esthat generate very little free cash flow. Conversely, there are smallcompanies that generate very modest earnings growth but gener-ate  significant  levels  of  free  cash  flow  from  operations.  Simplescreening  techniques  could  eliminate  either  of  the  companiesfrom consideration; however, a little more effort within the analy-sis can yield potentially great stocks.
As is the case with financial ratios, certain measures will bemore or less applicable, depending on the sector within which a
12035_Imperiale_c07.f.qxd  11/24/04  9:21 AM  Page 90
90
THE MICRO CAP INVESTOR
company operates. It is often the best strategy to use ratios thatreflect a company’s valuation relative to its peers rather than rel-ative  to  the  market.  In  addition,  it  is  important  to  study  theaccounting practices of the company and its peers to determinewhether any adjustments are necessary for different accountingpolicies and procedures. For example, manufacturing companiestend to lend themselves better to cash flow and EBITDA (earn-ings before interest, taxes, depreciation, and amortization) analy-sis, whereas fast-growing service companies tend to better lendthemselves  to  price-to-sales  ratio  analysis  or  earnings-per-sharegrowth analysis.
BASIC FINANCIAL ANALYSIS OF MICRO CAP COMPANIES
Academic research as well as studies done by Uniplan Consult-ing, LLC, our financial research affiliate, have indicated that somescreening variables are generally more useful for the purposes offinding micro cap opportunities than others. The intention here isnot  to  do  an  exhaustive  review  of  financial  statement  analysis;there  are  many  excellent  books  on  that  topic,  for  example,Financial Statement Analysis Workbook: Step-by-Step Exercisesand  Tests  to  Help  You  Master  Financial  Statement  Analysis,third  edition,  by  Martin  Fridson  and  Fernando  Alvarez  (Wiley,2002). The goal is to review some relevant financial analysis tech-niques  that  will  help  micro  cap  investors  screen  out  potentialinvestment candidates from consideration for their portfolios.
As mentioned, the valuation criteria most suitable for a givenmicro cap company will depend largely on the type of businessthe company engages in and the value of the company relative toits industry peers. However, there are some financial indicatorsthat are very useful in the screening of micro cap companies. Fol-lowing are discussions of three simple valuation criteria includinga description and some general comments on the strengths andweaknesses of each. We call them the “holy trinity” and use themas the basic screening tools to begin searches. Again, this is notmeant  to  be  an  exhaustive  list  of  valuation  methods,  but  rathersome general screening criteria that can help narrow the universe
12035_Imperiale_c07.f.qxd  11/24/04  9:21 AM  Page 91
Micro Cap Stocks and the U.S. Domestic Economy
91
of  micro  cap  companies  into  smaller  groups  for  more  rigorousanalysis.
Price-to-Book Ratio
This is such a simple ratio that it is often completely ignored bythe professional investment community. However, research indi-cates that a low price-to-book ratio is an excellent basic tool touse  when  screening  for  micro  cap  stocks.  Generally,  a  price-to-book ratio of less than 1.5 to 1 is a useful level at which to beginscreening. It is often a surprise to find that there might be a largegroup of companies that are trading at below book value. Thesecompanies are worth some study. Many have serious problems orpotential problems. But in many cases routine screening can pro-duce a list of financially healthy and growing companies with noobvious  business  problems  that  are  trading  at  a  market  pricebelow book value.
It is important to note that book value must be carefully stud-ied  when  analyzing  these  opportunities.  Tangible  book  value,sometimes referred to as hard book, is the book value after it isadjusted  for  intangible  assets  such  as  intellectual  property  orgoodwill that may be listed on the balance sheet as an asset of thecompany. These intangible assets are often of little value outsidethe company or are very difficult to value with certainty, so in mostcases it is best to exclude them from the book value calculation.When the adjusted book value after excluding intangible assets isnear  or  below  book  value,  then  the  company  merits  closerscrutiny. In many cases, these companies are simply out of favoror in industries that are not of current interest to the mainstreaminvestment community. If that is the case, it may be possible toacquire  shares  at  or  below  tangible  book  value.  This  normallyprovides  the  investor  with  famous  value  investors  Graham  andDodd’s “margin of safety” when buying a micro cap stock. In hislater writings, Graham moderated his stance on the importance ofbuying companies at or below book value as a result of prevailingmarket  conditions  that  translated  into  higher  book  value  multi-ples.  But  in  the  micro  cap  world,  there  are  frequently  temporalopportunities to buy with a relatively good margin of safety.
It is not unusual to see entire industries that are out of favoror not of interest to the broader investment community show up
12035_Imperiale_c07.f.qxd  11/24/04  9:21 AM  Page 92
92
THE MICRO CAP INVESTOR
in  low  price-to-book  screens.  The  price-to-book  screen  worksbest  with  operating  companies  in  more  mundane  businesses,such  as  the  dairy  industry,  which  is  discussed  in  a  case  study later  in  this  book.  It  is  not  as  effective  a  screening  tool  for development-stage companies that have a high level of intangibleor intellectual property on the balance sheet. These development-stage companies do lend themselves to a net cash analysis thatfunctions for them in a similar way to book value for operatingcompanies. The calculation takes current assets less all liabilitiesand  relates  this  amount  to  the  market  price  of  the  companyshares. Sometimes it is possible to find a development-stage com-pany that is trading at or near its net cash value. The question thenbecomes how does the future look for the company? An exampleof this is the Pozen Company, discussed in a case study later inthis book. After the collapse of the Internet stock bubble, therewere dozens of micro cap Internet companies that were trading ator below net cash value. However, most of those companies had abusiness  model  that  burned  some  percentage  of  that  cash  eachmonth  and  had  little  near-term  hope  of  showing  an  operatingprofit. Those were not the companies to invest in at the time. Nev-ertheless, there were some that were nearing profitability and hadthis cash on hand. These were the opportunities in the then out-of-favor  sector.  Again,  the  thoughtful  and  patient  micro  capinvestor  saw  many  of  those  companies  survive  and  produceextraordinary investment returns.
Price–to–Free Cash Flow Ratio
Take  a  low  price-to-book  company  and  couple  it  with  a  lowprice–to–free cash flow valuation, and the probability for invest-ment success increases geometrically. It is important to note thatthe  catalyst  is  free  cash  flow.  There  are  many  companies  thattrade at a relatively low multiple of cash flow, but have large debtsand  high  structural  costs  that  require  the  cash  flow  to  sustainbusiness  operations.  The  company  that  has  a  high  level  of  freecash flow, however, has the luxury of being in a position to impactshareholder value. In the most simple outcome, the company candeclare its shares to be undervalued and use the free cash flow tobuy  back  shares.  This  shrinks  the  shares  outstanding  andincreases  the  profit  per  share  for  remaining  shareholders.  The
12035_Imperiale_c07.f.qxd  11/24/04  9:21 AM  Page 93
Micro Cap Stocks and the U.S. Domestic Economy
93
company can deploy cash to perform any number of other actionsto enhance shareholder value, including, as in the case study ofMichael Foods in Chapter 9, using the cash flow to take the com-pany private at a significantly higher share price. In the world ofbusiness, happiness is a high level of free cash flow.
Low Price-to-Earnings Ratio
It sounds very clichéd, but low P/E stocks in the micro cap worldwill  ultimately  be  recognized.  Many  academic  and  investmentstudies point to low-P/E stocks as a powerful indicator of futurestock performance. It is important to note that the low P/E in themicro cap world is the trailing or historic P/E. Because there is ageneral lack of analyst coverage of micro cap stocks, the ability toget a consensus forward earnings estimate is nearly impossible.Without direct guidance from the company, it is possible to esti-mate future earnings only by building a company financial modelto estimate those earnings. This is not something the individualinvestor  will  typically  undertake.  However,  finding  companiesthat  are  trading  at  a  low  multiple  of  past  earnings  is  a  simplescreen that can be used on most Internet stock screening sites.Again, because there are very few analysts that cover the microcap world, these companies often post a strong change in earn-ings trend and trade at a low P/E multiple for some period of timebefore a broader cross section of investors realizes the valuationlevel and begins to examine the company. As can be seen in theGaran  Company  case  study  in  Chapter  8,  there  are  times  thatcompanies  with  good  growth  prospects  and  excellent  businessperformance trade at low P/E multiples. This can be a window ofopportunity to make excellent investments at reasonable prices.
CONCLUSION
In the micro cap world, stocks trading at a low price-to-book mul-tiple, a low multiple of free cash flow, or a low trailing price-to-earnings ratio are the most likely to show outperformance oversubsequent periods. If the investor can find micro cap companiesthat display all three of these valuation characteristics, they will
12035_Imperiale_c07.f.qxd  11/24/04  9:21 AM  Page 94
94
THE MICRO CAP INVESTOR
have  a  high  probability  of  investment  outperformance.  Whenthese  factors  are  coupled  with  positive  insider  activity,  high-quality  management  teams,  and  smart-money  recognition,  thechances for excellent investment performance are simply a mat-ter of time. The concluding chapters of this book present a seriesof case studies that examine companies that showed these char-acteristics and track the ultimate outcome of the companies andthe investors.
12035_Imperiale_c08.f.qxd  11/24/04  9:21 AM  Page 95
CHAPTER 8
Micro Cap Case Study: A Company with All theIndicators
This chapter will attempt to answer the following questions:
• What does a typical micro cap opportunity look like?• What are the indicators that suggest it is a good investment
opportunity?
As Chapter 5 discussed, public company federal filings are a valu-able  resource  for  micro  cap  investors.  One  particularly  usefulgroup of federal filings related to a company but not filed by thecompany are those that are often referred to by the institutionalinvestment community as smart-money filings. The SEC’s Sched-ule 13-D, Form 13-F, and Schedule 13-G are called smart-moneyfilings because under federal law they are required to be filed bywealthy individuals and large institutions. These institutions andindividuals often have access to the best research and informa-tion available and have the deepest resources when it comes tomaking investment decisions.
Schedule 13-D is filed by any beneficial owner of 5 percentor more of any class of a company’s stock. Form 13-F is a sched-ule that is required to be filed by investment management firmsthat  are  federally  registered  with  the  SEC  and  have  at  least$100 million under management. Schedule 13-G is filed by passive
95
12035_Imperiale_c08.f.qxd  11/24/04  9:21 AM  Page 96
96
THE MICRO CAP INVESTOR
shareholders with a 5 percent or greater cumulative ownership ofa company’s shares.
The Schedule 13 forms are often very useful in finding invest-ment  opportunities  that  are  of  interest  to  large  institutionalinvestors or very sophisticated individual investors. It’s importantto note that not everybody who is required to file a Form 13 wouldnecessarily  provide  outstanding  investment  results.  But  therehave  been  a  number  of  academic  studies  that  show  that  smart-money filings, when taken as an investment portfolio, can oftenprovide superior investment returns over time. For example, thelegendary value investor, Warren Buffett, or his various corporateentities, often shows up as a form 13 filer at companies. These arenot  always  micro  cap  companies;  however,  most  people  in  theinvestment  community  would  agree  that  if  Warren  Buffett  isacquiring shares in a company, at a minimum it would be worthtaking a look at the company. History shows that many compa-nies in which Mr. Buffett has invested in the past have wound upbeing  acquired  or  provided  very  substantial  investment  returnsover long periods of time.
SMART-MONEY OWNERS
Garan (GAN) was a New York Stock Exchange–listed micro capcompany that designed, manufactured, and sold apparel primarilyfor children. The company distributed children’s clothing underthe Garanimals name. Garan also distributed sports apparel suchas T-shirts, knit shirts, and sweaters for men and boys under vari-ous  trademarks  and  licenses  the  trademark  Bobbie  Brooks  forgirl’s and women’s apparel. The company sold its apparel to majordepartment stores and national chains, with the largest amount ofsales to Wal-Mart and J.C. Penney Company.
Cheap Valuation
The stock would have come through a number of various valuescreens during the year 2000; most notably, Garan was trading atbelow book value during the year 2000 and traded basically in a
12035_Imperiale_c08.f.qxd  11/24/04  9:21 AM  Page 97
Micro Cap Case Study: A Company with All the Indicators
97
range  from  80  percent  of  book  value  to  about  1.1  times  bookvalue  during  the  calendar  year.  This  looked  particularly  cheapfor a company that had a five-year historic growth rate of slightlyover 20 percent. Although the company showed a slight earningsdecline  from  the  1999  fiscal  year  to  the  2000  fiscal  year  ofapproximately 7 percent, nonetheless, the company still earned$3.25 per share during 2000. (See Figure 8.1.) At the time, Garanhad a market cap of approximately $100 million. In addition, thecompany traded in a price–to–cash flow range of four to seventimes during the fiscal year 2000, a surprisingly low multiple ofcash flow for a public company, particularly when you considerthe fact that Garan had no long-term debt on its balance sheet. Inaddition, the company had an interesting history of paying spe-cial  dividends  each  year.  During  2000,  the  stated  dividend  ratewas $.25 per quarter or $1.00 a year, which approximated a 4 per-cent to 5 percent dividend yield. At the end of 2000, the companypaid  an  $.80-per-share  special  dividend,  bringing  the  total  divi-dend return on an annual basis up to nearly 9 percent based onthe  year’s  average  share  price  for  the  company.  By  any  typicalvaluation  measures,  this  appeared  to  be  a  remarkably  cheapcompany. (See Fig. 8.2.)
FIGURE 8.1 Garan price chart.
12035_Imperiale_c08.f.qxd  11/24/04  9:22 AM  Page 98
98
THE MICRO CAP INVESTOR
FIGURE 8.2 Historical valuation analysis.
Skin in the Game
A review of the proxy statement filed January 28, 2000, showedthat  company  insiders  owned  just  over  20  percent  of  the  out-standing shares of the company. Of more interest was the listingof beneficial owners of over 5 percent not affiliated with the com-pany. This list included Lord Abbott & Company, the well-knownvalue managers from New York City; DePrince, Race and Zolo, aprivate  investment  company  from  Orlando,  Florida;  as  well  asDimensional Fund Advisors and General Re Corporation, an affil-iate of Berkshire Hathaway, Warren Buffett’s company. Thus, wecan  see  that  Garan  had  a  number  of  interesting  indicators  thatcould potentially signal an opportunity from an investment pointof view. To begin with, the valuation level looked quite compellingrelative to other micro cap companies as well to other companiesin the garment business, both public and private. As discussed in
12035_Imperiale_c08.f.qxd  11/24/04  9:22 AM  Page 99
Micro Cap Case Study: A Company with All the Indicators
99
prior chapters, a low multiple of cash flow affords companies alarge  amount  of  flexibility  to  withstand  industry  and  economicdownturn as well as to pay shareholders in several different ways.In the case of Garan, the management chose to elect special divi-dends from time to time as operating results created excess cashflow for the company. In particular, low multiples of cash flow incompanies that have no debt or low levels of debt tend to createopportunities for management to distribute special dividends and/or buy back company shares in the open market.
A relatively high level of insider ownership at Garan was alsoa positive indicator of a potential opportunity. Not only did com-pany management own over 20 percent of the outstanding com-mon stock, but for the previous 18 months they had been buyingcommon shares in the open market. These insider purchases, asdiscussed  in  Chapter  5,  are  also  possible  indicators  of  futureopportunities to come from a company or, at a minimum, an indi-cation that valuation levels look quite reasonable.
Finally, there is evidence of excellent representation by long-term  smart-money  value  investors  in  the  company.  With  threemajor  institutional  investors  owning  over  5  percent  of  the  out-standing common stock and management owning 20 percent ofthe outstanding common stock, analysis would suggest that, as agroup,  management  and  the  outside  shareholders  would  likelywork closely together to create higher levels of shareholder valuefor the company.
This  confluence  of  events  presented  an  outstanding  buyingopportunity  virtually  any  time  during  the  year  2000,  when  thestock traded in a narrow price range from a low of approximately$20 to a high of approximately $25 for most of the year. During theyear 2001, the share price moved from the mid-$20 range to over$40 in a steady progression of upward prices as the year went on.Share  price  of  Garan  rose  very  sharply  during  the  first  half  of2002, increasing from the low $40 range to over $60 per share in avery large increase in share volume. On or about May 17, Berk-shire Hathaway announced a definitive agreement to acquire theentire company for $60 a share. Note that the Berkshire Hathawayaffiliate, General Re, was a greater than 5 percent shareholder inthe early filings of the company. On September 4, 2002, the trans-action  was  completed  and  the  company  was  taken  over  oracquired in total by Berkshire Hathaway for a cash purchase price
12035_Imperiale_c08.f.qxd  11/24/04  9:22 AM  Page 100
100
THE MICRO CAP INVESTOR
FIGURE 8.3 Price-to-book range.
of $60 a share. This stock had many of the correct indicators to beof interest to a patient micro cap investor looking for a long-termopportunity. (See Figure 8.3.)
An investment in the shares of the Garan common stock at theaverage price of $21.50 during 2000 would have bought an invest-ment that had a stated yield of 4.8 percent. The special dividendthat could be anticipated as a matter of company action duringgood years amounted to another 4 percent. This created a situa-tion where investors were being, in effect, paid to wait while themarket began to realize the intrinsic value of the Garan franchise.At the $60-per-share buyout value, the investment in Garan wouldhave  yielded  a  total  return  of  224  percent  during  the  holdingperiod of 29 months. It is the few Garan-type positions that typi-cally propel the returns of a micro cap portfolio. Being investedand  being  patient  are  the  keys  to  making  the  asset  class  workwithin  a  multiasset-class  portfolio.  It  may  never  be  possible  todetermine why or when a successful and well-managed companysuch  as  Garan  might  be  sold.  However,  it’s  fair  to  say  that  themanagement teams of these micro cap companies are often frus-trated with the share price available in the public market, and asdiscussed in Chapter 5, the principal agent theory might precipi-tate  management  action  to  maximize  value  in  a  single  transac-tion.  In  the  case  of  Garan  it  is  difficult  to  determine,  but  it  isworth reading the brief portion of the final proxy statement asfiled on August 5, 2002, that describes the events leading up tothe sale transaction. It has been edited here for length, with some
12035_Imperiale_c08.f.qxd  11/24/04  9:22 AM  Page 101
Micro Cap Case Study: A Company with All the Indicators
101
comments added for background, but the primary events are welldescribed.
The Transaction
From  time  to  time  over  the  last  several  years,  Garan  has  beenapproached  by  investment  banking  professionals  and  othersregarding the possibility of Garan engaging in a strategic transac-tion. Garan did not seriously entertain any of those proposals. InMarch  2002,  Garan  was  approached  by  an  investment  bankingrepresentative of another apparel company regarding the possi-bility of a strategic transaction. Garan’s senior management deter-mined that they should meet with that third party, and followingdiscussions with members of its board of directors, determinedthat it would be an appropriate time to engage advisors to con-sider Garan’s strategic alternatives. (The rumor at the time of thetransaction  was  that  the  suitor  was  VF  Corporation,  another,larger publicly traded apparel manufacturer.)
On April 3, 2002, Garan engaged Goldman Sachs to act as itsfinancial  advisor.  On  April  9,  2002,  members  of  Garan’s  seniormanagement  met  with  representatives  of  Goldman  Sachs,  whopresented an overview of strategic alternatives for Garan, includ-ing possible acquirors.
On  April  11,  2002,  representatives  of  Garan  met  with  repre-sentatives of the apparel company that had expressed interest inthe possibility of acquiring Garan. Shortly thereafter, representa-tives of that company notified Garan’s CEO that it was not inter-ested in pursuing a transaction with Garan.
Following  discussions  with  other  members  of  its  board  ofdirectors,  members  of  Garan’s  senior  management  decided  topursue the possibility of a strategic sale of Garan. (No one everindicated why they decided to do this, but frustration over the lowshare  price  was  rumored  to  be  one  of  the  factors.)  At  Garan’srequest,  Goldman  Sachs  analyzed  potential  acquirors  of  Garan.Garan’s  senior  management,  after  consultation  with  GoldmanSachs, determined that an open and widely marketed auction wasnot likely to maximize shareholder value. Garan’s senior manage-ment also discussed with Goldman Sachs the advisability of con-ducting  an  auction  process  narrowly  directed  at  a  short  list  ofmore  probable  potential  acquirors  or  approaching  individually
12035_Imperiale_c08.f.qxd  11/24/04  9:22 AM  Page 102
102
THE MICRO CAP INVESTOR
one or more of the most likely candidates, and determined theywould  prepare  for  the  possibility  of  either  approach.  GoldmanSachs commenced a due diligence inquiry of Garan and the prepa-ration of offering materials.
In late April and again in late May, Garan and Goldman Sachswere contacted by the investment banker who had originally sug-gested  a  strategic  transaction  in  March  2002.  That  investmentbanker suggested that Garan consider a transaction with a differ-ent  potential  strategic  acquiror  and  offered  to  arrange  an  intro-ductory  meeting.  Garan  indicated  that  it  was  not  ready  toentertain  any  inquiries,  but  that  it  would  advise  the  investmentbanker if it was interested in a meeting.
Representatives of Garan (including six members of its boardof  directors)  and  Goldman  Sachs  met  again  in  early  June  toreview the process of analyzing Garan’s strategic alternatives andpotential acquirors. At that time, Garan’s management and repre-sentatives  of  Goldman  Sachs  agreed  that  Berkshire  Hathawaywas the most likely and attractive potential acquiror. Representa-tives of Goldman Sachs advised Garan that Berkshire Hathaway,based  on  its  past  practice  and  public  statements,  would  beunlikely  to  participate  in  an  auction  process  and  unlikely  to  beinterested if not approached on an exclusive basis. Garan decidedto have a representative of Goldman Sachs contact Warren Buf-fett, the chairman of Berkshire Hathaway, to determine whetherBerkshire Hathaway would be interested in acquiring Garan at aspecific price per share, which was in excess of $60.
On  June  12,  2002,  representatives  of  Goldman  Sachs  con-tacted  Mr.  Buffett  regarding  a  potential  strategic  acquisition  ofGaran and the proposed price at which Garan would be interestedin pursuing a transaction. The following day, Mr. Buffett advisedGoldman Sachs that Berkshire Hathaway would be interested inpursuing  an  acquisition  of  Garan  at  $60  per  share  in  cash,  andrequested that members of Garan’s senior management meet withhim at Berkshire Hathaway’s headquarters the following week todiscuss  a  possible  transaction.  Further  conversations  with  Mr.Buffett confirmed that the $60 offer was firm and not negotiable.He  also  said  that  he  would  not  be  interested  in  Garan  if  otherpotential  purchasers  were  contacted.  In  addition,  Mr.  Buffettexpected the existing Garan management team to agree to remainwith  Garan  after  a  transaction.  On  June  14,  2002,  members  of
12035_Imperiale_c08.f.qxd  11/24/04  9:22 AM  Page 103
Micro Cap Case Study: A Company with All the Indicators
103
Garan’s  senior  management  team  met  with  representatives  ofGoldman Sachs and, following consultation with other directors,determined  that  they  would  be  interested  in  a  transaction  withBerkshire Hathaway at $60 per share.
On June 17, 2002, Berkshire Hathaway executed a confiden-tiality  agreement  with  Garan.  During  the  afternoon  of  June  18,2002,  Seymour  Lichtenstein,  Garan’s  chairman  and  chief  execu-tive officer; Jerald Kamiel, president and chief operating officer;and William J. Wilson, vice president for finance and administra-tion,  met  in  Omaha,  Nebraska,  with  Mr.  Buffett  to  discuss  theterms of a potential transaction. Mr. Buffett reiterated that he wasinterested in pursuing a transaction only if existing managementagreed to remain with Garan and continue to run Garan, and thathe expected that the existing employment agreements Garan hadentered into with several members of senior management wouldbe  terminated  in  connection  with  the  transaction.  Mr.  Buffettagreed  that  any  change-of-control  payments  that  would  be  dueunder those employment agreements would be paid out in con-nection with the transaction. Garan’s senior management agreedin principle to recommend the proposed transaction to the othermembers of its board of directors, subject to the negotiation ofdefinitive documentation.
On  June  20,  2002,  Berkshire  Hathaway’s  lawyers  delivered  adraft merger agreement and stockholders agreement to Garan andits lawyers. Garan’s lawyers prepared drafts of the amendments tothe employment agreements of four senior Garan executives thatwould,  among  other  things,  terminate  those  employment  agree-ments upon the closing of the transaction and provide cash reten-tion payments to those executives in lieu of any change-of-controlpayments  they  otherwise  would  have  been  entitled  to  receive  ifthey terminated their employment following consummation of themerger.