Michael Melby is a featured instructor at Best Ideas 2017.
One of the key investment tenets at Gate City Capital Management is to purchase companies and not stocks. Although we do not plan on purchasing the entire company, we consider the purchase of a share of stock as an investment in a share of the assets and future cash flows of the firm. In our view, this methodology is the key differentiating factor between speculating and investing. While speculators purchase a share of a company with the hope that the share price appreciates (for any number of reasons), investors purchase a share of stock to own a portion of a company – usually at a discount to the company’s intrinsic value. Thus, we consider it imperative for all investors to understand the value of the assets, liabilities, and cash flows they are purchasing before making any investment.
In much the same way, when either individual or institutional investors consider which investment fund might be right for them, they should understand the pool of assets and liabilities they will be acquiring. This necessitates a very similar process to the one highlighted above, but instead of purchasing an ownership share of one company, the fund investor is purchasing an ownership share in a portfolio of companies. Understanding the underlying assets and liabilities of a portfolio of companies is certainly more time-consuming than analyzing a single company. This can cause fund investors to allocate capital to an investment fund without a solid understanding of the companies they are purchasing. We find this to be especially prevalent when investors look to allocate capital to index funds, where exposure to certain asset classes is desired (often based on pre-established asset allocation targets) with little or no knowledge of the underlying constituents of the index as well as the assets and liabilities they own.
Our focus on micro-cap value companies is centered on the view that this sub-segment of the U.S. equity market provides the best opportunity investment opportunities. We look for companies with clean balance sheets, owned real assets, and strong free cash flow. Building a concentrated portfolio of companies that meet these investment criteria should provide our investors with the potential for long-term capital appreciation along with a considerable margin of safety. To test this, we compiled the assets and liabilities of each investment in our fund. We then took the fund’s ownership stake in each company and divided this down further to represent the portfolio of assets and investor would purchase with a $100,000 investment. As of November 30, 2016, a $100,000 investment in the fund would acquire over 7 acres of land (including over 1 acre of timberland), 28 acres of mineral rights, 5.6 acre feet of water rights, and over 190 square feet of building space. The investor would also get $23,600 in cash and assume $7,500 in debt, resulting in a net cash position of over $16,000. The book value of the portfolio exceeds $110,000 with the assets generate over $105,000 in trailing revenue.
While the process highlighted above comes with no assurances that the portfolio companies or the asset they hold will not decline in value, it should provide our investors with comfort in knowing their investment purchased a tangible, unlevered pool of assets. This should help provide our fund with a stable, long-term investor base. For us, this approach provides us with additional conviction in the value of each of our underlying holdings should the stock price later depreciate in value. At the upcoming Best Ideas 2017 conference, we are excited to present on Gulf Island Fabrication (GIFI) – a company with a large owned asset base that we think could be a valuable addition to an investor’s portfolio.
Meet Michael Melby, Portfolio Manager of Gate City Capital Management.