Alluvial Investment Summary January 2014

Investing Off the Beaten Path January, 2014

Alluvial Capital Management, LLC Web-Site: alluvialcapital.com E-Mail: [email protected] Phone (412) 368-2321

Why Invest Beyond Traditional Equities? Most equity investors limit their investments to relatively large, liquid companies. The reasons for this are many, but three factors stand out. 1. Institutional Constraints – Investing vehicles like mutual funds and ETFs manage massive pools of capital and require extremely high liquidity at all times. These vehicles are unable to invest enough capital in microcap companies or thinly-traded issues to have a material impact on returns, regardless of the potential returns these securities can offer. 2. Unfamiliarity – Most investors are simply unaware of the existence of micro-cap and/or thinly-traded companies. These companies rarely make the news headlines, even though many have been operating profitably for decades and are highly respected in their niches. What’s more, few of these companies generate investment banking revenues for Wall Street, resulting in minimal coverage by sell-side analysts. In the absence of news flow and Wall Street-provided analysis, few investors possess the time or inclination to seek out lesser-known companies. 3. Perceived Risk – To many investors, small size and reduced liquidity are synonymous with increased risk. While many small companies are indeed under-capitalized and lacking viable business models, many others have strong liquidity, low debt, solid returns on capital and potential for earnings growth. Actual investment risk, defined as the chances of permanent impairment of a company’s intrinsic value, is mainly a function of balance sheet strength, managerial competence and industry prospects, not a company’s size or liquidity. By limiting their investments to well-known, widely-held equity securities strategies, investors must accept market-level returns, on average. While the majority of investors may be perfectly satisfied with the returns on offer in conventional strategies, non-traditional equities such as micro-cap companies, thinly-traded issues and complex situations offer opportunities for enhanced returns. To succeed in investing in micro-caps, thinly-traded securities and complex situations, an investor must be willing and able to perform extensive research and to tolerate reduced liquidity. Alluvial Capital Management, LLC’s mission is to identify attractively-priced, unknown securities and to use them to create portfolio strategies with strong return potential.

Investing In Micro-Cap Equities As of January 2014, investors in American stocks can choose from among nearly 4,000 different companies with market capitalizations over $250 million. By contrast, there are over 6,000 domestic companies with market capitalizations below that threshold. The micro-cap segment of the market offers a more diverse set of opportunities, though the small size of the components makes the segment nearly uninvestable for institutions and others with hundreds of millions under management. Historically, investors have been well-rewarded for investing in these smallest companies. From June 30, 1926 to November 30, 2013, the smallest decile of US stocks returned 12.91% annually, while the largest decile returned 9.37%.1 The reasons for this out-performance are hotly debated, but Alluvial believes this excess performance can be largely attributed to certain factors that persist in today’s market. Limited Investor Demand – Many investors cannot or will not invest in microcap companies. This results in reduced demand for shares, which in turn results in lower valuations and higher returns. Neglect – In a related fashion, small company size results in less attention and awareness from potential investors. Hence, lower valuation and higher returns. Growth Opportunities – Micro-cap companies frequently possess opportunities for revenue and earnings growth. Working from a small base of each, micro-cap companies can pursue growth projects that would be immaterial to large companies. Mergers & Acquisitions Activity – Micro-cap companies have natural buyers in larger competitors. When wishing to expand or capture a new technology or product line, these competitors may find it cheaper to purchase a tiny company rather than develop the new resource internally. Owner/Manager Alignment – Insiders at micro-cap companies frequently own a large percentage of shares outstanding and are thus incentivized to create value for shareholders, rather than extract value through salaries and bonuses. As pointed out by Horizon Research Group, these “owner-operator” companies frequently provide better returns than the market.2

These factors interact to create opportunities to invest in businesses that trade well below conservative estimates of fair value. Alluvial Capital Management, LLC seeks out micro-cap securities that offer the best riskadjusted return potential.

Investing in Thinly-Traded Securities Investors value liquidity and prefer the ability to liquidate any holding within minutes. As a result, securities that require days or weeks to liquidate in an orderly fashion often trade at significant discounts. In Alluvial’s view, the magnitude of this discount has increased over time as average holding periods have fallen3, affording patient investors with a long-term view the opportunity to purchase less liquid companies at extremely attractive valuations. Historically, the market has rewarded investors willing to purchase thinlytraded securities. A study by Roger Ibbotson, et al. revealed an average annual return premium of 5.34% for the lowest liquidity quartile of the 3,500 largest US companies stocks over the highest liquidity quartile of the same stocks, from 1972 to 2011.4 Investing in thinly-traded securities is an exercise in patience. Because days may pass between trades, it can be frustrating to watch illiquid positions hold steady when the market is soaring. It is helpful to remind oneself that an equity investment represents ownership in a real business, not merely in a ticker symbol on a screen. Though the share price may not be moving, the business itself is (hopefully) earning money and making productive investments that will inexorably be reflected in the share price in the long run. Long periods of boredom can be interrupted by sudden leaps, as the stock adjusts to news releases or the company is acquired. Less liquid securities often trade with a wide bid/ask spread. Patient investors should view this as an opportunity to purchase at a discount or sell at a premium. By carefully placing orders to buy at the bid or sell at the ask, astute investors can collect a spread from impatient buyers and sellers in thinlytraded securities. Though thinly-traded securities can offer attractive potential returns, liquidity needs are real and investing the majority of a portfolio in thinly-traded securities would be unsuitable for most investors. Alluvial Capital Management, LLC balances investors’ liquidity needs against the potential for enhanced returns in thinly-traded securities.

Investing In Complex Situations While the market is fairly efficient in general, Alluvial believes that investors regularly fail to properly price stocks where accounting or business complexity obscures the true value of earnings or assets. This complexity can take many forms. Understated Assets – Equity-accounted minority holdings in other companies, real estate held at historical cost, LIFO reserves and other assets can appear on the balance sheet (or only in financial statement notes) at a value that is much lower than the actual market value of these assets. Net Operating Loss Carryforwards – Accumulated losses can be used to shield future income from taxation, significantly increasing a corporation’s future earnings power, yet the full value of NOL assets frequently does not appear on the balance sheet. Non-Recourse Debt – Some companies, especially those that deal in real estate, use non-recourse subsidiary-level debt to fund projects. Investors often fail to distinguish between company-guaranteed and non-recourse debt and may misinterpret the parent company’s actual debt burden. Obscured Profitability – Sometimes, strong profits in one of a company’s segments can be disguised by losses in another. Shutting down or selling the loss-making segment can suddenly reveal a company’s true worth. Identifying these hidden sources of value requires in-depth study of company filings and disclosures. Alluvial seeks to identify and invest in these companies before their true worth becomes apparent to the market.

Finding Value World-Wide As of 2010, American investors exhibited a strong bias toward domestic investing, with 72% of their equity investments dedicated to American corporations, while US stocks represented only 43% of the world’s total equity value. Australian, Canadian and UK investors invested even more strongly in their own domestic corporations.5 Failing to consider stock investments in other jurisdictions can result in missed return opportunities. Alluvial endeavors to find opportunities in markets around the world, subject to a few constraints: Stability and Legal Protections – Nations and regions that have autocratic governments, high risk of armed conflict, weak contract law and legal rights for investors should be approached with extreme caution. Equity investors in companies operating in nations like Russia, China, Venezuela, Argentina and many others face a high risk of permanent loss due to nationalizations, capricious taxation and theft by company insiders. Alluvial prefers to invest in national exhibiting stability and strong legal systems. If an investment in a less stable region is to be considered, its discount to intrinsic value must be extremely high and its weighting in the portfolio will be very small. Tax Considerations – Many nations levy high taxes on dividends received by foreign investors. Alluvial avoids investments where the bulk of returns are expected to be generated by dividends subject to high tax rates.

About Alluvial Alluvial Capital Management, LLC is a registered investment advisor, able to provide investment management services in the US and many other domiciles worldwide. Alluvial’s sole member is David Waters, CFA. Mr. Waters is the author of the well-regarded blog OTCAdventures.com, which focuses on micro-cap, thinlytraded and complex equity securities. Alluvial offers separately-managed accounts through its custodian and broker-dealer, Interactive Brokers. Accounts are open to accredited and nonaccredited investors. Qualified retirement accounts are accepted. For more information, please contact David Waters at [email protected] or (412) 368-2321 during US Eastern business hours.

References 1

On Long-Term Returns of Micro-Cap Equities

Data derived from http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#HistBenchmarks 2

On Long-Term Returns of “Owner-Operator” Companies

http://www.frmocorp.com/_content/essays/The_Owner_Operator_Company.pdf 3

On Average Stock Holding Periods

http://www.businessinsider.com/stock-investor-holding-period-2012-8#ixzz22uVvTEmg 4

On Long-Term Returns of Illiquid Stocks

http://www.ibbotson.com/US/documents/MethodologyDocuments/ResearchPapers/LiquidityAsAnInve stmentStyle.pdf 5

On Allocations to Domestic Equities

https://advisors.vanguard.com/iwe/pdf/ICRRHB.pdf