Desperate Value

The last small cap cycle peaked in 2007, with the Russell 2000 reaching 856 before collapsing 60% to 343 in 2009. Small cap stocks were in a bubble and the bubble popped. Today the Russell 2000 stands at 1392! Equity prices, valuations, and justifications of the current cycle continue to amaze me. How can investors and policy makers not consider today’s small cap market a bubble, when prices are 63% higher than the previous cycle’s peak? Economic growth is a rational guess, but it’s an insufficient explanation as real GDP has only grown 13% during this period. Median equity valuations are also considerably higher this cycle, with overvaluation being much broader.

While the market cycle that peaked in 2007 wasn’t as expensive as it is today, it was challenging nonetheless. At that time I was also holding an above average cash position and was struggling to find buy ideas. As value became more scarce, my equity screens became more inclusive and friendlier to special situations (a nice way of saying companies with problems).

After screening through hundreds of small cap stocks, I eventually stumbled across an interesting company I’d never seen before called Charles & Colvard (CTHR). The company was, and continues to be, a market leading provider of moissanite jewelry. According to Charles & Colvard’s website, “Moissanite is a rare, naturally occurring mineral also known as silicon carbide, which was first discovered by the Nobel Prize-winning chemist Dr. Henri Moissan at the site of a massive meteorite strike in Arizona.” Eventually scientists learned how to create silicon carbide crystals in the lab and the synthetic moissanite gem was born. While I’m not a gemologist, to my untrained eyes, moissanite gems appeared identical to diamonds.

At the time I was considering Charles & Colvard for purchase, it was a busted growth stock. The company stumbled in 2006-2007 due to a decline in earnings and elevated inventories. Their earnings shortfall was causing growth investors to panic, while value investors, like myself, took their time sniffing around for value. In addition to needing a place to invest, I had a good batting average with former growth stocks, so I was intrigued.

I began my analysis and attempted to determine if moissanite jewelry was a viable market and if the inventory problem was temporary or a longer term demand issue. After doing considerable work on the business and the evolving industry, I remained interested and thought maybe, just maybe, I finally found some value in a very expensive stock market. The thought of making a new purchase was exciting. Der’s gold (or moissanite) in dem hills! Or so I thought.

Before I completed my analysis and business valuation, I visited a department store to inspect a moissanite gem in person. The lady behind the counter was very helpful and showed me several samples. They were extraordinary gems – flawless. And they were much less expensive than diamonds. More for less is exactly what this value investor needed! It was too good to be true. And then I asked a question I didn’t plan to ask, but in hindsight saved me and clients a lot of money. I asked, “Would you rather have diamond earrings with flaws, or moissanite earrings without flaws?” The look she gave me is difficult to explain, but it quickly made me realize I just asked a stupid question. “The diamond earrings, of course,” she said.

I left the store feeling defeated and yes, a little foolish. What in the world was I thinking? Moissanite may be considered a flawless substitute to diamonds, but they weren’t diamonds. Is moissanite a girl’s best friend? Probably not. Furthermore, Charles & Colvard, founded in 1995, wasn’t an established business at the time, which is usually a requirement for companies I consider for purchase.

Due to the company’s limited operating history, it was too difficult to properly determine the business’s normalized free cash flow and its appropriate discount rate. In effect, there were too many risks and unknowns to value the business with a high degree of confidence. Investing in Charles & Colvard would have been a violation of my process and buy discipline. As much as I appreciated their gems (they really did look nice), it simply wasn’t my type of stock.

In overvalued markets such as in 2007 and today, the temptation to reduce quality and valuation standards grows along with the need to find sufficient ideas to fill a portfolio. As prices rise and investors frantically search for value, the risk of veering outside of one’s comfort, or competence zone, increases. This is especially true for many relative return portfolio managers that must remain fully invested throughout the entire market cycle. It’s quite the dilemma. Should portfolio managers buy the high quality businesses they want to own, but knowingly overpay? Or should they buy businesses that appear less expensive, but have too many unquantifiable risks to value accurately?

Having to decide between overpaying or speculating is uncomfortable and unfortunate, especially for fiduciaries (please send all complaints to your local central banker). I can’t speak for other investors, but that’s how I feel about my current opportunity set. If I allocated capital today, I’d either have to knowingly overpay, or make some aggressive and questionable assumptions. As an absolute return investor, I’m fortunate to not be forced to do either – I can simply wait.

Although I’m not required to play the game, I can appreciate how difficult it must be for fully invested relative return investors. While no one is going to admit they’re managing the Desperate Value Fund, given current valuations and the devastating drought in absolute opportunity, I suspect there are plenty of investors who feel as if they do. Hopefully portfolio managers and analysts can find a way to make today’s challenging opportunity set work. If active management underperforms on the downside again this cycle, the industry could become defenseless from the growing onslaught of passive investing.

For those professional investors willing to look different and remain true to their value disciplines, I think there could be tremendous opportunity once the current cycle ends. If I’m wrong and this cycle never ends, patience never pays, and legitimate opportunities and free markets never return…well, active management is probably dead anyway, right? Instead of acting desperately, I suggest remaining disciplined, avoid overpaying, and refuse buying assets that compromise your investment standards.

Reminder: It’s Valentines Day, so don’t forget to pick up some flowers and moissanite on the way home!