We’re proud to feature our next guest in the “Meet the Buy Side” series, where we feature William DeRosa from Anthem Asset Management.
Anthem Asset Management is a hedge fund that invests in small cap companies with sound fundamentals, and positive cashflow. The fund’s inception was in 2004 with an annualized performance of 19% YTD (when measured up until August of 2019).
Anthem emphasizes fundamentals and invests carefully over long timeframes. Anthem holds concentrated positions in companies the management team has conviction in and has carefully vetted over a number of quarters. We’re glad to hear his thoughts on investing into smaller companies in our ongoing buy side series.
Q&A Section with Alex Cho and William DeRosa from Anthem Asset Management
Alex Cho (CEO and Founder of Cho Research) – Hey William, thank you for taking time out of your day to host this Q&A session, and to share your thoughts when pertaining to small & microcap investments.
So, this might be a bit of a softball question to start, but I wanted to learn more about your fascination with equities, and what got you into the industry?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – I have always had a passion about investing going back to when I was much younger. My father fed my curiosity as he also was very interested in the topic. I was completely obsessed with the notion that I could own a piece of a business that might grow over time. I can recall as early as age 10 I asked for shares of a company stock for Christmas rather than video games. My rationale was simple – as the investment appreciated, I could buy more video games in the future.
I made plenty of mistakes along the way, but I learned fairly quickly that small company stocks were much easier to analyze than their larger counterparts. Furthermore, their growth potential was much greater as well. For instance, a company such as Monster Beverage (Hansen Natural Bev) had a much greater potential runway than Coca-Cola. I never believed that shares of small companies are riskier than large ones simply because they are smaller. In my opinion, this is a popular misconception.
Alex Cho (CEO and Founder of Cho Research) – Makes sense, and so you know, I’ve been thinking for a while… the Russell 2,000 Index over the past five years has gained 34.45% cumulatively, whereas the S&P 500 has returned 50.61% over the same timeframe. So, the performance of small cap stocks has lagged in comparison to larger cap equities, and so I was hoping to find more answers to this question, especially given your background as a successful small cap manager.
Why are small cap stocks under-performing in general relative to large cap equities for the past five years?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – That is an excellent question. Sector, style, and size rotation are all very common in the equity markets. Generally speaking, it usually comes down to valuation on the broad level. Small caps had a very strong run heading into 2014 from the prior year. The Russell 2000 was trading at historically high multiples in that year. Simply put – the growth prospects for the index didn’t justify the multiple. Markets have a way of returning to trend line over the long run.
You mentioned the performance relative to the S&P 500 index. People may not realize that the S&P is a cap weighted index which means that the largest companies have the greatest impact on performance. Over the last decade, names such as Amazon, Apple, Netflix, and Google have represented the vast majority of returns. Strip out the four or five and the returns change in a meaningful way. The breadth of market returns over the past decade has been quite narrow – especially in large caps.
Alex Cho (CEO and Founder of Cho Research) – Pretty salient points, I mean, I was thinking that some of this could be driven by a skew in performance where there’s a lot of players, but a small number of distinctive winners that tend to take the lion share of the performance gains, and soon exit the definition of being a small cap company.
So, for example, if a company is good they tend to go onto become great, and tend to trade at those higher valuations that are defined as being a mid or large cap equity, and so it’s not surprising that a large number of companies tend to stagnate, and remain smaller equities, and it’s why the index-based performance of this group tends to lead to somewhat of a skew in favor of a small group of winners that soon exit the index, and are then tracked by mid & large cap indices where there’s higher amounts of capital flows.
Anyhow, those are just my thoughts, I wanted to ask you a question relating to your strategy, and I like how you have a fundamental approach. Could you elaborate further on your criteria and how you screen your selection, so you can carefully build your portfolio?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – Sure, there are many important factors. – our investment process tends to be simple in theory and difficult to execute. The most significant criterion is a company’s expected growth in economic profits. This is the ability to generate true free cash flow and return on invested capital, not GAAP accounting profits – a very important distinction. Accounting profits are what is reported in the earnings press release. Economic profits, on the other hand, are the profits that exceeds cost of capital. A company earning high incremental returns on capital over long periods of time will create a significant amount of shareholder value. This results in rock solid balance sheets – important for surviving all economic cycles.
The second key factor is the quality of the firm’s management team and board of directors. This is especially relevant for small companies. The ability to invest and allocate capital prudently is a crucial component to success. We want management teams that invest for the long-term rather than try to beat next quarter’s estimates. Shareholder friendly decisions from the board are a must. We’re not interested in executives who enrich themselves at the expense of minority shareholders.
Alex Cho (CEO and Founder of Cho Research) – Also, I recall in a separate conversation, where you mentioned position sizing, and this ties into capital preservation, but that you don’t view your fund as a diversification vehicle, so can you elaborate a little further on that as well?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – We run a highly specialized fund focused on unique micro and small cap equities. Our limited partners invest with us to gain this exposure to this part of the market. In order to achieve returns that exceed our benchmark, we believe in weighting only to our best ideas. This can be a few as ten to fifteen positions. Beyond a certain number of positions diversification is no longer effective in reducing risk. Our LPs understand that volatility does not equal risk.
In order to pursue this type of strategy, we must be extremely selective in our choice to allocate capital and be willing to change course on a position if necessary. In addition, we must invest with partners who understand the long-term nature of our strategy.
Alex Cho (CEO and Founder of Cho Research) – Makes sense, and so you obviously have to be very careful with what you invest into, because you don’t overly rely on diversification to diminish portfolio risk, which leads me to my next question. How do you diminish the risk within your investment portfolio?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – We believe there are a few components to help control risk beyond simply diversifying. Permanent loss of capital is how we define risk – not volatility.
First, we conduct comprehensive due diligence on our portfolio companies. We vet our positions as thoroughly as possible. This includes thorough review of financial filings, quarterly conference calls, discussions with senior management, etc.
One of the biggest risks relative to micro to small caps is the possibility of dilutive capital raises to fund ongoing business. Strength of the balance sheet and favorable capital structure is vital to offset this issue. Our businesses have little or no net debt on the balance sheet with an excess cash cushion to protect against downturns. The businesses are self-funding, so there usually is little need for our companies to raise additional capital either via equity of debt financing.
Valuation. The price we pay at initiation is crucial to reaching above average returns. Our investments typically have little to no sell-side analyst coverage. Therefore, our companies fly under the radar and are not afforded rich valuation multiples relative to the larger, more popular names.
We hold for the long term – a typical holding period of five years or longer is the objective. If our focus is a few years over the horizon, the volatility of quarter to quarter results tend to be much less important. We want our managers to invest for the future many years out – not next quarter.
Finally, we swiftly cut losses if we believe the thesis changed or we’ve made a mistake in our reasoning. Avoiding large losses are paramount.
Alex Cho (CEO and Founder of Cho Research) – Yep, the irony is that people tend to have a blanket view on small cap equities as being risky, and while some companies are small, it’s certainly possible to find competent management teams that emphasize stable cashflow metrics, limited use of debt, great cash conversion ratios with niche segmentation creating opportunities in the midmarket where there’s not a whole lot of price discovery among investors, and so the mispricing tends to be common in smaller cap equities.
So, I wanted to kind of highlight a case study, where you invested a bit earlier on into a company that met your criteria and contributed meaningfully to performance, could you discuss a couple of these companies? (mention Paysign)
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – Sure. One example is Paysign, Inc. Paysign has built a stable cash flow business around prepaid debit cards for plasma donation centers. It is a rarity when we find a combination of a niche business with long potential runway for growth and a very attractive economic model. We believe that PAYS possess those fundamentals. The company runs a prepaid debit card program primarily for the plasma center donation industry. Prepaid debit has a very attractive attribute – float. The company’s capital structure is an economic benefit creating a competitive advantage. However, our thesis becomes more compelling due to the forces driving growth. New opportunities in pharma co-pay cards and a reloadable debit card offer catalysts for further upside.
A second name is XPEL, Inc. It’s often the most basic and mundane businesses that make the best investments. The company produces paint protection film for high end automobiles. They are expanding into underpenetrated markets such as lower end vehicles, window tinting, and architectural window glass. XPEL works through a closely-knit group of installers in North America, Europe and Asia. The company has been scaling into profitability for many years while growing revenue rapidly. We have owned the name for almost two years.
We still own both names in the portfolio.
Alex Cho (CEO and Founder of Cho Research) – Yeah, I definitely think Paysign (PAYS) is interesting, and so this has been an outperformer within your portfolio, and so could you highlight the growth thesis a bit further on this particular company, because I’m not really familiar with the narrative, or the underlying fundamentals that might warrant a higher valuation?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – The company is growing sales rapidly. This is always a good place to start. What makes it more attractive, in my opinion, is the company has been able to scale successfully. Very little additional capital is needed to grow the business. They have a business model that has produced free cash flow from the plasma business much greater than reported GAAP profit. A few additional key elements, the model is a negative working capital business. This is incredibly valuable. Essentially their entire fixed and working capital needs are funded by non-interesting bearing liabilities. This, in turn, creates positive float. The use of other people’s money is a very beneficial form of leverage when it’s free. We believe this is an underappreciated aspect of the business which, in turn, deserves the high valuation.
Alex Cho (CEO and Founder of Cho Research) – Great points, and so I wanted to ask you some questions relating to the economy, and I know this isn’t really a macro oriented fund, so I’m not expecting you to make a crystal ball forecast, but it seems sentiment has turned the corner in 2019, and with the election in 2020 do you anticipate investor sentiment will swoon on a Democratic Presidential victory?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – In our opinion, it continues to be a favorable economic environment to invest in equities. Interest rates remain very low, inflation is stable, and corporate profits are strong. One area of potential concern is the current ongoing trade negotiations. The world economy is connected like never before and free trade is an important part of that equation. We are hopeful about a positive outcome on this issue.
In terms of elections, we have not had much success predicting outcomes not how the market will react. However, we expect markets to take it in stride regardless of which party takes the White House. It is true that any candidate proposing extreme tax rates for personal and corporations along with dramatic expansion of government spending would ultimately have a negative impact on the investing climate.
Alex Cho (CEO and Founder of Cho Research) – Okay, pretty interesting, so not relating to politics, but something more relevant to your fund, but what are the type of sectors do you tend to prefer within the small cap space, and why do you prefer those specific sectors over others given the current environment in the equities market?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – We have found that healthcare, consumer, and technology sectors provide the most attractive universe from which to search. These sectors offer solid growth opportunities while producing excellent cash flow. Occasionally we find a name in the industrial space as well, but we generally avoid companies that are highly cyclical and vulnerable to economic swings. We tend to avoid materials, energy and financials for this reason.
Alex Cho (CEO and Founder of Cho Research) – So, the portfolio weighting will obviously differ from broad basket index funds, and so you’re very differentiated from closet-indexer type asset managers where they simply collect fees while moving slightly under/overweight relative to the benchmark, so then what’s the benchmark you prefer to compare your returns to?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – Our primary benchmark is the Russell 2000 small cap index. We feel that we need to outperform this metric on a net-of-fee basis in order to justify our process. We don’t put any emphasis on sector weighting in the portfolio, rather we focus on our best ideas.
We present our returns relative to this index and the S&P 500 index as well.
Alex Cho (CEO and Founder of Cho Research) – That certainly makes sense, and so you’re obviously not going to dictate your strategy based on sector weighting, but rather the types of opportunities a sector can actually present, and you’re a bit open-minded, but you’re also savvy enough to recognize some of the risks tied to certain industries, like energy for example, and so at a high level can you explain why the energy sector is something you’ve been avoiding?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – We have looked at many oil and gas companies over the years – both upstream and downstream. In the end, we pass for many reasons. Energy issues are highly dependent on the underlying market they serve. As a commodity, these cycles are short and very hard to predict – especially true the small cap space. Furthermore, these businesses tend to be highly capital intensive. It takes a great deal of fixed capital to run these businesses with constant maintenance cap exp to replace equipment. Companies take on larger amounts of debt just to survive. The industry is vulnerable to over capacity causing prices to fall, yet those fixed costs are still in place. Losses are sure to follow.
We prefer companies that can control their own destiny as much as possible. These types of opportunities are much harder to find in the energy space.
Alex Cho (CEO and Founder of Cho Research) – That makes sense, and so technology is a certain sector that you have investments in, so can you talk a bit more about the small cap technology segment, and how those opportunities tend to differ from other sectors?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – Technology issues offer great potential but can have risks unique to this category. Industries such as hardware, software, and storage are constantly evolving at a rapid pace. Product innovation and disruption are a constant threat. Tech cycles are accelerating which make it all the more challenging. Small companies generally do not hold any technological advantage over larger companies – so we look for companies that dominate a niche market. A firm that can own a $100 million market offers natural protection against large competition.
Alex Cho (CEO and Founder of Cho Research) – Pretty fascinating observation, and so I wanted to ask you, what were some of the initial difficulties or hurdles you’ve had to overcome when you first launched your hedge fund?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – The biggest hurdles by far were start up legal expense and raising seed capital. Most funds, ours included, get started with friends and family allocations. From there it’s all about building a long-term performance track record. The longer and more sustainable the better. Potential investors will want to understand how your fund performs in market downturns – so a record through multiple market cycles is important.
Alex Cho (CEO and Founder of Cho Research) – So, now it’s obviously a bit more like cruise control after having managed your fund for around 15 years, but prior to launching this fund, you must have had some people that have impacted your career, or people who might have had a positive impact on your life whether that’s an author, or some other public figure, but could you reference someone that helped you immensely over the course of your 25 year career as an asset manager?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – Like many others in the investment community, Warren Buffett has had a tremendous influence in my early years. However, it was Philip Fisher, that was probably my greatest impact. I consider him to be a pioneer of growth investing. The book Common Stocks and Uncommon Profits is a must read for all small cap investors.
Ultimately, one needs to develop one’s own style which is unique to each individual. Read as much as possible and keep an open mind to investing. The learning process is never ending.
Alex Cho (CEO and Founder of Cho Research) – Pretty fantastic, and so one final question before we end the Q&A, but how can people get in contact with you, if they’re interested in getting involved with Anthem Asset Management, and is the fund still open?
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – Yes, the name of the fund is The Anthem Opportunity Fund, LP and it is open to accredited investors. Our office is located in Glastonbury, Connecticut. Contact phone is (860) 305-5468 and email is [email protected].
Alex Cho (CEO and Founder of Cho Research) – That was awesome, thank you for your time William, and if you ever want to share your thoughts via another Q&A, you’re always welcome to come back and share some of your ideas, or thoughts.
William DeRosa (Founder and Managing Partner of Anthem Asset Management) – Thank you for the chance to present our fund, The Anthem Opportunity Fund, LP to your audience. We have thoroughly enjoyed the past fifteen years and look forward to another fifteen and beyond!
***This concludes the Q&A section with Alex Cho and William DeRosa from Anthem Asset Management***
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