ROUGH DRAFT

Finding Deep Value:

An Introduction to Outperforming the Stock
Market
Christopher Moon

Copyright 2015 by Christopher Moon

All rights reserved, including in whole or in part in any form.

CONTENTS

Preface
Introduction
Part I
Chapter 1: Small-caps
Chapter 2: Spin-offs
Chapter 3: Post-Reorganization Equities
Chapter 4: Bank Thrift Conversions
Part II
Chapter 5: Case Studies
Chapter 6: Mistakes Investors Make
Chapter 7: Buying and Selling
Appendix
Recommended Reading List

DISCLAIMER

This publication contains the opinions and ideas of the author. It is not a
recommendation to purchase or sell the securities of any of the companies or
investments herein discussed. It is sold with the understanding that the
author is not engaged in rendering legal, accounting, investment, or other
professional services. Laws vary from state to state and federal laws may
apply to a particular transaction, and if the reader requires expert financial or
other assistance or legal advice, a competent professional should be
consulted. The author cannot guarantee the accuracy of the information
contained herein. The author specifically disclaims any responsibility for any
liability, loss, or risk, professional or otherwise, which is incurred as a
consequence, directly or indirectly, of the use and application of any
contents of this book.

PREFACE
Before beginning a Hunt, it is wise to ask someone what
you are looking for before you begin looking for it.
Poohs Little Instruction Book by Joan Powers, inspired by A. A. Milne

The efficient-market hypothesis (EMH) posits that it is impossible to beat the

market because the efficiency of the market causes existing share prices to
immediately incorporate all new relevant information. According to adherents of the
EMH, stocks will always trade at their fair value, making it impossible for investors
to buy undervalued stocks or sell them when they are overvalued. These adherents
believe it is impossible to outperform the overall market through expert stock
selection and the only way possible for investors to increase their returns is to
increase the risk. I completely reject this convenient but nave definition of the riskreturn relationship. In this book I will explain how using a deep value investing
approach will enable an investor to find opportunities that are both low in risk and
high in return.
Before we go much further, it is important to define what I mean by deep value
investing, as my definition is likely to be different from other value investors. I
define deep value as being a situation in which a security is trading at less than half
of its estimated intrinsic value and where there is a high probability the security
price will increase by 50% or more within a 1-2 year period. This can include garden
variety value stocks, special situations (such as spin-offs, mergers, and postreorganizations), and distressed securities. In this book I will cover deep value and
special situations two areas that have the potential to generate the biggest
returns. Distressed securities are not appropriate for individual investors (unless you
are willing to quit your day job) and will not be covered here. Deep value investing
is as simple as it is sophisticated. More importantly, it is about a willingness to stand
apart from the crowd and look in areas other investors ignore.
This book is meant for serious investors who have a basic understanding of the
stock market, enjoy the investment process, and wish to earn returns higher than
the overall market while employing less risk. While the case studies only cover
companies listed in the United States, the principles covered work equally well
across the globe. It is important to remember that the strategies covered here rely
only on information that is available to the public. All that is required is for the
investor to have an interest in finding opportunities that are off the beaten path, but
have a high probability of market beating returns. This means a willingness to look
at many different prospective investments and choosing only the best prospects.
Patience plays the most important role in this process. The best deep value
investors understand the need to allow an investment thesis time to unfold.
I have included a dozen investment case studies in order to make the content
practical and to illustrate the possibility of market beating returns. Among the
successful case studies I have included a couple that have been disappointments.
There is just as much to learn from these disappointments as there are from those
that have been successful.
In each case study I explain how and when I found the company. I then give an
overview of the thesis and discuss which factors influenced my final decision. At the
end of each case study I provide a link to the public filings I analyzed in order to

come to my conclusion. I want to avoid burying the thesis under endless details, but
allow readers to take a closer look at the information that was available at the time.
Readers will not master these strategies in just a few hours of reading. Learning
them will require time and attention. Success is not guaranteed and these
strategies require proper application and judgement. With the right frame of mind
and patience, these strategies can shift the odds in their favor.
This book is not meant to provide a robotic investment approach that can be copied
mindlessly. Rather, I hope to educate the reader on an entire way of thinking that
can be adapted by any thoughtful investor who is willing to understand why it works
and apply those fundamental principles to a wide range of investment
opportunities. It is important to remember that each individual investment has its
own unique characteristics, but the principles remain the same. My goal is for
readers to analyze the strategies, understand the logic behind them, examine the
evidence of their actual use, and come to the conclusion that consistent superior
performance in the market is a realizable goal.
This book is a preview of an expanded print version expected to be completed by
the end of 2016. It will cover deep value, risk arbitrage, options, hedging, and risk
management. I invite you to join the conversation by contacting me at
christopher@deepvalueinsight.com with any questions or comments.

Christopher Moon
July 2015

Introduction:
Knowing How to Find Deep Value
Where should investors look to find deep value stocks? In the age of the internet the
possibilities seem overwhelming. There is everything from reading the Wall Street
Journal or watching CNBC, to running stock screens, or even checking out the gossip
on Twitter and Stocktwits, but really the most important question investors should
be asking is how to look. Once the how to look has been established, the where to
look is easier to determine.
The reality is that with the superabundance of investment content available to
investors, there are numerous great places to look for potential opportunities. The
more difficult challenge is filtering out the wheat from the chaff and focusing on the
small fraction of stocks that are worthy of further analysis. The top value investors
know that their time is a valuable asset. They have learned how to quickly identify
the most promising deep value opportunities and devote their time accordingly.
How do I do that? I decided to write this book after having been asked that very
question countless times. I can sum that up in a few sentences. I start by asking
why a company or security is likely to be undervalued by the market. That theory
can be based on a number of factors: if it is a spin-off, if it is emerging from
bankruptcy, if it was recently removed from an index, etc. Once I have established
my theory, I then analyze the company to see if the particular security is, in fact,
undervalued. In order to invest, I need to understand why the opportunity exists.
To put it in other words, I do not start digging into the financial statements and
analyzing every company that I come across. Instead, I start with a theory on why
there could be a deep value opportunity and only then do I investigate further.
The top value investors are successful because they have identified their edge.
The goal of this book is to be an introduction for investors searching for their own
edge. The best way for investors to develop their edge is by identifying and
categorizing different strategies or situations that are most likely to offer mispriced
opportunities. I have attempted to provide an overview of some of my favorite
opportunities and the key points to analyze when readers are conducting their own
research. Establishing a mental database of categories and special situations will
assist the reader in quickly determining which companies and situations are worthy
of further analysis and which are a waste of time. My goal is for readers to focus on
developing their own edge which is paramount to investment success.
I am certain that by internalizing some of the concepts I present in this book,
investors will be on their way to identifying deep value opportunities. After reading
it, please feel free to use it as a refresher on the need to focus on those areas of the
market that offer the highest possibility of a deep value opportunity.

PART I

ROUGH DRAFT

Finding Deep Value Opportunities

Deep value investors want to buy stocks that are trading at a significant discount to
their estimated intrinsic value. The philosophy is buying a dollar for 50 cents. Given
the overall competitiveness of the market, which is not the same as the market
being efficient, it would be an overwhelming and time-intensive task to look for
deep value stocks if the investor does not know where to find them.
The best investors know that deep value opportunities are more likely occur in some
areas of the market than in others. In order to avoid misusing their time on
opportunities that do not warrant further analysis, they often look for deep value in
areas of the market where they understand the reason for the stock to be
undervalued. On the flip-side, they avoid areas of the market that are unlikely to
offer a deep value opportunity.
Part I provides an analysis of favored areas in the market that I have identified as
offering the highest probability for deep value opportunities. In some cases I will
provide examples of past opportunities that proved to be lucrative investments.

Chapter 1
Small-Caps
One way of dealing with information being more available is to stop playing the game and
seek out securities of asset classes where theres less information or competition.
-Seth Klarman, The Baupost Group

The first area of the market that we will explore are companies with a small market
capitalization, also known as small-caps. These are companies with a market value
between $250 million and $2 billion. Companies falling below $250 million are
known as micro-caps and companies with a market cap below $50 million are known
as nano-caps. For the sake of simplicity I am going to lump small-caps, micro-caps,
and nano-caps under the same umbrella. None of these should be confused with
penny stocks, which, quite frankly, are not worth the time or trouble. As a group,
small-caps have outperformed the market over long periods of time. This has not
prevented small-caps from having a bad reputation. The bad rap is due to the
perception that small-caps are prone to financial fraud or manipulation from pump
and dump schemes. I would say that this is hardly a problem that affects only
small-cap companies. Look no further than Enron or Worldcom, two of the biggest
corporate bankruptcies in history that were mired in fraud.

Reasons small caps may be undervalued

Before discussing why investors should consider investing small-caps, it is important
to understand why a small-cap is likely to be undervalued.
Small-caps are largely ignored by the larger market players including
hedge funds and mutual funds
Many fund managers do not bother with small-caps because they may be illiquid
and difficult to buy and sell in large increments. Or it could be that their charter
prevents them from investing in small-caps; this more so in the case of funds that
are only permitted to invest in stocks that are part of an index. Multi-billion dollar
funds may not even consider a small-cap because it would be hard to justify the
effort and time required to analyze them. Mutual funds are prevented from owning
more than 10% of a company. If a mutual fund manager that oversaw $10 billion in
assets wanted to invest in a company with a $100 million market cap, he would only
be able to buy $10 million in stock. Even if the companys stock outperformed the
market, it would barely move the needle on the funds overall performance.
Small caps are largely ignored by Wall Street analysts and the media
Small-caps are typically not known outside of their geographical area. Very few, if
any, Wall Street analysts will analyze and therefore promote a small-cap company

due to the low trading volume. Low trading volume means very little commission
income. Furthermore, the media tends to only cover companies that have extensive
analyst coverage.
A good example of an undervalued small cap-that was largely unnoticed and
unfollowed by the Wall Street community was Cepheid, a molecular diagnostics
company. In July 2010, with virtually no Wall Street analyst coverage and barely a
mention in any mainstream media, the stock was trading at $16. That was when a
small deep-value oriented hedge fund took notice of the company and its
undervalued stock. Before too long the hedge fund began drawing the attention of
other analysts and the media to this interesting and dynamic company. By the
summer of 2015 the stock was up to $60, for a return of 275% - a situation where
patient investors were amply rewarded!
Very little public information is available
When compared to large cap stocks, there is very little public information on smallcaps, save for filings with the Securities and Exchange Commission. Furthermore,
what information that is available is likely to be only positive since companies are
more likely to emphasize positive news and keep out of sight the negative news.
Subsequently, investors that rely heavily on public information will be circumspect
when it comes to investing in small-caps.
Small-caps are inherently carry more risk
Large firms with well-established histories have a lower risk profile when compared
to small-caps. Small- caps appear to be less safe due to more volatility and less
information. During periods of market disruption many investors will flee small caps
for the familiarity of established large caps. Small-caps do not benefit from the
same access to capital that larger companies tend to enjoy, putting them in a more
precarious position during market downturns.

Reasons for investing in small-caps

Now that we have covered why small-caps are likely to be undervalued, we can look
at why they make good investments, something the best value investors have
known for a long time.
Easier to analyze and understand
Small-caps are easier to analyze than big companies and their business models
tend to be simpler. They operate in only one or a few lines of business. It is easier
for investors to approach management with questions about the company or
financial results.
Growth potential can be significant
Most large cap companies were at one time small-cap companies. Small companies
grow from a smaller arithmetic base. It is easier to double the revenue of a $50
million company than the revenue of a $5 billion company. At some point all

companies stop growing at a fast rate, otherwise they would eventually outgrow the
entire economy.
Small companies are often in growth industries and find it easier to change their
strategy in the face of changing market conditions. Smaller companies are often run
by their founders or a small group of managers that own a large share of the
company and are therefore incentivized to increase shareholder value. Investors
often lament over missing the opportunity to have invested at the start of Wal-Mart
or Microsoft. Todays small-cap could be tomorrows mega-cap.
Greater universe of opportunities
There are over 7,000 companies listed on the NYSE and the NASDAQ. There are an
estimated 250,000 analysts worldwide. Approximately 80% of all analyst focus their
attention on just 20% of all publicly traded companies, typically those with market
caps of $2.5 billion or more. This leaves a large number of companies with
negligible analyst coverage. With very few fund managers performing in-depth
research on small-cap companies and the rest relying on conventional sell-side
research, a staggering amount of small-cap companies are overlooked. By focusing
on this large number of unrecognized companies, investors can increase their
chances of finding hidden value.
An inefficient market
Since few, if any, brokerage firms cover small-cap companies, there is a higher
probability of market inefficiency. Because small-caps have a smaller float and fewer
available shares trading, a liquidity problem can exist. This liquidity issue prevents
many large institutional investors from investing in these companies. This reduces
the number of potential buyers for the stock and can lead the stock price to be
unjustifiably low. Conversely, when a large institution tries to buy an illiquid stock,
the price can shoot up dramatically. This inefficient market works to the advantage
of the individual investor who is willing to accumulate undervalued shares and hold
on to them for the long-term. A small-cap company that grows and performs well
will draw the attention of the bigger market players and the increased trading
volume will drive up the market valuation.
A favorite target of activist investors
Small-cap companies have historically been ripe targets for activist investors. An
activist investor is a hedge fund, or an individual in some cases, that buys a large
stake in a public company with the goal of effecting major change in the company.
Oftentimes the goal will be to have the company sold to a larger competitor at a
premium to the market price, thereby unlocking value for shareholders. Investors
would do well by paying attention to activist investors and the moves they make.
One of the key questions I always ask about a small-cap, or any company for that
matter, is would an activist investor have an interest in this company? Activist
investors will target small caps if they believe it has the potential to become a
bigger company or it will make an attractive acquisition for a larger player.

One of the first small-caps I paid close attention to was Cinar Corporation, an
entertainment company based in Canada. It attracted the attention of noted activist
hedge fund manager Robert Chapman, who specializes in small-cap activism, and
soon after he became involved he pushed for a sale of the company. After much
back and forth between Chapman and the management, which included Chapman
taking out a help wanted ad for the CEOs job, the company was sold to a private
equity firm at a high premium to its market value and in the process benefitting all
shareholders.
In-depth research can be a game changer
Because small-caps receive little attention from Wall Street analysts, they offer an
opportunity for the individual investor willing to do the in-depth research necessary
to understand a small company, its economic cycle, its management, and its future
prospects. By going beyond the information readily available on the internet or in
public financial filings, opportunities that were previous hiding in plain sight become
available for investment. The management and investor relations of small
companies are not typically flooded with calls from Wall Street analysts, making
them far more accessible to individual investors that have questions or comments.

Risks associated with small-caps

Small-caps have less trading liquidity, meaning there may not be enough
shares available at acceptable buying prices. When selling it may be difficult
to quickly sell the shares at an acceptable price.

Small-caps have less access to capital and limited financial resources

compared to larger companies. This can make it difficult for the company to
obtain financing necessary for continued growth or to endure economic and
industry downturns.

Small-caps may lack the long operating histories or the proven business
models of larger companies. This leaves them vulnerable to sudden shifts in
customer demand or the aggressive tactics of larger competitors. Not to
mention, regulators tend to give more scrutiny to companies without long
track records or proven business models.

Less information is publicly available and financial filings may only meet the
minimum requirements imposed by the Securities and Exchange Commission.
This requires the investor to either be extremely competent in the analysis of
financial statements or to be willing to rely on the integrity of company
management, auditors, and the oversight of regulators.

A few words on time, volatility, and patience

Time
Finding undervalued small-caps worthy of investment is hard work and time
consuming. Many investors are intimidated by the serious research that is required
to be successful at investing in small-caps. While financial ratios and growth rates
are widely publicized for larger companies, this is rarely the case for small-caps. All
successful small-cap investors accept that the tedious number crunching will be left
up to them, knowing that the neglect and lack of coverage by analysts is what
provides the opportunity.
Volatility
Historically, small-caps have outperformed large caps, but this outperformance is
coupled with greater volatility. According to data from Morningstar, from 1926
through 2012, small-caps averaged an annual return of 12.28 percent, compared to
10.08 percent for large-cap stocks. With that reward comes higher risk. Over a 10year period that ended in 2013, the standard deviation for small-caps was 19.28,
compared to 15.54 for large caps. What this means is the returns for small-caps
fluctuated by as much as 19.28 percent in either direction. This queasy-inducing
volatility chases many investors out of small-caps and in turn, unwittingly deprives
them of long-term market-beating returns.
Patience
Patience is one of the most important character traits a deep value investor can
possess and this is a point I will repeatedly make. In light of the volatility displayed
by small-caps, it is important for investors to remain patient and allow their
investment thesis time to play out. It is not uncommon for a deep value investor to
buy the stock of a small-cap only to have the stock drop 40 percent in the first six
months. An impatient investor that lacks discipline may sell out in a panic and lock
in a 40 percent loss. That same stock could go on to return 200 percent over the
next 3 years, rewarding the patient deep value investor.
Rule of Thumb on Patience: When investing in a small-caps or in any other deep
value opportunity be prepared to wait at least 1-3 years for the investment thesis
to play out.

My Research Process
My research process for small-caps is extensive and thorough (and this goes for
every strategy I employ). I continually search for good candidates throughout the
small-cap universe. Once I have identified a candidate, I begin due diligence that
goes beyond just crunching the numbers. I consider it important to act like an
investigative journalist. I investigate company management, take a tour of the
companys headquarters (or talk to someone that has), and interview
knowledgeable people about the industry and the company, including consultants
and competitors.

Visiting the company is important it provides an opportunity to discover promising

areas that are hidden in weak numbers. On the flip-side, it provides an opportunity
to find problems that have yet to show up in the numbers. While I find reading
reports from other analysts to be helpful, talking to management and viewing the
facilities is much more important. Only a small number of companies will meet my
exact criteria. Once a companys stock has been purchased or added to my watch
list, I stay in close contact with the company and continue to analyze all new
financial data to monitor whether or not my original investment thesis remains
valid.

How I find new ideas:

Experience
As deep value investors continue to grow and learn by analyzing more and more
companies, they compound knowledge and gain experience. This experience will
enable a deep value investor to quickly recognize what is a potential opportunity
and what is not. After two decades in this business I have analyzed thousands of
companies and special situations. Often, when a deep value opportunity presents
itself it is possible that I have already been watching the company for years, either
having previously analyzed the company or a close competitor and understood it
very well. This allows me to quickly interpret new developments or changes in the
stock price. Other times I may have analyzed a company and made a decision to
not buy due to overvaluation, but kept it on my watch list. A sudden drop in the
stock price or a favorable industry development can renew my interest. Due to my
previous analysis and familiarity with the company and management, I am able to
move quickly and reach an investment conclusion.
Screening
I am constantly searching for new investment opportunities that meet my exact
criteria. This includes reading through the Wall Street Journal or Financial Times and
other financial publications or browsing through investment surveys such as
Valueline. I use my own customized screens or screens provided by third party
vendors. When I use a screen, I am able to narrow down the universe of potential
opportunities that meet my stringent criteria such as low price-to-earnings or low
price-to-book ratios, attractive debt-to-equity characteristics or other preferred
metrics. This leaves me with smaller and easier to manage basket of companies
that I can add to my watch list for further in-depth analysis and investigation.
Industry analysis (along with a little macro and regional trends)
I consider myself, first and foremost, to be a bottom-up analyst, focusing on
individual companies and opportunities rather than going after what is trendy.
Although some of my ideas will come from noticing industry or macro trends, I have
never relied on economic forecasts or interest rate movements in making a buy or
sell decision. But a market crash or recession will cause me to pay closer attention
to debt levels and look for companies that display countercyclical characteristics.
For example, a drop in oil prices could cause an overreaction in the stocks of oil

services companies and thus interest me in taking a closer look at companies across
the sector.
Occasionally, stocks in an entire region or country may become cheap when
compared to historical averages, much like what appears to be happening in China
at the time of this writing. The cause could be something as simple as a currency
devaluation or more complicated such as a recovery from a recession. An
opportunity is created when companies in affected regions or countries have opted
to raise capital in the United States and list on American exchanges and is now
undervalued due to trouble at home.

How I evaluate an idea:

Once I have a company in my sights, I analyze it with all of the skepticism and
curiosity of an investigative journalist. I am looking for a gotcha that will cause me
to discard the idea and look for the next one. Unfortunately, many investors feel
obligated to buy a stock after they have invested a minimal amount of time
analyzing it an attitude that is not conducive to outperforming the market. I
remind myself that stock picking is a messy business and that I would rather spend
20 hours figuring out what not to buy than convincing myself I am obligated to buy
it. Analyzing companies is a multistep process. The following is a general outline of
all the steps I take before I come to a decision to buy or not buy. Please note that, in
addition to small-caps, I use this same process anytime I analyze a potential
investment opportunity, whether it be a spin-off, a post-reorganization equity, or a
bank thrift conversion.
Reading the public filings and other publicly available information
A companys financial statements are the most important component to serious
analysis. I use them to to discover what is behind the numbers, what is driving the
growth (or lack of it), and come up with a prognosis for the companys future
prospects.
I begin my financial quest by pulling the last 3 years of Form 10-Ks (annual reports)
filed with the Securities and Exchange Commission along with the last 6 Form 10-Qs
(quarterly reports) and any Form 8-Ks (amendments to the 10-Ks and 10-Qs). This
gives me all of the numbers from the annual reports from the last 5 years and the
all of the quarterly reports from the last two years. This allows me to compare
trends on cash flow, inventories, receivables, and margins.
I find it helpful to divide the financials into small parts and then put them back
together and see if they fit. I consider the footnotes to the financial statements to
be the most useful tool in determining if the numbers make sense. The footnotes
are where any red flags to creative or fraudulent accounting will pop up. If the
footnotes are complicated and difficult to comprehend I will assume it is deliberate.
In addition to analyzing the numbers, I will review the last 3 years of proxy
statements looking for corporate governance issues such as bloated executive
compensation or management that is unfriendly to shareholders. I look for any kind
of poison pill or change-of-control provision that would prevent an activist investor
from coming in and pushing for a sale of the company.

Crunching the numbers

Many professional investors build elaborate financial models I do not. Models are
only as good as their inputs which can often be nothing more than an educated
guess. If you are looking through a telescope out at the night sky and tilt your
telescope a few degrees, you could change your view by a million miles. Instead, I
spend my time doing an extensive amount of numbers crunching. The primary
questions I want to able to answer when I have finished going through the numbers
is, are these numbers solid and believable or is management pandering to investor
expectations with creative accounting?
The Balance Sheet
I first look at the most recent balance sheet and compare it to previous years
balance sheets. I then start investigating whether or not the assets are believable.
Some of the questions I might ask right off the bat: Are the assets, such as real
estate, listed at inflated values? Are the inventories packed with obsolete product?
Are loss provisions too low? What is the policy for booking receivables?
I pay close attention to accounts receivable and inventories by comparing them to
the growth in sales and the cost of goods sold if they are out of alignment it is a
red flag and should be explained. Then I look at deferred charges to see if the
company is pushing expenses too far into the future; a bad habit that can lead to a
sharp reversal if revenues slow. I then move on to intangible costs like goodwill and
amortization and look for evidence the company could be capitalizing routine costs
a sure sign of earnings manipulation. Accumulated depreciation is another area I
check, if the company has recently changed its average life assumptions I will want
an explanation. This is why it is important to go over the footnotes with a finetoothed comb.
I then move onto the liability side of the balance sheet. I want to know if there are
any liabilities that are difficult to comprehend a red flag that management could
be using the company as a personal piggy bank. Next I want to know if short-term
debt growing and when is long-term debt due. I check the footnotes to see if the
company has any off-balance sheet liabilities.
The Income Statement
Much like with the balance sheet, I review several years of the income statement. I
want to know if the company has a history of relying on nonrecurring income to
bolster results. This could be the sale of land or securities, tax credits, and one-time
credits from suppliers happening year after year. I look for a change in accounting
policies and revenue recognition. Again, this information can be fleshed out in the
footnotes. What I am looking for is a business that is stable and likely continue
being stable for the foreseeable future. On the flip-side I look to see if one-time
charges are strictly one time.
I always look carefully at earnings-per-share (EPS). Are earnings per share up only
because there are fewer available shares? I compare the numbers using the
previous years fully diluted shares outstanding, never relying on just the undiluted

average shares. Another trick is to take the number of shares from the 10-K, add in
convertible shares that are close to conversion, add in options that are close to
being exercised, and add in warrants if there are any. Add up all of those numbers
for fully diluted shares outstanding. Inexplicably, Wall Street often fails to make this
calculation and gives EPS manipulation a wink and a nod.

The Cash Flow Statement

The cash flow statement is the toughest part of financial statements to understand
and it is also my favorite. In a nutshell I am looking for sustainable operating cash
flow. Let me rephrase that; I am looking for sustainable operating cash flow that is
trading at a low valuation if you are paying attention I have just given away my
biggest secret.
Cash flow statements are broken up into three parts: operating, investing, and
financing flows. I look at the cash flows from financing to see if the company needs
to keep borrowing money in order to stay in business. I look to see if the company
has to keep issuing new shares every year to raise much needed capital. Then I look
at expenditures and what is necessary to keep the business going. One calculation I
like is to take the net income and add in depreciation, amortization, and deferred
taxes and then subtract nonrecurring items (adjusted for taxes) and then add or
subtract changes in current assets. That calculation will give me a more accurate
picture of what is truly operating cash flow getting to know the company inside
and out will tell me if that number has room for improvement or is sustainable.
I check cash flows from investing to see what exactly the company is investing in; I
want to know if it is new real estate or plant and equipment. Then I want to know if
it is a necessary expenditure for conducting business. I then check for free cash flow
by deducting capital expenditures and dividends to find out if that number is
negative or positive. If it is negative I will do a year-by-year check to see if it is a
one-time anomaly or if the situation is deteriorating. If the company is a cyclical
business with up and down cash flows I want to know if the company has a strong
enough balance sheet to weather the downturn or if it will need to raise cash
through more debt or an equity offering. I want to know that if the company will
need to borrow money and if a cyclical downturn will make borrowing difficult due to
impaired coverage ratios?
I like to think of the balance sheet, income statement, and cash flow statement as
individual parts of a 3-D puzzle. The bottom line question is do all of the pieces fit
smoothly?
My Checklist of Ratios
Keeping track of the various ratios is crucial to truly understanding the company
and its numbers. While not an exhaustive list, the following are just a few of the
ratios I rely on the most.

Return Ratios:

Return on equity
Return on assets
Return on invested capital

I look at return ratios over a course of several years, it lets me see the trends and
the volatility of the returns over a period of time. It also allows me to compare the
numbers with other similar companies in the same sector or industry. More
importantly I want to know if the company is earning more than its cost of capital.
One of my favorite metrics is return on invested capital (I owe this one to famed
short-seller James Chanos), it allows me to spot which companies are not what they
say they are. My calculation: earnings before interest and taxes divided by average
total capital. This is a hard number for companies to manipulate and it is a good
indicator of a high quality business.

Capital Structure:

Long-term debt-to-equity
Total debt-to-total capital
Total debt-to-equity

It is important to understand how a business is capitalized. I compare several years

of balance sheets to look for trends in the ratios. I am wary of companies that are
trending towards over-leveraged.
Valuation Ratios:

Price-to-earnings
Price-to-book
Price-to-cash flow

I always keep a close eye on the valuation ratios of the companies I keep on my
watch list. It allows me to check in minutes if the stock is running up or if it is
tanking. I also use them for a quick-and-dirty comparable with other companies,
which comes in quite handy if a competitor is taken over. Keep in mind that
valuation ratios are relative to the industry lower in financial services and higher in
retail companies. A high price-to-earnings (P/E) is an indication Wall Street believes
there is growth potential. A high price-to-cash flow (P/CF) is an indication Wall Street
believes there will be a buyout.
Other Useful Filings
Form 13-D
A big part of my overall investment philosophy is to look for companies that could
become targets of activist investors. Studies have shown that companies that
undergo a campaign by an activist investor tend to outperform the market. Through
experience I have found that most market outperformance is the result of a catalyst

that unlocked shareholder value. The most efficient catalyst is some type of onetime event such as a spin-off or a merger and this why it is handy to have an
activist investor waiting in the wings. An activist investors reason for being is to
push for a catalyst that unlocks value.
The best way to find out if an activist investor is pushing management to take
action is to check the 13-D filings. These are required by the Securities and
Exchange any time an institutional investor buys 5% or more of the outstanding
stock and intends to communicate with management. Aside from the boilerplate
language, 13-Ds are fascinating to read because it offers the activist investor an
opportunity to communicate its ideas about the company to the market. If you want
to know what a top investor thinks the future potential of a company could be, read
the 13-D. Many times I have read a 13-D and then contacted the activist investor to
gain more insights into their thoughts on the company. Paying attention to the top
activist investors is not only a good way to learn how to think about investing, but it
can lead to market beating opportunities.

Proxy Statements
All publicly traded companies must file a proxy statement before the annual
shareholders meeting. The proxy serves as an announcement to shareholders on
what they will be voting on at that annual meeting. It is packed with information
that gives investors insight in the companys philosophy. In it can be found
management salary including bonuses, option awards, and perks. It also details
employment contracts with key executives always good to know if management
has golden parachutes. One game I like to play is to count how many times it says
certain transactions. It is also a good place to look for pending litigation.
Many institutional investors farm out the analysis of proxy statements to
institutional proxy services such as Glass, Lewis & Co. or Institutional Shareholder
Services, who then recommend to the institution how they should vote. The reason
for this is beyond the subject of this work, but I have always felt it was an abdication
of an institutions fiduciary duties. I prefer to read them myself and come up with
my own conclusions and questions.
A short list of some of the questions I want answered by the time I have finished
reading the proxy:

What is the percentage of executive compensation to earnings?

Does the company pay large bonuses?
How is the bonus determined? Performance, return on equity, or some other
measure?

Are bonuses tied to EPS growth? (If so, there is motivation to fudge the
numbers)
Does the company pay for stock options?
Does the company pay a bonus to cover the taxes on options?
How many shares do top executives own?
Does the company have a severance payout in the event of a merger or buyout?
What are the terms of the retirement contracts?
Are there perks such as apartments, planes, cars, etc.?
Are there any arms length transactions?
Are any of the officers related?
Does the company do any deals with companies controlled by relatives of key
executives?
Does the company loan money to executives? If so, what is the interest rate?
Are there any joint-ventures in which executives are limited or general
partners?
Are there any lawsuits? What is the potential liability?
How independent is the board of directors?

Once I have done my homework with the financial and other filings, I will move onto
the next step, contacting investor relations and management as well as listening to
earnings calls.
Contacting the company
One of the advantages of investing in small caps is that the companys investor
relations and upper management is unlikely to be flooded with requests and
questions from other analysts. Listening to earnings calls and talking to
management is a powerful tool for filling in the gaps left from simply reading the
financial statements. By getting to know the management, an investor can discern
if management is trustworthy and competent. Investors should want to work only
with management that is candid when things are not going according to plan and
when mistakes are made. The question all investors should ask is, do I trust this
management with my money?
Following small caps within a particular industry or region for many years and
developing rapport with top level management can pay off in other ways. There
have been occasions I have been able to call an executive with a company I
previously covered and ask them for their thoughts on a competitor that I am
looking at. Some of the best analytical intelligence will come from a competitor.
Never underestimate a companys need for an active and vigorous investor
relations team. Their job is to increase awareness and demand for the stock. How
else will the stock ever go up if no one knows the company even exists? I look for an
investor relations team that is honest in discussing the companys opportunities and
challenges. One that is willing to give presentations at investor conferences, and
arrange conference calls between investors and management. I avoid companies
where investor relations is insincere and unwilling to engage in an all-out effort to

attract investors and promote the company. When I speak with investor relations
one of the first questions I ask is what is their strategy going forward.
Listening to earnings calls
Listening to earnings calls is one of the most overlooked sources of information
about the company, its most recent performance, and the management. During an
earnings call, investors and analysts can call in over the phone to hear management
discuss the financial results of the most recent quarter. Most companies hold four
calls a year, shortly after the quarterly results are announced. Usually the call is
available online as an audio or a transcript of the call is available from investor
relations. No matter how boring a call may be, I find them a valuable tool to gain
insight into managements mindset.
Most calls follow the same format: an introduction by the operator, then the general
counsel or CFO will give the usual legal disclaimers; the following discussion will
involve forward-looking projections, which are only expectations and are not factual.
Next up the CEO or CFO will give a recap of the earnings announced in the most
recent press release, covering what happened in the past. Management will move
on to discuss what is happening currently and what management expects
performance to be in the future. It is always a good idea to go back and see how
optimistic or pessimistic management was in previous earnings calls and how those
results mesh with the current results. Is management prone to overstating or
understating future performance expectations?
After management completes that part, the call is opened up to questions from
analysts or significant shareholders. I believe this is the most important part of the
call as analysts and investors are able to pose questions about any area of the
company that requires elaboration from management. An investor can learn a lot
about the quality of management when they are in the hot seat. This can provide
insight into concerns other investors have about the company and how well
management handles them. It is a chance to see whether management can answer
the questions candidly and confidently or whether they fumble the questions when
pressured. More than anything, earnings calls can be used to gain a gut feeling for
the companys management. The key is to differentiate what is boilerplate
conference call speak and what is useful information.
After taking in all of this information the financials, future prospects, management,
etc. I decide whether or not I am a buyer. A lot of that depends on how the
company scores on my checklist. If I do not buy, the company could stay on my
watch list in the event something occurs that later makes me change my mind.
My Final Checklist
I look for investments that have all (or at the very least many) of the following:
Low valuation: I am looking for a cheap price in relation to earnings, cash flow, or
book value. Without this there really is no need for me to even consider the
investment.

Financial Strength: Strong balance sheets with low-debt levels in relation to

assets and sufficient working capital to help the company survive downturns.
Profitable: I look for companies with a history of profitability. This is one reason
why I generally avoid start-ups because they are usually losing money, but, like with
turnarounds, I will make exceptions if the near-term projections are compelling.
Cash Flow: Cash is king and reported earnings mean little if there is no cash flow. I
look for companies with strong cash flows after accounting for capital expenditures.
I steer clear of companies that are capital intensive as they may need to raise cash
through equity or debt to finance their needs.
Overlooked: I prefer companies with little to no coverage, any company being
scrutinized by an army of analysts is not likely to be undervalued.
Growth: I look for companies that have consistent growth rates of 15% or more.
How else will a small-cap become a large cap? If it is selling for super cheap, I will
consider a small-cap with a slower growth rate.
Industry: I look for industries that are growing. The probabilities are against my
finding a good undervalued company in a declining industry.
Competitive Strength: Companies with a market niche or that dominate their
industry can grow revenues and margins even in downturns.
Solid Management: Taking a page from Warren Buffett, I only want to be in
business with management I can trust and respect. I look for management that is
competent and knowledgeable. It is important to have management that is candid
and upfront when things go bad and that is capable of fixing the problem. On the
flip-side, I want management that does not get overly optimistic when things are
good.
Significant Ownership: I look for management that has skin in the game, their
interests are more likely to be aligned with shareholders. At the same time, I do not
want management that has majority ownership and running the company like their
own private fiefdom.
Active Investor Relations: I look for investor relations that is actively promoting
the company. Whether that be conference presentations or setting up conference
calls with analysts and investors. Investor relations need to be in the trenches
drawing the attention of other investors to the stocks value.
Lawsuits and Regulatory Scrutiny: I typically avoid small companies that are
fighting a major drawn-out lawsuit or facing extensive regulatory scrutiny. Not only
is it a distraction for management, it can have a negative impact on valuation. Not
to mention, an adverse ruling could have dire consequences for the companys
survival.
Key takeaways:

Investing in small-caps requires hard work, discipline, and patience.

Extensive due diligence and fundamental analysis is required.

Short-term volatility is to be expected.

Expect to wait several years for the thesis to play out.