Paul Sonkin is a portfolio manager with Gabelli Asset Management. This article is based on the interviews which he had given while managing Hummingbird Value Funds. Hummingbird Value Funds used to concentrate on the sub-USD100m market cap companies, which is the smallest 40 basis points of the U.S. market [where there are still 8,000 companies]. He maintained a very diversified portfolio, 10-20 positions would be about 50% of the portfolio while another 100 stocks will make up the rest. He insists that there is an enormous difference in the effort required to follow a big company than a small company. He prefers buying securities when the sentiment for a company’s outlook is bleak and the price of the stock is low, and to sell them in periods of optimism and high prices. In small & micro cap companies, most of the investors restrict themselves only to net-nets or special situations. But Paul Sonkin extended his search even to high quality companies. Streetcapitalist.com explains this better
I also thought it was interesting that Sonkin sees some of these companies as ones with great long term prospects to grow as business. I know that other investors only venture into companies of this size range in order to find net-nets or special situations, but it seems like Sokin is taking a much comprehensive approach. To find these kinds of companies you’re probably going to have to broaden your search a bit in order to find them, since they may not come up on an ordinary screen.
Below are the few interesting extracts from various interviews of Paul Sonkin. Extracts are given in italics.
Teaching gives time to do research on research process
What I really enjoy about teaching it gives me time to research on the research process. A lot of the materials I have start as lecture, it is hard to know where the money manager starts and the teacher begins. I really try to integrate them both and I really try to bring a lot of live theses into my class.
Next to teaching, I think writing a blog post are one of the best ways to do research on research process. Many times your thought process gets much more clear after you write a post on any topic.
Source of ideas
You know I’d say that most of my ideas come off of the new lows list. I take that that’s sort of the best hunting ground. And then the other thing that I do is I have these lists of companies I’ve owned before or am interested in. And then I get the news headlines for them on a daily basis and then I do a lot of keyword searches for like spinoffs, liquidations, merger arbitrage, stuff like that. And then I go to conferences I source my ideas pretty much from everywhere. The only place where I don’t source my ideas from is Wall Street. Not a lot of Wall Street research at all. [Interview with Streetcapitalist.com, 2009]
You can buy a few shares in a stock that meets your criteria to force yourself to follow the business. By purchasing a very small piece of a business, you’ve guaranteed that you will not forget the business, and that you’ll have consistent reminders about that business. Paul Sonkin of the Hummingbird Value Fund calls this his grab bag. In his personal account, Sonkin has purchased one share of more than 300 companies. In the mail each day, he usually receives something from some of the companies. He has followed some of the companies for many years, and he uses this method as a way of filling his in-box with companies that he has already screened as being interesting. [Shearn, Michael, The Investment Checklist: The Art of In-Depth Research]
How to use screens
Paul Sonkin, manager of the Hummingbird Value Fund (a micro-cap fund), uses stock screens and new-lows lists, but he believes these tools are misused by investors 99 percent of the time. According to Sonkin, “. . . a lot of investors will put together a screen of low price-to-book or low price-to-earnings stocks, but usually 90 percent of the companies on the screen are cheap for a good reason. Many stay on these lists for a long time.” Sonkin believes the proper way to use a screen or new-lows list is to run them on a weekly basis and look for new companies that appear on the list. This way, you are able to separate the companies that deserve to be there from those that may only be suffering from a temporary problem.
During periods when stock market has risen, there are powerful incentives to take new companies public…..To accommodate all these interests, the firm being taken public makes a strenuous effort to put its best face forward. [By freezing hiring, reducing discretionary expenses and accelerating revenues wherever possible] – Value investing: From Graham to Buffet and Beyond
Research Process & Time Allocation
Few things which Paul Sonkin highlights in his research process are 1) Meeting with management only AFTER DOING ONE’S HOMEWORK. 2) Time allocation should be based on position size and the business quality matrix. I think time allocation is as important as capital allocation. Time allocation needs to be inline with your investment philosophy. 2) Doing in-depth industry analysis 3) Analyzing many years of data to see how the company has performed in good and bad times. I prefer reading atleast 10-15 years of annual report in a serial order. Once you do that, you can see a story unfolding in front of you. [Generally I share the extract of last 10-15 years of annual report of various companies on twitter]
There is an art to identifying what needs to be analyzed in each situation and how to go about analyzing it. An arbitrage deal can entail reading reams of documents and speaking with the company. A moderate neglect situation may require a complete competitive analysis, talking with customers, competitors and industry consultants as well as the company. We always begin by reading. This includes public filings and screening online databases for articles about the company and its principals. We also do enough industry analysis to put the company into some type of context. For example, if a company makes parts that go into forklifts, we need to know the outlook for the forklift industry. We also analyze competitors and customers. We array as many years of financial data as possible to see how the company has performed in good and bad times. With a long list of questions, we then either talk or meet with management. We are always looking for either confirmation or red flags. We seek information that confirms our hypothesis but are very careful not to ignore information that disproves it. In that case, we throw out the hypothesis and develop another or dispose of the name entirely and move on to the next.
Meeting with management
Sometimes they [management] are very receptive sometimes they’re not receptive. I would say that we always talk to management over the phone and we’ll sort of have them walk us through the story and we’ll discuss their capital allocation decisions and just you know, go through various things like that. Since shareholder base is very small better to work along with other shareholders. In our larger holdings we will have done a lot of due diligence and expect to know management and need to be impressed with them. In our smaller positions contact with management is less important – we’re buying into the business mostly because it’s statistically cheap. The financials and whatever other communication exists can generally give us a good sense of how shareholder friendly those companies are. I’d add that while it takes a lot less time to cover a micro-cap company, the potential value added by the research is substantially greater. I have a lot less competition. I’m also much more able to speak directly with the CFO or CEO, who may not be as polished in the ways of Wall Street and might be more open and forthcoming about their business. All of that makes it easier to uncover new and previously unknown facts, which can be an important edge. [Investor insight, 2009]
Diagnosis: Is the market really making a mistake?
Once we have weeded out the obviously undesirable, we scrutinize the remaining to understand why the price has declined. We ask ourselves whether the market is really making a mistake. Prices in the stock market are set by the collective judgment of many intelligent and energetic investors. While we believe that prices do not always reflect intrinsic value, we start with the assumption that most prices are reasonable. We want to know whether the security is in fact a bargain. Why are we getting such a gift? Once we have uncovered what looks like a mispricing, we seek to understand why it should exist.
It was a big position, so we put a lot of work into it. Typically, you start out with a small position and you put a little bit of work into it. As you start to build on the position, you do more and more work. Eventually, your biggest positions are the ones you’ve put the most work into. Small companies are much easier to understand. Both their financial statements and their business models tend to be simple. Usually they operate in one line of business, not the 5 or 15 of a Standard & Poor’s 500 firm. They probably have a few competitors and a few major customers. Put in economic terms, the marginal value of time spent studying a small company far exceeds that spent on a large one. [Value investing: From Graham to Buffet and Beyond]
There are two main types of catalysts—internal or external. An internal catalyst may simply be that the business improves, thereby increasing the intrinsic value. In this case, the gap remains but the stock price increases in conjunction with the rise in intrinsic value. You always want to look for a catalyst but sometimes there is no catalyst. So with Steinway (NYSE:LVB) there’s no real catalyst there. Earnings will recover and that will be the catalyst but the catalyst isn’t obvious and when it is obvious it’s too late. Interview with Streetcapitalist.com, 2009]
If we can identify a catalyst, we have an answer to the question of how we are going to make money, and also a sense of when that will happen. We earn money only when the gap between the discounted market price and the intrinsic value closes. We want this closing to be upwards; it does no good if the intrinsic value falls to the price of the security. And the closing should be timely — a security trading at a significant discount may not be a good investment if the spread closes only over an extended period. In most cases, we try to identify a specific catalyst that will close the gap.
Learn from all great investors and adopt what suits you
Keep your eyes open and your mouth shut. The most common mistake that students make is when a boss, for example, asks him for a red umbrella and then he comes back with a blue one and an explanation for how it’s going to keep him dry. If you have seven different teachers, you might need to learn how to do something seven different ways. Then you can just absorb it and decide what suits you. Then when you go to work, you’re probably going to need to learn to do it in an eighth way. Arguing with your boss is just not a good idea. [CBS interview 2009]
Arbitrage in small & micro caps
We try to exploit opportunities in the micro-cap area that are too small for the established arbitrage community. The spreads on these deals may not close instantaneously, affording us our opening.
From my personal experience, I can say that delisting and open offers situation in small & micro caps are very attractive. Big players cannot enter due to liquidity concerns. Eg. Delisting of Fairfield Atlast & EICL, Open offer of Intec capital & Gujarat Automotive etc. Return on time invested is very high. Generally, I allocate only the debt part of my portfolio to such situations.
Ideal Investment in micro caps
As a micro cap investor what you are looking for is something where it can grow against the industry returns or grow against negative economic trends. We buy established small and microcap companies with customers, revenues, and earnings. We look for companies with pristine balance sheets including large cash balances, good growth prospects, seasoned management, large product and customer bases, defendable competitive positions, , and high returns on capital which generates free cash flow.
We are looking for companies that are unloved, there is no institutional sponsorship, there’s no analyst coverage. We are always looking for a stock that can return a multiple on our money. We look for situations where the stock could easily double. With these small companies, we’ve seen stocks go private at double where they were trading. Where there’s very little liquidity, and where management is pretty quiet – they have been sort of “run silent, run deep.” So you go from unloved, no institutional sponsorship, no analyst coverage, little liquidity, and quiet management, to – these stocks become loved, they get the institutional sponsorship, the analyst coverage, more liquidity, and management starts selling the story.
Our contention is that there’s no better place to look for inefficiently priced securities than in those of unfollowed, unwanted and unloved companies. We call it combing through the back alleys of Wall Street for garbage people have thrown away. That’s how you can find small, obscure companies trading at 2-3 times earnings.