocan replace key managers as this becomes necessary over time.The manner in which companies develop and promote people cangive an important indication of the quality of the management cul-ture.  In  today’s  world  of  high-performance  corporations,  keyspots will have to be filled from either existing middle manage-ment staff or through outside connections the company alreadyhas with industry professionals. Developing a talent pool within
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