Welcome to Inside Active, a podcast about active managers that goes beyond soundbites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne, i lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Michael casper Us, small cap and sector strategist at Bloomberg Intelligence. Mike, thanks for joining me today.

Welcome to Inside Active, a podcast about active managers that goes beyond soundbites and headlines and looks deeper into their processes, challenges and philosophies and security selection. I'm David Cohne, i lead mutual fund and active research at Bloomberg Intelligence. Today my co host is Michael casper Us, small cap and sector strategist at Bloomberg Intelligence. Mike, thanks for joining me today.

Thank you, David.

Thank you, David.

So you wrote an interesting note last week on the connection between small cap stocks and M and A. So how to merge his and acquisitions affect Russell two thousand performance?

So you wrote an interesting note last week on the connection between small cap stocks and M and A. So how to merge his and acquisitions affect Russell two thousand performance?

Yeah, Well, first a recap of what happened in twenty twenty four, and it was the weakest year we had on record going back to about two thousand, with the last quarter of twenty twenty four being particularly bad, just two deals worth a paltry four point four billion in the fourth quarter, But that caped a year where there was only about fifty two deals that was worse than two thousand and eight sixty one deals and making it the worst going back to two thousand. Now you might be wondering where did that dip come from. It was definitely in financials, they made up just nine point three percent of last year's fifty four deals. Typically they average around eighteen point three percent or so of deals annually going back to again two thousand, So really the big departure was in financials only. Energy, though saw more deals than its pre pandemic and X Great Financial Crisis average. But why does this really matter for small cap stocks? At the end of the day, small cap performance and the amount of M and A, so the amount of targets in the small cap index are pretty closely linked. So if you look at calendar year performance of the rest of two thousand and deal count and value in the correlation between the two Russell two thousand annual performance, calendar year performance is point five two correlated with count and it's point four correlated to deal value. So a pretty significant positive correlation there. Obviously is takeouts to accumulate. It drives a premium for some of these small cap stocks in some of these sectors. And one of the cool things just before I give up on this, one of the cool things we did that I want to mention is that we tried to look for commonality across these takeout targets in the Russell two thousand, going back to again two thousand or two thousand and one, and what we found the commonality amongst them was most of them had positive EBADA for the year prior to the deal's announcement. Over sixty percent of all those deals going back to two thousand had positive EBADA seventy two percent or so. We're cheaper than the index median ev to EBADA and about seventy percent had lower net debt to ebadas, a lower leverage leverage than the median stock in the Russell two thousand. So we did a nice little takeover target screen looking at companies in the Russell two thousand today.

Yeah, Well, first a recap of what happened in twenty twenty four, and it was the weakest year we had on record going back to about two thousand, with the last quarter of twenty twenty four being particularly bad, just two deals worth a paltry four point four billion in the fourth quarter, But that caped a year where there was only about fifty two deals that was worse than two thousand and eight sixty one deals and making it the worst going back to two thousand. Now you might be wondering where did that dip come from. It was definitely in financials, they made up just nine point three percent of last year's fifty four deals. Typically they average around eighteen point three percent or so of deals annually going back to again two thousand, So really the big departure was in financials only. Energy, though saw more deals than its pre pandemic and X Great Financial Crisis average. But why does this really matter for small cap stocks? At the end of the day, small cap performance and the amount of M and A, so the amount of targets in the small cap index are pretty closely linked. So if you look at calendar year performance of the rest of two thousand and deal count and value in the correlation between the two Russell two thousand annual performance, calendar year performance is point five two correlated with count and it's point four correlated to deal value. So a pretty significant positive correlation there. Obviously is takeouts to accumulate. It drives a premium for some of these small cap stocks in some of these sectors. And one of the cool things just before I give up on this, one of the cool things we did that I want to mention is that we tried to look for commonality across these takeout targets in the Russell two thousand, going back to again two thousand or two thousand and one, and what we found the commonality amongst them was most of them had positive EBADA for the year prior to the deal's announcement. Over sixty percent of all those deals going back to two thousand had positive EBADA seventy two percent or so. We're cheaper than the index median ev to EBADA and about seventy percent had lower net debt to ebadas, a lower leverage leverage than the median stock in the Russell two thousand. So we did a nice little takeover target screen looking at companies in the Russell two thousand today.

That's great. So if we are talking about small caps, I think it's a great time to welcome our guest. I'd like to welcome Brian Wong to the podcast. Brian is vice president and small cap growth portfolio manager at Ostrowis and a manager for the Austrowis Opportunity Fund ticker OSTGX. Brian, thanks for joining us today.

That's great. So if we are talking about small caps, I think it's a great time to welcome our guest. I'd like to welcome Brian Wong to the podcast. Brian is vice president and small cap growth portfolio manager at Ostrowis and a manager for the Austrowis Opportunity Fund ticker OSTGX. Brian, thanks for joining us today.

Thanks for having me.

Thanks for having me.

David, So I'd like to begin by asking you how you got your start in the investment business.

David, So I'd like to begin by asking you how you got your start in the investment business.

Sure, well, I went to college at Yale. I was a political science major, so a great great training for investments, of course, and really what I was focused on studying in college was the Grand Strategy of Countries. So I wrote my senior essay on the Grand Strategy of Dung Dungshaoping, who's really China sort of modern leader following Mount Malzaedong really opened up the economy there, but still preserved capitalism with Chinese characteristics. And when I was graduating from college, I got a great opportunity to join a long short hedge fund run by Yale history major Dan, who really saw how my skill set might translate, and so the first book he gave me was Competitive Strategy by Michael Porter. So really I went from studying the Grand strategy of countries and leaders to companies. That was just a tremendous opportunity to learn the craft of investing. The senior analyst that the firm was a fellow by the name of Sal Khon, who went on to found the con Academy. And so I remember just sitting with Sal after work many days, seeing him watch him record these videos of him tutoring his cousin in math, and really sort of grew to appreciate the power of technology, obviously leveraging a new model of distribution YouTube to reach a much broader audience of millions of people. And the idea of using technology as this efficiency driver. You can record something once, but obviously the content is forever. And then additionally, I think just this idea of scaling by creating value for others. You know, dominant companies don't start out that way. Every entrepreneur has humble, humble beginnings. UH an idea. You know, it requires very hard work.

Sure, well, I went to college at Yale. I was a political science major, so a great great training for investments, of course, and really what I was focused on studying in college was the Grand Strategy of Countries. So I wrote my senior essay on the Grand Strategy of Dung Dungshaoping, who's really China sort of modern leader following Mount Malzaedong really opened up the economy there, but still preserved capitalism with Chinese characteristics. And when I was graduating from college, I got a great opportunity to join a long short hedge fund run by Yale history major Dan, who really saw how my skill set might translate, and so the first book he gave me was Competitive Strategy by Michael Porter. So really I went from studying the Grand strategy of countries and leaders to companies. That was just a tremendous opportunity to learn the craft of investing. The senior analyst that the firm was a fellow by the name of Sal Khon, who went on to found the con Academy. And so I remember just sitting with Sal after work many days, seeing him watch him record these videos of him tutoring his cousin in math, and really sort of grew to appreciate the power of technology, obviously leveraging a new model of distribution YouTube to reach a much broader audience of millions of people. And the idea of using technology as this efficiency driver. You can record something once, but obviously the content is forever. And then additionally, I think just this idea of scaling by creating value for others. You know, dominant companies don't start out that way. Every entrepreneur has humble, humble beginnings. UH an idea. You know, it requires very hard work.

So that was a neat experience to see very early on in my career.

So that was a neat experience to see very early on in my career.

And so when Sal left to start kN Academy and and Dan retired, I joined the Packard Foundation, which is now run by Kim Sargent, a disciple formerly of the Yale Endowment, and and there I learned the value of long term investing uh and and for the past decade I've been at Osterweiss applying sort of what I've learned through those three to two former stages of my career. First the idea of strategy and competitive advantage, second the long term focus, and third this idea of you know, how how do these companies start out from from something small and scale to become something very significant. So I'm very I'm very fascinated by that, and that's what I've been applying for the past decade.

And so when Sal left to start kN Academy and and Dan retired, I joined the Packard Foundation, which is now run by Kim Sargent, a disciple formerly of the Yale Endowment, and and there I learned the value of long term investing uh and and for the past decade I've been at Osterweiss applying sort of what I've learned through those three to two former stages of my career. First the idea of strategy and competitive advantage, second the long term focus, and third this idea of you know, how how do these companies start out from from something small and scale to become something very significant. So I'm very I'm very fascinated by that, and that's what I've been applying for the past decade.

So let's let's kind of dig into the opportunity fund. You know, it sounds like you started getting into the philosophy, you know, behind the fund strategy. Can you, I guess, give us a little bit more about that philosophy that you're using, I guess for the investment process of this.

So let's let's kind of dig into the opportunity fund. You know, it sounds like you started getting into the philosophy, you know, behind the fund strategy. Can you, I guess, give us a little bit more about that philosophy that you're using, I guess for the investment process of this.

Yeah, I guess just to take a step back even before we kind of talk about the philosophy. I mean, why being sort of small caps at all? I think it has to do with this, you know, defining characteristic of capitalism, right, which is this this what makes America exceptional?

Yeah, I guess just to take a step back even before we kind of talk about the philosophy. I mean, why being sort of small caps at all? I think it has to do with this, you know, defining characteristic of capitalism, right, which is this this what makes America exceptional?

Right?

Right?

It's innovation and sort of this process of creative destruction whereby smaller companies and entrepreneurs come up with newer, more innovative ways of doing things, they offer superior value to customers and improve lives. So I think, you know, I very much believe in that fundamental process. And then if we kind of move to active management, right, we firmly believe there's there's a value of active in small cap And you start with the idea that small cap is inefficient. You have a universe of emerging companies with limited analyst coverage. So it's certainly an area where active management can add value. I think Morgan Stanley did a great study where they found the cumulative media and alpha by active managers and small cap was nearly sixty percent over the past thirty years. It's, you know, very different versus sort of mid MidCap and large cap. And then third, similar to private markets, the best managers and I'm really talking about sort of the top quartile, the top descl can add tremendous value. And that's similar to kind of like an institutional investor looking at private equity or venture capital. You don't want to be in sort of venture capital just for the sake of being in venture capital. You really want to be in a top quartile type manager. And so those those are the things we believe. And if you then layer into kind of our strategy, you know, we think we have a few key advantages. First, all we do is small cap, at least my team of four, we focus on this emerging company universe. We happen to be located in San Francisco, which obviously gives us a backdoor seat to a lot of the innovation, particularly in the tech, technology and healthcare sector. Second, our team experience. Again I mentioned the four of us as industry specific sector analysts. Third and absolute valuation discipline, which I'm sure we'll get into later, but every name has to have at least one hundred percent upside at the time of our purchase over a five year time horizon. We use no more than a thirty times pee multiple and our five year model estimates. And then finally, fourth, a high conviction portfolio. So on average we have about forty names in our portfolios, so fairly concentrated. And so what that gives us is this portfolio of innovation and growth, but it's also tethered to reality and valuations, and we think that's the secret sauce to full cycle returns and the alpha that we've been able to generate over time.

It's innovation and sort of this process of creative destruction whereby smaller companies and entrepreneurs come up with newer, more innovative ways of doing things, they offer superior value to customers and improve lives. So I think, you know, I very much believe in that fundamental process. And then if we kind of move to active management, right, we firmly believe there's there's a value of active in small cap And you start with the idea that small cap is inefficient. You have a universe of emerging companies with limited analyst coverage. So it's certainly an area where active management can add value. I think Morgan Stanley did a great study where they found the cumulative media and alpha by active managers and small cap was nearly sixty percent over the past thirty years. It's, you know, very different versus sort of mid MidCap and large cap. And then third, similar to private markets, the best managers and I'm really talking about sort of the top quartile, the top descl can add tremendous value. And that's similar to kind of like an institutional investor looking at private equity or venture capital. You don't want to be in sort of venture capital just for the sake of being in venture capital. You really want to be in a top quartile type manager. And so those those are the things we believe. And if you then layer into kind of our strategy, you know, we think we have a few key advantages. First, all we do is small cap, at least my team of four, we focus on this emerging company universe. We happen to be located in San Francisco, which obviously gives us a backdoor seat to a lot of the innovation, particularly in the tech, technology and healthcare sector. Second, our team experience. Again I mentioned the four of us as industry specific sector analysts. Third and absolute valuation discipline, which I'm sure we'll get into later, but every name has to have at least one hundred percent upside at the time of our purchase over a five year time horizon. We use no more than a thirty times pee multiple and our five year model estimates. And then finally, fourth, a high conviction portfolio. So on average we have about forty names in our portfolios, so fairly concentrated. And so what that gives us is this portfolio of innovation and growth, but it's also tethered to reality and valuations, and we think that's the secret sauce to full cycle returns and the alpha that we've been able to generate over time.

So I know quality is an aspect that you're looking for. Is there anything that you would you define quality as? Any specific characteristics?

So I know quality is an aspect that you're looking for. Is there anything that you would you define quality as? Any specific characteristics?

Yeah, I think I think traditional managers would certainly look on you know, wide modes, high an uninvested capital, that sort of thing. And I think quality has a number of different dimensions. As you said, you know, we like high return on invested capital businesses just as much as everyone else. But I think sometimes the opportunity in this emerging company universe is to have a more forward definition of quality and sort of, you know it s Gretzky said, skating to where the puck is going to be. So we're much more forward looking than sort of backward looking. So in addition to kind of the playbook of being able to buy high return on invested capital businesses when they sell off, you know, we want to kind of be diving into the mystery of the emerging company universe and think about these future, forward looking quality metrics, and so, you know, certainly we care about competitive advantage, but I think frequently there's an innovation component which we're looking for. There's a strong margin expansion component, so we're often focused on incremental margin as opposed to just kind of current margin. And then we're focused a lot on management, obviously, and trying to invest with these entrepreneurial management teams that set ambitious objectives but also have a clear plan and track record upon which they can execute towards those objectives.

Yeah, I think I think traditional managers would certainly look on you know, wide modes, high an uninvested capital, that sort of thing. And I think quality has a number of different dimensions. As you said, you know, we like high return on invested capital businesses just as much as everyone else. But I think sometimes the opportunity in this emerging company universe is to have a more forward definition of quality and sort of, you know it s Gretzky said, skating to where the puck is going to be. So we're much more forward looking than sort of backward looking. So in addition to kind of the playbook of being able to buy high return on invested capital businesses when they sell off, you know, we want to kind of be diving into the mystery of the emerging company universe and think about these future, forward looking quality metrics, and so, you know, certainly we care about competitive advantage, but I think frequently there's an innovation component which we're looking for. There's a strong margin expansion component, so we're often focused on incremental margin as opposed to just kind of current margin. And then we're focused a lot on management, obviously, and trying to invest with these entrepreneurial management teams that set ambitious objectives but also have a clear plan and track record upon which they can execute towards those objectives.

And you mentioned PES as one of the metrics that you use. How do you feel about equity valuations broadly and are there any other metrics that you like to use for valuing stocks.

And you mentioned PES as one of the metrics that you use. How do you feel about equity valuations broadly and are there any other metrics that you like to use for valuing stocks.

Yeah, our primary valuation metric is long term earnings power, and so we have a process we call it this anchor point, where we're focused on intrinsic value five years out. So we're oftentimes looking, we're trying to understand the unit economics of these companies. Everything we do is focused on fundamental bottoms up research, and so if you break down revenue of any company, right, there's often a volume component and a price component. A company can sell a certain amount of widgets and charge a certain price per widget, and then you layer on the incremental margins. I've on the earnings per share target and so upon which we applied no more than a thirty times p multiple to those five year estimates, and every company to enter the portfolio has to have at least one hundred percent upset on those on those metrics. So that is the primary valuation metric we use. We do look at other relative valuation metrics, you know EVD sales, EVD, EBITDA, things like that, but the primary metric is really the five year earnings power and the intrinsic value of these companies.

Yeah, our primary valuation metric is long term earnings power, and so we have a process we call it this anchor point, where we're focused on intrinsic value five years out. So we're oftentimes looking, we're trying to understand the unit economics of these companies. Everything we do is focused on fundamental bottoms up research, and so if you break down revenue of any company, right, there's often a volume component and a price component. A company can sell a certain amount of widgets and charge a certain price per widget, and then you layer on the incremental margins. I've on the earnings per share target and so upon which we applied no more than a thirty times p multiple to those five year estimates, and every company to enter the portfolio has to have at least one hundred percent upset on those on those metrics. So that is the primary valuation metric we use. We do look at other relative valuation metrics, you know EVD sales, EVD, EBITDA, things like that, but the primary metric is really the five year earnings power and the intrinsic value of these companies.

I wanted to do a follow up on you know, you were talking about management teams just a few moments ago. You know, what are the exact qualities? I know you mentioned you know, having ambition and you know having you know, good products. Are there any other I guess qualities you look for in management teams?

I wanted to do a follow up on you know, you were talking about management teams just a few moments ago. You know, what are the exact qualities? I know you mentioned you know, having ambition and you know having you know, good products. Are there any other I guess qualities you look for in management teams?

Yeah?

Yeah?

Management, I mean it is there's kind of the science of investing, and I guess there's the art, right, and I think management is much more of an art than than a science, uh to to say there's one way of managing a companyany Obviously, every company can be very different. But I think the best entrepreneurs do tech. If you look at just the Magnificent seven for incentra right, I mean, the most successful companies were all sort of founder led. These these folks who are driven to change the world and and and and have been able to scale the company's in remarkable ways. I don't I don't think every founder has the capability to scale to those levels, obviously, but those are the most successful outcomes. But we do, we do analyze culture of companies, uh, you know, even glassdoor reviews, things like that. We certainly like to take advantage of our location, again being in the B area, being able to access private companies, venture capitalists, competitors, suppliers, kind of the traditional Fisher scuttle butt work, and and then ultimately I think somebody once told me the best managers do set low expectations.

Management, I mean it is there's kind of the science of investing, and I guess there's the art, right, and I think management is much more of an art than than a science, uh to to say there's one way of managing a companyany Obviously, every company can be very different. But I think the best entrepreneurs do tech. If you look at just the Magnificent seven for incentra right, I mean, the most successful companies were all sort of founder led. These these folks who are driven to change the world and and and and have been able to scale the company's in remarkable ways. I don't I don't think every founder has the capability to scale to those levels, obviously, but those are the most successful outcomes. But we do, we do analyze culture of companies, uh, you know, even glassdoor reviews, things like that. We certainly like to take advantage of our location, again being in the B area, being able to access private companies, venture capitalists, competitors, suppliers, kind of the traditional Fisher scuttle butt work, and and then ultimately I think somebody once told me the best managers do set low expectations.

And constantly sort of surpass them.

And constantly sort of surpass them.

Right, Not not to say that they're unambitious expectations, but if you can consistently kind of outperform relative to the expectations you set, that's a very good thing.

Right, Not not to say that they're unambitious expectations, but if you can consistently kind of outperform relative to the expectations you set, that's a very good thing.

Are there any sectors you currently find particularly compelling? And one of the things I've focused on in twenty twenty five is the sector rotation that kind of moved away from tech, especially in large caps. Do you think that could last in twenty twenty five?

Are there any sectors you currently find particularly compelling? And one of the things I've focused on in twenty twenty five is the sector rotation that kind of moved away from tech, especially in large caps. Do you think that could last in twenty twenty five?

I am hopeful.

I am hopeful.

I personally spend a lot of time in the technology sector. But you're absolutely correct that when you look at the drivers of the s and P five hundred, obviously they're very much concentrated in the magnificent seven or eight. One of the interesting things about the small cap universes, to some extent, we've seen that broadening. So if you look at the drivers of the returns in the small cap space. It is not solely technology, and certainly for our strategy, we've seen great performance in consumer and healthcare and in industrials and other sectors. So I think we're already starting to see some of that broadening. We haven't seen it to the extent in the S and P. Five hundred, but I think some of that will depend on, obviously, whether technology can maintain its leadership, particularly in AI, and whether some of these other sectors can broaden out. Certainly with the new administration, that that that there is some reason to be supportive of the overall economy.

I personally spend a lot of time in the technology sector. But you're absolutely correct that when you look at the drivers of the s and P five hundred, obviously they're very much concentrated in the magnificent seven or eight. One of the interesting things about the small cap universes, to some extent, we've seen that broadening. So if you look at the drivers of the returns in the small cap space. It is not solely technology, and certainly for our strategy, we've seen great performance in consumer and healthcare and in industrials and other sectors. So I think we're already starting to see some of that broadening. We haven't seen it to the extent in the S and P. Five hundred, but I think some of that will depend on, obviously, whether technology can maintain its leadership, particularly in AI, and whether some of these other sectors can broaden out. Certainly with the new administration, that that that there is some reason to be supportive of the overall economy.

Yeah, and it's it's good that you bring up the new administration.

Yeah, and it's it's good that you bring up the new administration.

Uh.

Uh.

Do you think that any of the election results changed any of your investment theses?

Do you think that any of the election results changed any of your investment theses?

Yeah, yes, and no.

Yeah, yes, and no.

I mean I think we are much more focused on these secular growth themes of technology, healthcare. Uh, you know, just just more innovation throughout the economy. Consumer businesses have are offering, you know, always offering better value to customers. New companies like sweet greens and restaurants along healthier living trends or elf and beauty and cosmetics offering sort of you know, value at at a good price point. And so those those don't tend to be correlated as much, uh with sort of administration changes, where you might have more cyclical factors of you know, industrials being more in or out of favor. But I do think on the margin, obviously we're paying attention to tariffs, we're paying attention to the drive towards government efficiency. But I think the most positive factor with the administration is there does seem to be a renewed focus on innovation and technology in general. So obviously you have JD. Vance who is formerly a venture capitalist. There's reasons to think he might be better for little tech as opposed to just big tech, which would benefit the small cap space as well as venture capital. And you have Elon and and other folks are who are driving efficiency and innovation, which I think is good good for America and good good for a small cap.

I mean I think we are much more focused on these secular growth themes of technology, healthcare. Uh, you know, just just more innovation throughout the economy. Consumer businesses have are offering, you know, always offering better value to customers. New companies like sweet greens and restaurants along healthier living trends or elf and beauty and cosmetics offering sort of you know, value at at a good price point. And so those those don't tend to be correlated as much, uh with sort of administration changes, where you might have more cyclical factors of you know, industrials being more in or out of favor. But I do think on the margin, obviously we're paying attention to tariffs, we're paying attention to the drive towards government efficiency. But I think the most positive factor with the administration is there does seem to be a renewed focus on innovation and technology in general. So obviously you have JD. Vance who is formerly a venture capitalist. There's reasons to think he might be better for little tech as opposed to just big tech, which would benefit the small cap space as well as venture capital. And you have Elon and and other folks are who are driving efficiency and innovation, which I think is good good for America and good good for a small cap.

And I've been really focused on rates, and obviously the rate pictures increasingly more up in the air as we get into twenty twenty five, but I've been really focused on rates as a catalyst for small cap stucks to kind of inherrow the gap with the S and P five hundred, What do you think the catalysts are for you know, maybe a small cap resurgence this year.

And I've been really focused on rates, and obviously the rate pictures increasingly more up in the air as we get into twenty twenty five, but I've been really focused on rates as a catalyst for small cap stucks to kind of inherrow the gap with the S and P five hundred, What do you think the catalysts are for you know, maybe a small cap resurgence this year.

Yeah, I think.

Yeah, I think.

I think a stabilization in rates is really the key. We've never wanted to make explicit bets on rate cuts and things like that, although we understand the market does that for us and and may have gotten a little bit ahead of itself maybe let's say six six months ago, But now I think the general consensus will see maybe one or zero rate cuts. Again, I think putting putting sort of the past five years in context. You know, rates on the ten year went from close to zero, maybe fifty basis points to four and a half percent, and so that was a big headwind for small caps. And now I think there's a debate of you know, do rates stick down a bit or take up a bit? Again, putting putting this all in the context of the past five years, I think the most important takeaway is we're not nobody's expecting a four or five hundred basis point increase in rates, right. We seem to be entering a more stabilized period of interest rates broadly, and I think along combined with the strong economy, that's going to be a very positive thing for small caps.

I think a stabilization in rates is really the key. We've never wanted to make explicit bets on rate cuts and things like that, although we understand the market does that for us and and may have gotten a little bit ahead of itself maybe let's say six six months ago, But now I think the general consensus will see maybe one or zero rate cuts. Again, I think putting putting sort of the past five years in context. You know, rates on the ten year went from close to zero, maybe fifty basis points to four and a half percent, and so that was a big headwind for small caps. And now I think there's a debate of you know, do rates stick down a bit or take up a bit? Again, putting putting this all in the context of the past five years, I think the most important takeaway is we're not nobody's expecting a four or five hundred basis point increase in rates, right. We seem to be entering a more stabilized period of interest rates broadly, and I think along combined with the strong economy, that's going to be a very positive thing for small caps.

And since I talked about it at the beginning of the segment, What do you see as the outlook for IPO and M and A D see a comeback after this really week two year stretch that we've had.

And since I talked about it at the beginning of the segment, What do you see as the outlook for IPO and M and A D see a comeback after this really week two year stretch that we've had.

Certainly so, I think we're already starting to see it. We've seen a trickle of technology IPOs, but you're correct that following a ro us twenty twenty and twenty twenty one, twenty two, twenty three, and twenty four were fairly meager.

Certainly so, I think we're already starting to see it. We've seen a trickle of technology IPOs, but you're correct that following a ro us twenty twenty and twenty twenty one, twenty two, twenty three, and twenty four were fairly meager.

That window is beginning to lift.

That window is beginning to lift.

I follow the private technology ecosystem very closely. Supposedly there are fifteen hundred private unicorns with valuations of a billion or higher, and I think there's been a strike by the private markets to really underwrite the lower valuations that are necessary in some cases to take those companies public. Obviously, many of these companies were funded during a period of very low interest rates, and so there's been a disparity in terms of private versus public market valuations. I think certainly the lower regulatory environment going forward, the certainty of the new administration will be positive catalysts for that, and I think that's necessary. I think there's been this trend of companies staying private for longer. I'm not sure that's such such.

I follow the private technology ecosystem very closely. Supposedly there are fifteen hundred private unicorns with valuations of a billion or higher, and I think there's been a strike by the private markets to really underwrite the lower valuations that are necessary in some cases to take those companies public. Obviously, many of these companies were funded during a period of very low interest rates, and so there's been a disparity in terms of private versus public market valuations. I think certainly the lower regulatory environment going forward, the certainty of the new administration will be positive catalysts for that, and I think that's necessary. I think there's been this trend of companies staying private for longer. I'm not sure that's such such.

A good thing.

A good thing.

Uh, And I think I think we'll want to see smaller companies come come come public sooner.

Uh, And I think I think we'll want to see smaller companies come come come public sooner.

You had mentioned you know the portfolio is pretty concentrated. Do you have any I guess things in place to manage portfolio risk?

You had mentioned you know the portfolio is pretty concentrated. Do you have any I guess things in place to manage portfolio risk?

Yes, I think.

Yes, I think.

I think when we look at portfolio risk first and foremost, we are we are looking at the the risk of losing capital as opposed to to solely volatility. Although you know, you can screen our portfolio on sharp ratios and downside capture ratios and we happen to look pretty attractive on those metrics. I think part of that is due to our absolute valuation discipline and our general each company has to have at least one hundred percent upside. Again, at the time of purchase, we use no more than a thirty times pe on those price starting's estimates, and then we're generally trimming when the upside falls to fifty percent or lower. As opposed to a pure buy and hold manager, We're not willing to hold an exceptional company at an infinite price, and so we're quite disciplined about that. The best companies that stay in the portfolio over multiple years have to continuously prove themselves in terms of the upside. Otherwise we'll trim and sell the lesser companies as they become more fully valued. So our best defense is really our knowledge I think of the individual portfolio companies. We certainly want to know the key drivers of these companies as well or better than anyone else to mitigate the constant intration. Though again, we have a five percent max position limit, so we're not going to hold companies above a five percent weight because we recognize there can be additional volatility and risk associated with that. But really it is it is our knowledge of these companies and our absolute valuation discipline.

I think when we look at portfolio risk first and foremost, we are we are looking at the the risk of losing capital as opposed to to solely volatility. Although you know, you can screen our portfolio on sharp ratios and downside capture ratios and we happen to look pretty attractive on those metrics. I think part of that is due to our absolute valuation discipline and our general each company has to have at least one hundred percent upside. Again, at the time of purchase, we use no more than a thirty times pe on those price starting's estimates, and then we're generally trimming when the upside falls to fifty percent or lower. As opposed to a pure buy and hold manager, We're not willing to hold an exceptional company at an infinite price, and so we're quite disciplined about that. The best companies that stay in the portfolio over multiple years have to continuously prove themselves in terms of the upside. Otherwise we'll trim and sell the lesser companies as they become more fully valued. So our best defense is really our knowledge I think of the individual portfolio companies. We certainly want to know the key drivers of these companies as well or better than anyone else to mitigate the constant intration. Though again, we have a five percent max position limit, so we're not going to hold companies above a five percent weight because we recognize there can be additional volatility and risk associated with that. But really it is it is our knowledge of these companies and our absolute valuation discipline.

I had one follow up question to that. You mentioned trimming companies, and so I'm curious, are there any other things you look at? You know, I guess we trigger selling the portfolio, not just you know, trimming a company gets.

I had one follow up question to that. You mentioned trimming companies, and so I'm curious, are there any other things you look at? You know, I guess we trigger selling the portfolio, not just you know, trimming a company gets.

Yeah, we sell for one of three reasons, typically one the position becomes fully valued, to upgrade to better opportunities, or three. I mentioned this anchor points concept we have whereby we're really looking out five years into the future and trying to anchor it to these estimates of intrinsic.

Yeah, we sell for one of three reasons, typically one the position becomes fully valued, to upgrade to better opportunities, or three. I mentioned this anchor points concept we have whereby we're really looking out five years into the future and trying to anchor it to these estimates of intrinsic.

Value if those.

Value if those.

If those companies are failing to meet those objectives over time, which does and that's a third reason we sell.

If those companies are failing to meet those objectives over time, which does and that's a third reason we sell.

So I've been following fundamentals for for small caps for for some time, and it looks like consensus is very weak for the fourth quarter earning season. Are there any macro factors you're you're watching that might help turn the tide on fundamentals?

So I've been following fundamentals for for small caps for for some time, and it looks like consensus is very weak for the fourth quarter earning season. Are there any macro factors you're you're watching that might help turn the tide on fundamentals?

I think interest rates and valuations would be the main thing we're focused on, in addition to just company earnings. I think, you know, the biggest debate in the market right now is technology and AI. I was just at a conference the other week, and so I think the biggest question in the market right now is you know, perhaps AI probably has the most promise of any technology we've seen right because it's it's tam unconstrained in terms of being able to address labor, labor and services, not just tools and software spend. But because of that, it can be prone to overhype. And so I think, you know, a lot of Fortune one thousand type companies want to bet on a technology that's well understood and minimize risk. I think with Cloud there was much more, much more consensus over the value of cloud, and even then I think you saw some companies be resistant for some time. So with the risks of hallucinating, you know, I think it's hard to see widespread enterprise adoption right now. Certainly from a consumer standpoint, it's easier to see adoption there. I think another area that folks are wondering about is the scaling laws. Right we're quickly exhausting all the data upon which we're training these models, and we're using increasingly synthetic data and reasoning and trying to see sort of how that progresses, as well as well as the return on invested capital versus the capex. So these hyperscalers are all extremely well funded, the Microsoft's Amazon schools of the world, and they can support this capex I think for some time, but at a certain point it starts diminishing your free cash flow. And so it's striking to me that a company like Microsoft is reporting a decline in its free cash flow for share this year. I think investors might overlook that for a period, but over time, you obviously want to see the growth in the free cash flow, and so Sequoya put out a good paper I think last year on AI's six hundred billion dollar question asking whether whether the return on this two hundred billion of Nvidia, you know, data data center spend is supported by the six hundred billion in revenue software and application revenue, which we've yet to seen. So I think that's the biggest debate in the market right now. I know that's less of a macro factor, but in terms of thinking about something I'm watching in terms of secular growth trends, Yeah.

I think interest rates and valuations would be the main thing we're focused on, in addition to just company earnings. I think, you know, the biggest debate in the market right now is technology and AI. I was just at a conference the other week, and so I think the biggest question in the market right now is you know, perhaps AI probably has the most promise of any technology we've seen right because it's it's tam unconstrained in terms of being able to address labor, labor and services, not just tools and software spend. But because of that, it can be prone to overhype. And so I think, you know, a lot of Fortune one thousand type companies want to bet on a technology that's well understood and minimize risk. I think with Cloud there was much more, much more consensus over the value of cloud, and even then I think you saw some companies be resistant for some time. So with the risks of hallucinating, you know, I think it's hard to see widespread enterprise adoption right now. Certainly from a consumer standpoint, it's easier to see adoption there. I think another area that folks are wondering about is the scaling laws. Right we're quickly exhausting all the data upon which we're training these models, and we're using increasingly synthetic data and reasoning and trying to see sort of how that progresses, as well as well as the return on invested capital versus the capex. So these hyperscalers are all extremely well funded, the Microsoft's Amazon schools of the world, and they can support this capex I think for some time, but at a certain point it starts diminishing your free cash flow. And so it's striking to me that a company like Microsoft is reporting a decline in its free cash flow for share this year. I think investors might overlook that for a period, but over time, you obviously want to see the growth in the free cash flow, and so Sequoya put out a good paper I think last year on AI's six hundred billion dollar question asking whether whether the return on this two hundred billion of Nvidia, you know, data data center spend is supported by the six hundred billion in revenue software and application revenue, which we've yet to seen. So I think that's the biggest debate in the market right now. I know that's less of a macro factor, but in terms of thinking about something I'm watching in terms of secular growth trends, Yeah.

That's definitely interesting. And did you have any major takeaways from the third quarter earning season and is there anything you're watching as fourth quarter results start to roll in for small cap companies.

That's definitely interesting. And did you have any major takeaways from the third quarter earning season and is there anything you're watching as fourth quarter results start to roll in for small cap companies.

No, I mean, I think it's it's mostly a function of what what I just described. I think I think we're try to think about the broadening I guess, first and foremost what's happening in the technology sector, but second also the broadening of the economy, certainly with industrial industrial economy, ism, data like that as well. But again, our focus is more on secular growth and whether these companies are tracking towards these long term anchor points. I think during the dot com bubble, Jeff Bezos said it best. I think his stock Amazon was down something like eighty ninety percent at one point. But he was talking about how by any measure, Amazon was stronger than a year ago. Its customer account had increased from fourteen million to twenty million, its sales had climbed over sixty eight percent, its operating loss had narrowed. And so we're trying to think about these fundamental metrics in terms of the drivers of unit expansion and incremental margins that are creating heavier and heavier businesses over time, because in the short term market is a voting machine, but in the long term it's a weighing machine, and we're trying to invest in these heavier companies over time.

No, I mean, I think it's it's mostly a function of what what I just described. I think I think we're try to think about the broadening I guess, first and foremost what's happening in the technology sector, but second also the broadening of the economy, certainly with industrial industrial economy, ism, data like that as well. But again, our focus is more on secular growth and whether these companies are tracking towards these long term anchor points. I think during the dot com bubble, Jeff Bezos said it best. I think his stock Amazon was down something like eighty ninety percent at one point. But he was talking about how by any measure, Amazon was stronger than a year ago. Its customer account had increased from fourteen million to twenty million, its sales had climbed over sixty eight percent, its operating loss had narrowed. And so we're trying to think about these fundamental metrics in terms of the drivers of unit expansion and incremental margins that are creating heavier and heavier businesses over time, because in the short term market is a voting machine, but in the long term it's a weighing machine, and we're trying to invest in these heavier companies over time.

And you mentioned the AI investment maybe not justified by the payoff as a risk. Are there any other big risks you see the stocks this year?

And you mentioned the AI investment maybe not justified by the payoff as a risk. Are there any other big risks you see the stocks this year?

Well, certainly, as we touched on that, I think interest rates and valuation metrics would be the concern, so that those are factors we will be falling. I think the market is relatively expensive by traditional metrics. One of the encouraging factors on small cap is relative to large cap we are undervalued on a relative basis, and certainly small caps have underperformed large caps over the past decade. I think it's the longest stretch in history. Traditionally, obviously, there's been this small cap premium. I think over the past ninety seven years, if you invested a dollar in small cap versus large cap, you would have ended up with over four times your money in small So that hasn't been the case for the past decade. There's good reasons why that is the case, with the rise of these Magnificent seven companies and so forth. But markets trends don't tend to last in one direction forever, and we think there's a real opportunity for me and reversion here. As a small cap has underperformed and the evaluations are relatively cheaper. That should bode well as the economy broadens and we could see some momentum and small cap and then again, additionally, an active manager doesn't have to invest in the whole asset class, but we can really invest in the most exceptionally well positioned companies within the asset class.

Well, certainly, as we touched on that, I think interest rates and valuation metrics would be the concern, so that those are factors we will be falling. I think the market is relatively expensive by traditional metrics. One of the encouraging factors on small cap is relative to large cap we are undervalued on a relative basis, and certainly small caps have underperformed large caps over the past decade. I think it's the longest stretch in history. Traditionally, obviously, there's been this small cap premium. I think over the past ninety seven years, if you invested a dollar in small cap versus large cap, you would have ended up with over four times your money in small So that hasn't been the case for the past decade. There's good reasons why that is the case, with the rise of these Magnificent seven companies and so forth. But markets trends don't tend to last in one direction forever, and we think there's a real opportunity for me and reversion here. As a small cap has underperformed and the evaluations are relatively cheaper. That should bode well as the economy broadens and we could see some momentum and small cap and then again, additionally, an active manager doesn't have to invest in the whole asset class, but we can really invest in the most exceptionally well positioned companies within the asset class.

It would be something to definitely look forward to. But before we let you go, we'd love to hear what some of your favorite reads are. You know, any financial favorite financial books you like?

It would be something to definitely look forward to. But before we let you go, we'd love to hear what some of your favorite reads are. You know, any financial favorite financial books you like?

Yeah, I began talking a little bit about the Phil Fisher scuttle, but type work, you know, attending conferences, industry events, expert networks. We mentioned kind of our location here in the Bay. I remember one investment we made in a software company called Avalara for sales tax collection. Obviously, there's only two certain days in life, death and taxes, and so I remember going to one of these some of these tax tax conferences and hearing from the California Department of Tax and Fees that they were expecting additional you know, one a half to two billion revenue back in I think the twenty eighteen or twenty nineteen time frame, because there was a Supreme Court decision called South Dakota versus Wayfair, which ruled that it overturned the physical presence requirement where if you bought something on Amazon, let's say, from California, but it chipped from Texas, Texas couldn't collect state tax on that unless the seller had a presence in Texas.

Yeah, I began talking a little bit about the Phil Fisher scuttle, but type work, you know, attending conferences, industry events, expert networks. We mentioned kind of our location here in the Bay. I remember one investment we made in a software company called Avalara for sales tax collection. Obviously, there's only two certain days in life, death and taxes, and so I remember going to one of these some of these tax tax conferences and hearing from the California Department of Tax and Fees that they were expecting additional you know, one a half to two billion revenue back in I think the twenty eighteen or twenty nineteen time frame, because there was a Supreme Court decision called South Dakota versus Wayfair, which ruled that it overturned the physical presence requirement where if you bought something on Amazon, let's say, from California, but it chipped from Texas, Texas couldn't collect state tax on that unless the seller had a presence in Texas.

And so when the Supreme Court court overturned.

And so when the Supreme Court court overturned.

That ruling, there was a huge rush to sort of tax a broader jurisdiction. So Avolara was well positioned for that trend and so the scuttle butt I mentioned in terms of that primary due diligence really is the craft of small cap investing, and Phil Fisher very much pioneered that with his book Common Stocks and Uncommon Profits. I think one of the questions he always asks management teams is what are you doing that your competitors aren't doing right, because you really have to sustain innovation to drive future appreciation in your business. And then the second book, I think is a book called Seven Powers by Hamilton Helmer, and it's a little bit an extension of Clay Christensen's work on the innovator's dilemma, but he has a concept called counter positioning which is very very powerful in small cap and a classic example I think is Netflix versus Blockbuster. So when you look at Blockbuster's business, they were challenged in a couple different ways, not only with sort of the internet distribution model changing that from brick and mortar, but also if you looked back at their business, I think a substantial chunk of their income was derived from late ease, and so when you had a newer incumbent like Netflix rise, they were able to compete in a way that Blockbuster was really powerless to sort of respond to because to compete they had to not only change their business model in terms of the generation from late fees, but also the brick and mortar model to Internet. And so we like this idea. But whereby new companies can counterposition against legacy incumbents.

That ruling, there was a huge rush to sort of tax a broader jurisdiction. So Avolara was well positioned for that trend and so the scuttle butt I mentioned in terms of that primary due diligence really is the craft of small cap investing, and Phil Fisher very much pioneered that with his book Common Stocks and Uncommon Profits. I think one of the questions he always asks management teams is what are you doing that your competitors aren't doing right, because you really have to sustain innovation to drive future appreciation in your business. And then the second book, I think is a book called Seven Powers by Hamilton Helmer, and it's a little bit an extension of Clay Christensen's work on the innovator's dilemma, but he has a concept called counter positioning which is very very powerful in small cap and a classic example I think is Netflix versus Blockbuster. So when you look at Blockbuster's business, they were challenged in a couple different ways, not only with sort of the internet distribution model changing that from brick and mortar, but also if you looked back at their business, I think a substantial chunk of their income was derived from late ease, and so when you had a newer incumbent like Netflix rise, they were able to compete in a way that Blockbuster was really powerless to sort of respond to because to compete they had to not only change their business model in terms of the generation from late fees, but also the brick and mortar model to Internet. And so we like this idea. But whereby new companies can counterposition against legacy incumbents.

That's an interesting point. I guess I never really thought about, you know, all those nights, you know, going to Blockbuster years ago, the late fees drove so much of their revenue, but definitely makes sense. This is great, Brian, thank you so much for joining us today. Thank you, Mike, thanks again for being my co host today.

That's an interesting point. I guess I never really thought about, you know, all those nights, you know, going to Blockbuster years ago, the late fees drove so much of their revenue, but definitely makes sense. This is great, Brian, thank you so much for joining us today. Thank you, Mike, thanks again for being my co host today.

Thank you both.

Thank you both.

Until our next episode, this is David Cohne with Inside Out

Until our next episode, this is David Cohne with Inside Out

Four No.

Four No.