Issue #5, February 2002

Illiquid Dreams: Finding Value in Micro Caps at Palo Alto Investors

By Richard Hefter, Editor, Small Cap Manager

Palo Alto Investors isnít a fund youíll read about in Morningstar. Itís a hedge fund, distinct from a mutual fund in that it has greater flexibility (the ability to go short as well as long), greater incentive for its managers (who, in addition to receiving a percent of assets under management, also get a share of profits), and more restrictions on its investors (i.e., big minimums and multi-year holding periods).

Focusing on micro caps with long-term horizons, the fund has netted investors 23.4% annualized over the last 10 years, nearly twice as much as the Nasdaq (+12.76%) and the S&P 500 (+12.91%). Chief investment officer Will Edwards, a Stanford University engineering graduate with a penchant for tech stocks who cut his teeth in small-cap research at T. Rowe Price, shares the strategies of his $200 million fund.

How has the fund performed thus far this year?

This year has been tough so far for the fund. Normally January for us is a month where you get a big rebound because you end up with tax-loss selling at the end of the prior year and without the selling pressure the stocks tend to gravitate upward. Last year was the second year in a row in which stocks broadly declined and we just didnít see the tax-loss selling, and we havenít seen the rebound weíd normally see. Traditionally the first quarter has been our best quarter, and this quarter is not shaping up to be our best.

Can you take advantage of downturns by going short?

We can, but really our strategy is to apply fundamental research to companies in the micro-cap area, and use that fundamental research to gain an informational advantage mostly on the long side. Short selling for us is tactical. If we have a highly appreciated position in a small company, rather than selling the shares and incurring the taxes we will, if the opportunity presents itself, sell short an overvalued competitor. So we reduce the market risk by selling the overvalued competitor and we donít incur the taxes.

What are you looking for in your investments?

Weíre looking for equities that are distinctly undervalued by a factor of 2 compared to other public market similar companies. Micro-cap stocks that will remain micro caps are uninteresting as investments. So weíre looking for companies that deserve to be small cap or mid cap or eventually large-cap companies. What that entails is either itís a very large company selling at a very low multiple or itís a company with very favorable ìdynamics.î There are a couple of industries where little companies can become big companies and we tend to focus on those industries -- healthcare, information technology and the Internet. We look for companies within those spaces that are misunderstood, distinctly undervalued, and have large potential for sustained high rates of growth.

How do you source ideas?

We normally source the ideas through primary contacts, people who are directly touching the company. We often find companies in doing research on other companies -- competitors or suppliers of the companies weíre doing research on. If we find them through brokers it tends to be 144 brokers who specialize in insider transactions. Recently, weíve been finding them through venture capitalists. The venture guys know the companies well.

Does the lack of research on small caps present a problem for you?

Lack of research actually results in less liquidity, which results in weirder valuations. It doesnít bother us because weíre doing our own research anyway. Weíre intentionally going into areas where you donít have good information on the companies and are thus likely to find good values.

We do a lot of hard work It normally takes us from two to six months to do the background work necessary to get us to the position where we make an investment. Weíre highly selective, probably investing in 1 in 20 or 1 in 30 of the companies we start out looking at. And we start out looking at companies that we think have a higher probability of being good companies than youíd normally get with just computer screens, because weíre hearing anecdotal primary evidence that itís a good company.

What are a few holdings you like?

Our largest holding is one called Tumbleweed (TMWD). It does software that manages email for enterprises. I think email is going to be the preferred way for communicating in business. Being able to sort through that email to find objectionable or harmful stuff is important. Being able to redirect and encrypt email to key suppliers or clients is very important. Tumbleweedís software does all that. They have an excellent board of directors and phenomenal customer references. I think theyíve got a distinct lead in the market and itís an area that could be worth many hundreds of millions or billions of dollars potentially in the future.

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Where are they priced currently relative their true value?

How high is up on this? I have no idea, but the shares are currently trading at around 4. For comparison, the shares traded at $136 per share in March of 2000.

Whatís their P/E?

They have no E, thatís the problem. A lot of these businesses were predicated on free capital forever. They had models that were aimed at maximum growth rates. Theyíve all had to re-tool their business models in the last year as capital was cut off. We think these guys will be earning money soon, and we think theyíll be earning a lot of money. Wall Street is still expecting a loss for 2002. It doesnít have a 2003 estimate, but the estimate of the loss has gone from $1.50 to 40 cents in the last year, so the estimated loss is narrowing rapidly. My guess is theyíll be profitable by the 4^th quarter of this year.

What other stocks do you like?

Another one in a similar vein is Art Technology Group (ARTG). They are a company in the East Coast doing software that allows enterprises to connect their legacy systems to the Internet in ways that are very attractive to the company. They use XML and J2EE technology, which makes it very easy to integrate with the world of the Internet. This company has been growing at a very high rate, at least until this last year. They have enormous group potential in the future and are trading at a modest multiple.

You obviously have a lot of technology names ñ do you consider yourself more growth-oriented than value?

In micro cap you need both things. You need value. It has to be the right price. Youíre taking advantage of the fact that illiquidity in this space creates very strange pricing from time to time.

Are there many ìvalue playsî now in the tech sector?

Oh yeah. I think youíve seen capitulation right now in the venture community, and youíre seeing tremendous values, especially among the recent IPOs. Of the IPOs in the crop that came public in 1999-2000, almost all of those have lost sponsorship. Many of them are trading at values that are below their venture rounds. Some of them are trading at values that are below their first round of venture funding. There are just tremendous opportunities for investment.

Healthcare had a big run-up in 2001. What are your thoughts on the sector currently?

Healthcare is one of the few areas where I think substantial market risk remains. If you look at Tumbleweed or Art Technology Group theyíre trading at pretty reasonable valuations, but in healthcare youíve got an awful lot of companies that are in Phase I or II of clinicals where substantial risk still exists and yet the company has a valuation in the hundreds of millions. And a lot of the larger players in that industry lack internal growth prospects.

What are you buying in that arena?

We are focusing more on sort of the platform providers, companies that have a technology that can, say, aid in drug discovery for everybody, and we are trying to avoid the riskier single-product companies. Among of the ones we own that we think have excellent prospects are Biosite (BSTE) and Genencor (GCOR), both of which actually have products (in the diagnostic area) and both are trading at relatively low values. Genencor is one of the few biotech companies that actually has earnings, and yet their market value is an order of magnitude lower than other similar companies.

What other industries are you invested in?

We also do things in retailing. One of our favorites there is a company called Restoration Hardware (RSTO), which is a turnaround. We think that one has an outstanding potential for growth.

What do you like about it?

We like the new guy running it, Gary Friedman. He is a veteran of the industry. He comes out of Williams-Sonoma and was one of the creators of Pottery Barn. I think he has the potential to deliver double-digit same-store growth for the coming three years. That type of growth is the kind of thing that can create enormous wealth for investors.

So heís exemplary of the kind of management youíre looking for?

Yes. Before Gary showed up, the company was getting killed and in danger of insolvency. He put his own money in. He put in millions of his own dollars, and that makes us very happy. That gives us a high degree of goal congruence with management. We always like that. Restoration Hardware sells furniture and hardware items for upper income households. Itís like Crate and Barrel or Pottery Barn, which Gary built from zero and which now heís going to compete against. So he knows that space well, he knows the competition as well as anybody and was very successful in the past. We like betting on guys who have been successful in the past.