DAVE WATERS – LESSONS FROM INVESTING IN SMALL PUBLIC COMPANIES – EP. 74

My guest on this episode is Dave Waters. Dave is the founder and CEO of Alluvial Capital, a value based hedge fund focused on the smallest public companies with market caps of $5-100 million, located in Pittsburgh, Pennsylvania. Dave is fascinating to me because he has dedicated his career to investing in similar sized companies as other podcast guests of this show, but through the public markets. I wanted to learn how he views these companies through a public lens, his investment process, and his thoughts for private company owners thinking of investing in comparably sized public companies.

We also talk about how his business-owner LPs view their investment in his firm, the most unique companies he’s come across, and how he evaluates managers of these small public companies. This was a super interesting discussion that I’m positive you’ll enjoy.

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Thank you, Dave, so much for coming on the podcast. I’ve been excited to chat with you, especially since you’ve dedicated a great portion of your career to focusing on companies that are similar size as many other podcast guests we’ve had on the show, but through the public market lens. I’d love to hear how you view companies through the public market’s sentiment, but I would first love to hear just your background and how you got to start your company here in Pittsburgh. Well, not here unfortunately.

I’m from Pittsburgh, and a Steelers fan, but unfortunately, I’m not in Pittsburgh today, but I’d love to hear how you got started.

Absolutely, thanks for having me on. I’ve been looking forward to this. I’ve been running Alluvial Capital Management for seven years now, hard to believe, but started in[redacted]I’m also a Pennsylvania guy. I grew up here and there, mostly small towns, and got a taste for business and investing by watching my dad’s career. He was a lifelong UPS employee. They went public in 1999, in the middle of the internet bubble. They were not, of course, in internet stock, but they still did very well, and so I think they closed that first thing in the ’90s. My dad had shares he bought in the ’70s when they were employee-owned at 25 cents.

He suddenly found himself looking at a very comfortable retirement. I thought, “This is amazing. Wait, people can just put their money, and it will work for them.” My family is very, very blue collar, and the idea that you can make money from some other way and then just an hourly wage was a revelation for me. That’s where I caught the bug. I was 14. After that, I started tracking markets very, very carefully. I knew I wanted to study finance. Again, this is not something that anyone in my surroundings knew much about growing up in a tiny little timber town in northern Pennsylvania. I knew that’s what I wanted to do.

Like I said, I graduated college. I went to work for a couple of different wealth managers. I was at Wilmington Trust and Philadelphia Office. I was at a bank in New York, Mellon, a bank across the state and close to my hometown in Pittsburgh, and did that for five years, but found it unsatisfying. At a large trust bank, you’re doing good work for your clients, but it’s really a game of preserving wealth and diversifying as much as possible. We definitely were not investing anything all that interesting. It was just, “Here’s the list of 50 S&P 500 components that our analysts like. Choose 30, and that’s the large cap portfolio for your clients.”

At the same time, I was discovering that there were so many more interesting companies out there, little companies that no one talked about. At the time, this was probably 2011, 2012. We weren’t too far out from the financial crisis, and a lot of investors were still really, really afraid to put money into the market, not knowing if things were truly better or things were truly on demand. Many of these little tiny companies I was looking at were very, very cheap. I’m talking three, four, five times earnings or big discounts to asset value, real estate, what have you. There were just bargains everywhere.

I thought, “This is what I want to do. This is how I want to invest.” I started putting my own money there and really loved it. It wasn’t long when I thought, “How do I turn this into a career? How do I escape the clutches of the big bank, which treated me well, I have to say, but it was not a career path I was interested in pursuing?” I thought, “Well, here I am in Pittsburgh, awesome city, love it here, but there’s not exactly a lot of hedge funds or private equity groups, and I don’t have an MBA. I don’t have any investment banking background on my resume. If I want to get hired somewhere, I have to publish some research. Maybe if someone likes it, somebody will give me a chance.”

I started writing online at a blog I called OTC Adventures, because the majority of the stocks and companies I was looking at, at the time, traded on the over-the-counter market, which has a reputation for sleaziness that’s deserved, but nevertheless has hundreds of reputable quality companies to trade on there. I started writing, and I started getting inquiries almost immediately from people who said, “I like this. This is unique. Can you manage some capital for me?” I’d say, “No, I can’t do that, because, well, I work for a large bank. I can’t compete against my employer.”

They’d say, “Well, if you ever go off on your own, let me know. I’d love to give you a shot.” I did that in[redacted]I established an IRA, started with about two million in capital under management, and told myself, “If I can’t take a salary in two years, I’ll hang it up, and I’ll try something else.” Thankfully, it went well. Ever since then, I’ve been focusing on little companies. I’m talking market values, five, 10, 25, 50 million, companies that probably are smaller than some in your own city or neighborhood private concerns, but it’s been fun. It’s a blast. I still have a great time checking out these little companies all the time.

One of my favorite parts about running this podcast and focusing on private companies with that same size is just how many different types of companies there are. There’s always some random company doing something that you never thought existed or was a service. I would love to hear what are some of the most unique micro caps in small companies that you’ve come across just in terms of what they do with their business model or how they operate.

I mean, this could be an entirely separate podcast. There are so many interesting businesses with really, really cool business models out there. That’s one thing I love is that large companies, they do a lot of cool stuff, but many of them do so many different things that it’s hard to point out one aspect of them that makes them really unique, but most small companies focus on one or two products or services, and so you get some really cool stuff out there. One of the more interesting ones in the past couple years, and unfortunately, this company went private, but they had a robots that they used to inspect sewer lines, water pipe, things like that.

Their division was called queues. This robot of theirs was not the speculative thing where, “Oh, maybe someday we’ll sell some of these, and someday we’ll make money,” but they were selling these all the time. They were either selling or leasing these to municipalities who had aging water infrastructure, which a lot of places in the U.S. do because so many of the pipes were installed 50, 80, 100 years ago. This little robot could simply crawl up and down the pipe and look for leaks. I thought that was the coolest thing.

Here’s a company making something extremely useful, extremely helpful, saves people millions upon millions of dollars, and yet they’re tiny. Of course, it didn’t last. Someone took a look at this and thought, “We have to own this,” and so they were bought out by a larger company. I just thought that was extremely cool. I do international investing as well. I always like when I find companies that do some unique consumer product like a traditional food or beverage of some kind. Historically, I’ve always liked to invest in honey companies. There’s not that many of them. In fact, there’s only a couple of them that are public in the world right now.

One’s in New Zealand. Another one is Poland, and the UK has one they just launched. It’s really, really tiny. But my thinking is that human beings have liked honey for thousands of years. It’s one of the oldest foods, and assuming we don’t exterminate all the bees, somehow, we’ll be eating it in thousands years from now, because it’s delicious and relatively healthy compared to most kinds of sugary things you can consume. I like that. I know that sure, some years will be great. Some years will not be as great. Honey prices go up and down, but people will always want honey.

I really like it when I find a business that offers a product or a service that is really the opposite of faddish, that it’ll grow. It’ll increase and diminish in popularity, but it’ll always have a baseline level of demand because they have something that people will just love by the virtue of being human. That’s another really fun one that I like.

That is a fun one. I also love honey, so that’s an exciting one. How big are those companies by market cap roughly?

Off the top of my head here, I think the New Zealand one is maybe 50 or 60 million in local currency, but the Polish wine is only about the equivalent of $5 million, U.S. dollars. I think the United Kingdom one is about the same size. These are really, really tiny businesses. I mean, probably just a fraction of the size that a lot of private honey producers are.

That’s fascinating. One common question, and when I asked other private search investors or just folks who own private companies, and I ask them about small public companies, and what they think of them, a lot of them ask, “Well, why would I invest in that company since there’s not much reason for them to be public, or there doesn’t seem to be a reason for them to be public as if it was a good company to be private, or it never would have had to raise outside public capital?” I’d be curious what are some of the reasons you’ve seen for why some of these companies that are really, really small, remain public companies.

It’s honestly something I try to answer every time I’m looking at a small company is why is this company public, because a lot of them shouldn’t be? A lot of them really aren’t getting any benefit from being public, or they went public for poor reasons. It was a business that was deeply cyclical, and they were running high, and so they thought they wanted to cash out or something, and so public market’s back in. For a lot of them, it’s not that way. I think that sometimes people who are in the search area or private equity think that everything good already has people looking at it, is already been looked over by PE.

If it’s public, well, it was pass over for some reason, but I don’t think that’s the case. I don’t doubt these people out there have great abilities to find good businesses, but I’m telling you, there are lots of businesses, especially in the more… Backwater is a negative term, but that’s what a lot of these places that these businesses operated are, and I can say that being from those places. There’s a lot of businesses operating especially deeply rural areas or just areas that don’t have a lot of deep-pocketed investors that are good little businesses, but they’ve just never been approached by anyone with a takeover offer, or they just grew for years on end without that involvement from private equity, or the business was able to self fund.

It was a good business from the get go, and so it generated a lot of capital. Honestly, the way a lot of these businesses went public in the first place is a banker approached them and said, “Hey, you should be public. You’ll get this amazing valuation, and you’ll have a currency you can reward employees with. It’s easier than using phantom stock or whatever.” Then there’s just the cachet of saying like, “I have a company that’s listed on the NASDAQ, or even that just trades anywhere.” It’s a cool thing for a lot of people to say that you’re the CEO of a public company, and so banker gets some fees. Small company gets the prestige, and often times, they over promise.

Small companies rarely get the valuation premium that they’re hoping for when they go public, but that’s a lot of it. The issue is even magnified overseas, a lot of places where there just is not a cottage industry of Micro-P or research funds or whatever. Really, your only exit if you want to cash out can be to a public market. Other countries often do better in encouraging small companies to go public than the U.S. does, but the reasons are incredibly varied. I think it probably depends on each company, what their motivation is for being public and staying public.

Some of them just have momentum, been public for a while, and so I don’t really see any need to change that, even if changing would be beneficial. I think a lot of these companies could use a shaking up. Maybe that means going private. Maybe that means going public, but doing more, trying harder to grow, become a larger company, but it depends so much on the people in charge and what their particular motivations are and where they want the company to be.

That’s fascinating. A personal interest of mine is in business owners who also invest in public markets and at companies of similar size to their own as a way to almost diversify their investment in a small company. I’d be curious, I know some of your LPs are also business owners or former business owners who sold. How do they view your company as an investment of theirs?

I do think it varies a little bit from person to person, but I think a lot of them just enjoy the experience of being a small business person, enjoyed running a business, enjoyed seeing it grow, had the experience of seeing the ups and downs and getting through the tough times and getting back to the good times and enjoying that. I think they just feel an affinity for these businesses that are similarly sized. They know what it’s like. They know the challenges that these businesses face, and the opportunities, and they like seeing them succeed. They feel good when the success of these businesses contributes to the portfolio, and contributes to their wealth.

I think a lot of these people just don’t relate that strongly to the international mega corporations that are out there, which, I mean, probably should be a portion of everyone’s portfolio. I mean, their access to capital wasn’t limited. They employ some of the best, smartest people out there, but there’s just something about little companies that speaks to some people. It’s not for everyone. I mean, I certainly would not say everyone needs to go out there and be invested in micro cap equities publicly or have small business ownership. It’s a certain kind of person that enjoys that, is good at it, benefits from it.

But I think once people are in that, doing that and enjoying it, they want more, and for some people, that means a diversified collection through a vehicle like what I offer or that other people do. For some people, it’s just other investments and private entities, but for anyone who wants just a bit more liquidity than small business sometimes offers that it can make sense to look at some of the really, really intriguing public micro caps that are out there.

How do you think private business owners should view micro caps and small companies as a side investment of theirs or just a way to diversify their own money?

I think it can be both. These people own businesses. For a lot of businesses, if it goes well, eventually, there’s a point where there’s more capital coming out of the business that can be redeployed into the business. That’s both a problem and an opportunity. I mean, for a lot of people, they work for years and years, and every penny the business generates and cash goes right back in for more growth or for investment of any kind, but a lot of them get to the point where suddenly, the business is putting off 100,000, 500,000, even a couple million once it really gets going. What do you do with that?

I think a lot of people don’t have the interest or the time or the competence to go out and do it again. I mean, running one business is demanding enough for most people, except the super humans among us, I suppose, but I think it can be a really, really viable and attractive alternative to determine the public markets. You’re outsourcing the management. You’re outsourcing the capital allocation, and if you find the right people, people who you trust and have those skills in public corporations, then you can let someone else work for you. That’s really, really tough for a lot of entrepreneurs, a lot of business owners. I mean, I’m one myself, I have a very difficult time with the idea that somebody else is going to manage capital of mine, because obviously, I feel pretty confident about my abilities to do it myself, but it also can be a little bit of a check on our own overconfidence sometimes.

Like I said, I believe in my own abilities, but there’s nothing wrong with taking a portion of my capital and saying, “All right, I’ll give someone else a try, because they’ll see opportunities I don’t. They’ll put their money to capital and industries I’m not involved in, which I think is a big thing as well.” Keep in mind, I mean, if you’re running a small business, you’re highly exposed to a particular industry or sector, even if you’re doing your best to be relatively diversified. Then you can do everything right. In your industry, you could still hit a real hard patch just from changing consumer behavior or the state of the economy.

Especially if you’re at the point where you’re generating excess capital, rather than put it back to work in the same industry or the places you know, I think you can make a lot of sense to just spread it around a little bit, because it’s just a risk reduction mechanism.

Do you lean on your business owner LPs for advice or insight into how companies of this size run, or do you also study private companies of similar sizes?

I definitely do. I found that there’s a wealth of knowledge that the business owners, whether they’re current or previous owners that I’d be stupid not to lean on that, not to try to access that pool of knowledge that I don’t have. Definitely, if I run across a business that I’m interested in investing in, and I know someone who has experience in that industry, whether it’s an LP of mine or just a friend or a colleague, I’m absolutely going to reach out. A lot of the businesses I looked are unique. I don’t know anyone who has that expertise. But if I do know someone, that’s a huge, huge learning opportunity for me.

It is important to gather a variety of perspectives because no two businesses are the same. I’m not saying that the business that this person I know owns is exactly the same, and that the lessons and the knowledge translates 100% one for one, but that’s an important perspective to add to my collection of knowledge and experiences when I look at that business. It’s incredibly valuable to know people and talk to people who run businesses in the private sphere that are similar to the businesses I’m looking at publicly, because I’ve gained some really valuable perspectives that way.

Can you describe your investment process in companies of this size?

I definitely can. My process is incredibly manual. It was Warren Buffett who said that the best way to find a good investment in is to start with the As. I very much agree with that. From time to time, I generate lists of every business below a certain size in a particular market. I usually cut it off at around 100 million. Sometimes I look a little larger, but that’s my sweet spot is businesses below $100 million in enterprise value. I just go one by one. I mean, it could be the U.S. markets, which probably has about, I don’t know, 500 companies that are interesting, but I also will look at Scandinavia has a really, really vibrant business culture.

Even places like Italy, to my surprise, have a great ecosystem of encouraging small companies to be public and make themselves investable to everyone. Australia is another really, really great place that has a lot of small companies going public. It’s interesting, I do go one by one and through hundreds of companies, and that can be really painstaking and laborious, but I can usually tell if a company is at all interesting in the first five minutes of looking at it. Most of the companies I checked out are never going to be investable for me. They’re just too speculative. They have a really checkered history that people don’t have much of a track record, or they have a really, well, shady track record.

Some of them have that, especially in micro caps and especially stuff that trades OTC. Integrity is just a non-negotiable for me, but I just look one by one. Even if I go through a list of 100 companies, and it takes me a week, and I found nothing that looks potentially investable, I learned something. That’s the important thing. It’s just the accumulation of knowledge. I gained some knowledge about an industry up on the trends of a certain sector, or I have better knowledge of what the current financing terms look like for little industrials or little consumer companies. Like, what terms are they getting from banks right now?

What are the latest trends in management compensation and things like that? I can add that to my pool of knowledge. That makes me that much more able to find that next attractive investment, but it’s an intensely manual process. You have to love businesses. If I didn’t love businesses, I would burn out or be so bored immediately. But the fact that I love learning about these businesses, and I always find that even if it’s not interesting from a potential investment perspective, if a company has a cool product or a cool new process they’re implementing, or just a different approach, that’s tremendously interesting to read about. I don’t get bored.

I can’t imagine you’d ever be bored. At my private wealth management job previously to running this podcast full time, we would look at a lot of public companies. I was always curious, because you can look at all these filings and talk to people, but you’re still not in the company. You still can’t really talk to the owners as if it was a private company, and just ask them all day long about their business and get every small, tiny detail that a public company can’t share. I’d be curious what details that are really relevant and important to you are usually the hardest to get out of a public company.

I’ve been involved in the internal dealings of a few public companies. It’s always really, really intriguing to see what the atmosphere in the company is like compared to how the company presents itself in its public filings, on its website, or its presentations, and the message they’re trying to present to the public of who we are, what we do versus how things are inside the business can be very different. I think that’s an important thing to remember for anyone who invest in public equities, not from the perspective of being a board member or a large owner is you will never know everything. You just cannot know everything.

A company is limited in what it can tell you if it’s following the laws. I mean, it can’t really ever tell you anything that’s not disclosing publicly if it’s material. However, I think investors are remiss if they don’t make an effort to get to know the people running the company, at least on some level, talk to them. I mean, call them up, have a conversation, go to the shareholder meeting, and look at the body language of the people presenting about the business because you can see. Do they want to be there? Are they excited to tell people about their business and discuss results and answer questions, or are they treating it as a formality to be ended as quickly as possible, and get these pesky shareholders out of their office, and quit sticking out the place?

That’s incredibly important. How does this company regarded shareholders? Do they see them as partners, or do they see them as just someone to be a piece, and to leave them alone until the next quarterly call if they have those, or the meeting, server meeting or whatever? Especially at the small end of the scale, in terms of business size, the people matter so much. I tell people like Microsoft, gigantic corporation and one of the largest. The people matter, but they have an institutional culture. You could replace the C-suite of executives next week, and things will be a little bit different, but Microsoft has an institutional culture that will keep the business moving forward in roughly the same direction for quite some time, just that momentum.

Not the same way for small companies. I mean, I’ve invested in a couple of industrial companies that have maybe 25 employees and a CEO, and a CFO and maybe an operations head. If you replace those three people tomorrow, the business will be radically different, and it will not be all the same, and might be better, might be worse, but it would be very, very different. It behooves investors in small public companies to know the people who are running the business, because it’s so important. They have so much influence in the direction of the business.

If you can’t trust them, and if they’re not intelligent, and they’re not properly motivated and incentivized, it’s a recipe for disaster.

What are some notable stories or pieces of insight you’ve gleaned from talking to people at different companies or going to shareholder meetings?

Some of the best info I’ve gotten from going to shareholder meetings, and talk to their shareholders is information about other similar companies, about competitors. You don’t know how many times I’ve gone to a shareholder meeting, and they talked about how the business did this year, and like, “Oh, well, we’re a little bit worried about what competitor XYZ is doing, but here’s how we’re going to counter that.” I had no idea that competitor XYZ was doing that, and now, it might be interesting to look at that business if they’re public, because clearly, the business I’m here learning about is a little bit rattled by this, and not that they can’t overcome it, but they think that’s very interesting.

They’re either going to copy it or come up with a way to counter it, or I’m just there talking to other shareholders, and some of them are large. I find that people who care enough about small businesses to get to know management and to go to the meeting often know other really interesting businesses that I should be checking out and following. Sometimes, it’s just like, “Hey, what other businesses are cool? What other businesses are doing interesting things, and who should I look at?” It can be a really, really valuable tool. I mean, it’s a small community of people who are true enthusiasts about this, and we love to trade ideas.

Some of my best finds have come from exchanging ideas and notes with other investors in this space. Knowing which businesses they think are really interesting, knowing which other managers they think are just really, really smart, and doing innovative stuff can be a tremendous source of information, but you never know if you don’t ask. It’s important to build those relationships, and not be afraid. I think when I was younger, just my background, there’s the humility which comes from growing up in a small, quasi Midwestern town. I was really, really afraid of talking to other investors, that they might think I was stupid or just not worth talking to, or just being afraid to talk to companies because, I mean, here are these mighty business people, and I’m just sitting here with my little brokerage account.

But I found that people who really liked this, overall, they’re really kind, and they’re really, really willing to share their insights if they can tell you’re serious, if they can tell you really care. I think people can tell someone who just wants to pump them for information a mile away, but people can also tell who actually enjoys, who’s an enthusiast, and people are really, really willing to share info and to build relationships with other people who are like them.

It’s funny how similar the search world and SMB world sounds to this micro cap world. When you’re looking at one of these companies, at what points in your process would you pass on a company? What would tell you to stay away from them?

I think you have to be willing to say no at any point in the process up to and probably including after you actually purchased shares. It’s a continuous process to figure out what’s worthy of being your portfolio. That’s one place where I have it a little easier than people who invested in private companies. I mean, you buy a private company. All of a sudden, you decide you don’t want it. Well, tough place to be. A lot of stuff I buy is not very liquid, and so that does apply to me a little bit. It’s not like I can turn around and sell something this afternoon. I bought it this morning, and decided I don’t want it.

If I want to get out of something, it might take me months to do so, so I really try to avoid ever having to do that by buying well, and buying stuff and willing to hold for several years, but you have to do a… In my comprehensive review of the business, I mean, it’s everything like, “Do the financials make sense? Is this company attractive from a quantitative perspective?” I mean, return on capital, margins and trends and all those things, the growth potential, is it good? Is it… Are there any obvious red flags (inaudible)? Do they produce cash? I mean, a lot of businesses report great net income year after year, but all the cash goes right into inventory or something like that.

That’s not particularly attractive. Then, of course, are the people properly incentivized, and what are their backgrounds? Do I trust these people? Even after that, there’s a sense you just develop after having done this for several years. I don’t know that I can put it really into words what it is, but I’m sure that people who invest in private businesses gain this too over the time. You just get a feel for the business. It’s just like your intuition. If I do all my work, and the financials look great, and the people seem pretty reputable and well motivated, and I generally like the industry and feel that there’s a good future here.

But if there’s just something about the business I can’t quite pinpoint, and I just don’t feel comfortable, I wait. I put it on the back burner and say, “We’ll see how I feel about it in a few months,” because maybe I’m feeling it’s just me feeling a little bit nervous about a new industry, or it could be anything. But sometimes that feeling never goes away, and I think that you have to be supremely comfortable with the businesses that you own, because that’s what gives you the confidence to own these businesses through the good times, through the bad, because the worst thing you can do, especially for public markets investor like me, because now and then, the public markets just have a freakout.

They just get super, super afraid of whatever. It could be… I mean, COVID was last year. It made sense for people to be nervous about that. But this year, maybe it’s fears about inflation, or fears about a recession or changes in tax policy, what have you. You just have to know that you can own a company. At some point, the market is just going to have a panic about it. Devaluation is going to just decline 30%, 40% maybe. If you don’t know what you own, and don’t have a lot of confidence in it, and know that it’ll get through, then you’re going to panic and sell just like the market.

You can’t be an emotional owner of these businesses, because by being willing to buy small businesses, tiny businesses, you’re saying that, “I’m okay with some volatility.” You’re saying that, “I really believe in this, and I think in five, 10 years, I’ll hold me a lot of money.” But you have to be willing to say, “Maybe this quarter is going to be terrible. That just is going to happen. Nearly every business is just going to have a rough patch now and then.” If you don’t know what you own, if you don’t have confidence in it, and you don’t really, really believe in it, well, you’ll be looking to sell out at the exact wrong time.

If I can’t get incredibly comfortable and incredibly confident in a business, it’s just not the one for me. Maybe I pass on it, and maybe it does great. That’s okay, because there are other businesses that will also do great. I’ll own those instead and feel comfortable with it. A great business that I don’t have the confidence to hold, I won’t end up doing great with, because I’ll end up selling it at the exact wrong time. If there’s anything I’ve tried to add to my process, it’s just spending more time getting really, really comfortable with a business, because that’s what will give me the confidence to keep on holding even when things don’t look so good for the next six months.

You mentioned earlier that if you took the top two or three managers out of some of these companies, that things would radically change, which is incredible, because it’s so similar to a lot of the small private companies we discussed in the show as well. I’d be curious, how do you become comfortable with these operators, and how do you build that trust with them?

I think it’s far away, just track record. One thing I always, always do is pull the bios and the work histories of anyone who considering investing with, because, I mean, I’m not taking control positions in these companies, at least not at this point in my career. If I get in there, and I suddenly realize that management is bad, or I don’t trust them, I can’t do anything about it other than sell. I don’t have the ability to influence management at this point, and so I have to trust them. Number one is just looking at their history, checking out what they’ve done at this company, at previous companies they’ve been with.

Some of them have been with a company their whole life. That’s okay as long as the business is done relatively well while they’ve been in charge. But some of them, if you look at them, they’re just serial managers. They bounced from company to company. You can tell they do it every couple years after their restricted stock vests, or after they get that payout from whatever enterprise it is, and they’re on to the next thing. That’s a bit of a red flag for me. I like people who are more interested in building something. Maybe that’s okay, because they build a business and they sold it, and they built a business and they sold it.

That’s okay, too, but I don’t like people who just want to be at a business during the good times. As soon as the (inaudible) authority comes along, well, they’re on to the next thing. I’d rather see someone who is able to stick it out and really build the business over a decade. I like that a lot better, but one of my fundamental assumptions is that managers who have a history of sleaziness, I’m not going to accuse anyone of borderline fraud, but I do see it, but those managers keep on doing that. It’s not like they get to another company and think, “Okay, now I’m going to walk the straight and narrow. Now, I’m going to do the right thing for shareholders.” They just don’t do that.

A lot of them talk a good game, and they convince shareholders and new companies that do great things, but managers who have a history of mistreating shareholders and milking companies for value and cash keep on doing that. Managers that have a history of treating shareholders well, and taking appropriate, reasonable compensation from a properly-aligned incentive package, they tend to keep on doing that. Those are the managers I focus on. I want to see managers that are adaptable as well. I want to see them having gone through some trial by fire. If you’ve only ever managed companies that have operated in ideal operating environments, and their shares have only ever gone up because the industry has just been in general bull market for so long, I’d like to see a bit more experience in a tougher operating environment.

For example, I mean, software has been in maybe a 20-year bull market almost. Not to say there’s not a lot of amazing managers and software. Of course, there is, but I put a little bit more… I have more confidence in a manager and software that’s been through a tougher period, because I mean, honestly, with how they say software is eating the world, and I guess that’s true in some circumstances. There’s a lot of very mediocre people in those industries who’ve just benefited from the really, really combinative environments. I mean, you probably could…

You don’t have to be that talented to have made a lot of money in tech and in software in this past couple years, but somebody in industrials or consumer has a bit of a tougher time. If they managed to succeed despite that, that really says something to me. It’s about experience. It’s about ethics, and it’s about figuring out if I can trust these people.

You mentioned looking for people who want to build things, and turning it around on you. I’d be curious as you’ve run Alluvial for the seven years, how has your role changed over the seven years since founding Alluvial?

I would say that one of the challenging things is there are not as many public companies as there once were. When I got started, there were probably six to 700 really, really interesting, tiny companies trading on U.S. exchanges or over the counter in the US. Frankly, that’s probably been cut in half over this time for not bad reasons, necessarily. A lot of these businesses prove they were very, very great little companies, and maybe they’re acquired by private equity or by larger company. Others were taken private by their management teams. I mean, good for them. Happy it worked out that way for them, but they’ve not been replaced by new interesting companies, frankly.

I mean, I understand Sarbanes-Oxley. I understand why we needed to have stricter accounting regime and a better corporate governance standards out there, but it’s made it very, very difficult for small public companies to justify their public status. I mean, if you’re paying NASDAQ or the American exchange or even OTC markets $100,000 a year to maintain your listing, and then you’re paying internal people another $500,000 a year just to keep up with filing requirements and making sure you have all your committees set up properly, and proper internal controls, all good stuff, but it’s very difficult to justify for a small company doing five million in operating income this year.

I understand why a lot of them have gone private, and I understand why a lot of them are opting for capital from private equity instead. On top of that, you have very, very low interest rates, which makes it very, very easy to finance buyouts of these little companies. My job is to become a bit tougher just by the fact that there are fewer companies to choose from. On the other hand, like I said, places like Scandinavia, Italy, Australia have done a great job of encouraging little companies to go public, and so I’m spending more time looking overseas than I used to, and finding a lot of really, really intriguing stuff there.

I would say I think I’m better at my job than I was seven years ago. I mean, there’s something wrong for anyone if you’re not better at your job than you were seven years ago. What did you spend seven years doing if that’s the case? I think I take a more sophisticated approach to evaluating management and looking at quantitative aspects. I’m happy about that, but, of course, there’s a lot of other people doing this, and they’re all really, really good. My job is to make sure I stay sharp, so I can… It’s always a friendly competition, but I want to stay sharp, and I want to make sure I’m delivering the best I can for my LPs.

It just requires learning all the time. I mean, I’m in my mid 30s now. I look back at some investments I made seven years ago, and I’m like, “What was I thinking? That was not the best I could have been doing.” Probably seven years from now, I’ll be thinking the same thing, but my task is to get a bit better every day and improve my skill set and my knowledge. If I can keep doing that, I’m sure I’ll be just fine.

If you think over those seven years, what are some systems and processes and perhaps team members that you’ve added that have really helped advance your business through a tremendous degree?

Well, I have an employee now. His name’s Tom. He’s great. He’s been with me for three years, and he increases my productivity just exponentially. That was one thing I found is that, I mean, everyone needs to find ways to maximize the time they spend doing what they’re actually good at, and adds the most value for their business and their clients or customers or what have you. I mean, I’m good at the analysis. I’m good at reading the docs and getting the information. Me spending a lot of time on administrative tasks or just compliance, stuff like that is not what I should be doing, and so bringing on employee was super, super helpful, and freed me up and well worth the salary and all the stuff that goes into that.

That was a great decision. I went back and forth on, “Should I bring someone on for a long time?” I have never once regretted it after that. I think that people can be really hesitant to let go of things, but you have to be able to really move to the next level. Also, I mean, software, as I mentioned, there are so many wonderful solutions now for productivity, for keeping track of information. It can take a bit of a learning curve to learn a new software system or set up some processes that automate things, but automation is so important, especially for a small business that has limited resources.

There’s only so many hours in a day. There’s only so many hours you can be doing productive work in a day, and maximizing that, automating the less important stuff, that is critical. I mean, I used to be… I still have some manual processes, but I still used to be so intensely manual. Now, I have automated software stuff that keeps track of things for me, and flags me when there’s something that needs my attention, but I don’t have to spend every second looking at it. That was one thing when I was 27 and had no kids and no house, whatever. But these days, I mean, I got a family.

I’m a homeowner. I run a business. I don’t have all the time I used to, so I have to find ways to economize on time, and software is fantastic for that. I mean, it takes time to get it set up and running efficiently, but it’s well worth it.

I’d also be curious too of what you’re most excited to add or change or improve on Alluvial over the next five years. I’m curious to phrase it as if you had an extra $100,000 in your operating budget for expenses, for your business, where would you invest it?

I have, I mean, big plans, and I’m still staying flexible with that. I mean, as an investor in public markets, I am dependent to some degree on what those markets do. Obviously, I love my investments. I think they’ll do wonderfully, but the market might not agree in the short term. It depends a little bit on how the market treats my holdings, and that in turn probably affects how able I am to attract additional partners and clients to the firm. But assuming things go pretty well, I want to branch out a little bit as far as strategies go. I would love to do some sort of (inaudible) that has some private assets in it because believe me, oftentimes, and more and more as I get more involved in these companies, I see opportunities where a really, really interesting private asset is available.

I can’t do anything about that right now, but I’d love to be able to delegate some client capital buying some cool stuff at some point in the future. We’ll see. I have my fund right now, and it’s awesome. I love running it. We’ve done well. But in the future, I would like to be in a position to buy more interesting assets that don’t trade publicly when they come across my radar. I want to get that capability up and going in the next few years. I’d love to add maybe another staff person down the line. I mean, Tom does a great job, but as the business grows, eventually, he’ll become overtaxed with his responsibilities, and might need to take on a junior person.

Tom has a lot of interest in doing more of the analysis work, and I’d love to have some more help doing that. Maybe it’s time for him to put that operating stuff on someone else. We’ll see. I mean, Alluvial could grow. I don’t ever want to be a huge business. I don’t, frankly, enjoy managing people as much as I enjoy looking at the numbers and learning about businesses, and so my biggest fear is I would become a team leader and not have time to spend looking at the businesses. That’s not for me. No, thank you. I’ll stop short of that, but… I’d love to spend more time visiting the companies.

I do a little bit of that, but I mean, I have a young family, and they’re a huge priority. I don’t like spending too much time away from them. But as the kids get a bit older and are in school full time, I’ll fly over to Stockholm. I’ll fly to Milan or whatever, and check out my little Italian telcos that I own and things like that. I want to spend more time on the road, seeing things firsthand. That’ll be great. But I mean, I’m keeping my options very much open. That’s the exciting thing is I’ve been really, really blessed with a great group of clients. I’ve been very, very, very supportive. We’ll see where I go next. I’m just tremendously excited about the next decade.

Moving into some closing questions, what class would you teach in college if you could teach about any subject you wanted?

I would have to do a lot more of my own research and learning here first. I would love to teach a class on the history of capital markets in the U.S., really fascinating to me how the idea of what investment is has changed so much over time. I mean, you look at some of the very earliest corporations and developments in capital markets. I mean, civil war bonds were one of the really, really hastened to the development of the fixed income industry in the U.S. Then, of course, financing for railroads was a major, major factor that hastened the development of the equity markets in the U.S. I’d love to talk about that, and figure out how that all these systems we have developed over time, because it used to be that in a lot…

This is not rare info, but investing in stocks was considered distasteful and not something that respectable people did for a long, long time. Even long after that, the idea of a stock or even a corporation was a corporation, they make money. They pay it all out every year. The idea of retaining capital for growth, that was even okay for companies to hang on to the money they made. Well, that’s a recent development in equity markets, in capital markets. It used to be that your shareholders would be very, very upset at the idea that you would make money and not give it back to them.

I’d love to learn more about that and how that develops and the ups and downs along the way, because also, I mean, we’re used to the idea that, “Oh, a recession will hit every few years, but we’ll all be okay.” It wasn’t like that for much of the U.S. history. We used to undergo a severe panic about once a decade where banks would fail, and people will lose their savings, and business investment would just shut down. Thankfully, that’s not been the case for a while, but, man, it was a much tougher environment years and years ago. I’d love to see how that changed the development of all of that.

I’m not knowledgeable enough to teach a class like this at this point, but it’s endlessly fascinating to me. I love to read about economic history of capital markets in the U.S. That would just be so much fun.

What’s a belief you used to hold strongly that you changed your mind on recently?

There’s a saying that’s fairly common on Wall Street, and that is that there are no toxic assets, only toxic prices, and the idea being that there’s really no asset so bad that it’s not worth buying at some price. I think I used to believe in that pretty strongly, because I used to find these little businesses that were obviously not good at all. Obviously, in fact, really bad most of the time, but I thought, “If I can just buy them cheaply enough, I’ll still do well. If I can just buy them at two times the earnings or 30% of tangible book value, I’ll still make money.” I guess I don’t really believe that anymore.

I believe that if you can take ownership and have a controlling position in these businesses, but for most investors on public markets, that’s not the case. You’re buying a very, very small percentage of the business, and you have no ability to influence operations. I found that usually in a case where a business that just looks so bad, and it’s trading at that valuation, it’s there for a reason. Even if they do make money, even if they do have valuable assets, the people there will capture that for themselves. Shareholders will end up seeing almost nothing. I can’t tell you how many times I’ve seen…

Especially in the case of a controlled business where one shareholder owns 50, 60, 70%, so many times I’ve run across little businesses trading over the counter, or even they’re listed. I mean, they have some issues. Business has not been good for a while, but maybe they’ll turn around, or maybe they’ll just keep on making a little bit of money. If you can buy it really, really cheap, maybe it works out, but it almost never does. In the end, as soon as the business starts to turn, the insiders make a low ball offer to buy the whole thing. You can’t really fight it unless you want to go through an appraisal, and spend years in court and hire attorneys.

These people find a way to pull the rug out from under you just as thing starts to get good. Really, my investment process has evolved over the years. I pay a lot more attention to business quality, and like I said many times before, a lot more attention to the integrity and the alignments of the people in charge. I guess I no longer really believe that you can make up for terrible quality just by buying really, really cheap. That’s an expensive lesson I’ve had to learn a couple times. I think it works better in large caps where there’s more eyes on the business.

It’s more difficult for anyone to opportunistically come in and buy the exact point where things are changing, because there’s enough large hedge funds and enough people looking that that can happen. But small businesses in public markets rarely get that attention on them, and so there is the ability for people to just come in and take that from right under your nose at the worst point. I avoid… I only want good quality little businesses at this point. Other people may disagree, but that’s just what has worked out well for me.

What’s the best business you’ve ever seen?

I put some thought into this, and I had a lot of fun thinking about it, because it was a really good exercise for me to benchmark my existing portfolio against it. What do I really think makes a lot of sense for a business, and there are a few different metrics that I came up with, ways to think about this. It led me back to thinking like, “What is the business, and how does the business make money? What makes it easier for a business to make money?” I got to thinking about a particular holding of mine. What are some of the characteristics that make it so great? Well, if you have a business, and you want the business to grow, it’s better if you can do that without a lot of capital.

That rules out any business where you have to invest a gigantic amount of capital in facilities, and working capital and inventory and receivables, networking (inaudible), I should say. A good, little business is one that you can grow it without a lot of investment. I do tend to prefer businesses that have that high return on capital. At the same time, you want it to have some barriers to entry, because, I mean, sometimes in winter mornings, teenagers are showing up on my doorstep with a shovel on their shoulder and saying like, “Hey, can I mow your side… Not mow. Can I shovel your sidewalk for 10 bucks?”

Like, “Go for it.” That’s a business that requires almost no capital. I mean, what does a snow shovel cost? 20 bucks maybe if you get a nice one, but there’s no barriers to entry. Anyone can do that. You want to have not only high returns on capital, but barriers to entry, and so it has to be a business or product that not just anyone can do. You have to be differentiated in some way. There has to be something about this business that not anyone and not any competitor can say, “I’m going to do that, because I see you over there and making great returns on capital, and I want some of that for myself.”

There has to be some kind of barrier of entry. Also, another really, really important thing is cash cycle, right? A lot of businesses are in this terrible loop, where if they want to sell a product, they first have to go out there and make that product, and pay all those suppliers, and pay all the labor expense and all that. Only then, once they have the product in their hand, can they sell it. Then sometimes, they don’t even get paid for that for another two months, because they have net credit terms with their customers or something, and that’s tough. I mean, businesses do that and get by all the time, but it’s much, much better if you can flip that.

A couple businesses I know and I hold, the best sort where the customers pay them, and only then do they have to deliver the goods or the services. That’s really, really hard to do. It’s typically businesses that are more service oriented with a collect up front for a small discount or something, and only then deliver this service over the course of a year or something. I think that’s awesome. It’s a combination of capital intensity. What does the cash look like? I mean, obviously, what is the growth potential and what is the potential market here? It helps if it’s a product that everyone wants and needs.

If they want more of it all the time, that obviously helps too. I mean, autos, most people live in a very, very dense area. You want a car, but it’s not like people wake up and think, “This year, I want two cars, and next year, I want three cars, and maybe in 10 years, I want 10 cars.” It doesn’t happen. That’s ridiculous. But for something like, for example, broadband internet, a lot of people are like, “Okay, well, 100 megabits is fine this year, but probably in five years with video conferencing and just data needs, maybe I need 500 megabits in five years, and eventually, I need gigabit service.”

It’s hard to see people needing less connectivity over time. Our data needs go up every year, and so if you’re in a position to provide that, you have a built-in increase in the demands your customers have on you. I have a business that I own in Sweden, Bredband2 i Skandinavien, and they are an internet service provider. The great things about them are they don’t own their own infrastructure. It’s very interesting. In Sweden, a lot of the fiber optic networks are owned by municipalities. Each city or town will have its own fiber optic network, and then they invite ISPs to come in and offer services on that network. Then the people can choose from four or five providers.

It’s actually a pretty cool system I wish we had more here. But if you’re a broadband, you are the low cost provider. You don’t have to pay for the network. It already exists. At most, you need a couple switches and routers, and so your capital investment is low, but you have a lot of expertise. You have very, very highly trained technicians. You have really, really great support staff and people who do that, and so not just anyone can come in there and do that. You have to have a highly skilled workforce, and you have to have a brand name and a good reputation, but you can go in there and offer your services on that network at low cost to yourself, but it’s difficult for someone to say, “I want to do what you do,” and scale up to where you are immediately.

Capital intensity is low. (inaudible) business where anyone can just come in tomorrow. On top of that, the cash flow cycle is negative working capital. There’s no inventory. It’s an intangible service, so what inventory could there be? Additionally, when someone comes to you and says, “I want internet,” you can say, “Okay, it’s this much a month, but if you pay us six months in advance or a year in advance, we’ll give you 15% off or 20% off.” A lot of them are like, “Okay, I can do that,” and so you get a year’s worth of revenue up front. Only then do you have to undergo the expense of delivering that service over the next 12 months at a high margin to begin with.

They generate a ton of cash, and their customers want more and more every year. They have some ability to raise their prices over time as that goes on. If you look at the financials of the business, they are incredible. They produce cash well in excess of their reported earnings every year from customer pre-payments, because the revenue just keeps on growing, because every year, they get more clients, and every year, those clients want a higher level of service, and so they pay them more and more.

It’s the best business I’ve ever found. They pay out nearly all their earnings every year in dividends, but they still manage to grow at 15% to 20% a year because people want their service. More and more people want it every year, and they want faster and faster speeds all the time. I love it. I’m a big shareholder. I own 2% of the business, and that’s going to stay that way for a long, long time, so fantastic business.

That’s awesome. That’s so cool to hear. Thank you, Dave, so much for coming on the podcast. It’s been super fun to have you. I’ve wanted to have a discussion around public market equivalence for some of these small companies, so I’ve really been excited to have that with you. Thank you so much for sharing this. It’s been really fun.

This has been great. Thanks so much.



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