Issue #9, June 2002

A Bares Market: How Bares Micro-Cap Equity Strategy Earned its #1 Ranking

By Richard Hefter, Editor, Small Cap Manager

Brian Bares canít boast a long track record but he can say this: Heís at the head of the track. His two-year-old Bares Capital Management, which manages private accounts, was ranked #1 last year among private U.S. small-cap equity managers as tracked by Money Manager Review, up 68%. The Austin, Tex.-based firmís Micro-Cap Equity Strategy also placed first for the 12 months through March 31, 2002, up 79%. A chartered financial analyst and graduate of the University of Nebraska with a degree in mathematics, Bares attributes much of his success to math as well as to the principles of another great Nebraskan, Warren Buffet.

Whatís unique about your strategy?

Weíre a little bit different in that we run a concentrated micro-cap strategy, holding between 10 and 20 stocks in our total portfolio. There are a lot of concentrated strategies and there are a lot of micro-cap strategies around, but very few venture into that realm.

Why do you do it?

Statistically, youíre more apt to outperform the index with fewer and fewer positions in the portfolio. The math works out that way. If we can concentrate our funds in the best investment ideas in the portfolio, we think the performance will reflect that over time. The obvious downside is that with fewer positions in the portfolio youíre statistically more apt to underperform as well as outperform. But the risk to a lot of managers isnít necessarily in the positions that you own, itís in the positions you donít own vis-?-vis your benchmark index. By being concentrated we can eliminate a lot of the land mines that are out there in the micro-cap universe, and there are a lot. A very large percentage of the stocks in the micro-cap universe are companies going out of business, overly speculative companies that have never made a dime in profits.

What is it you like about the micro-cap universe?

The obvious answer most micro-cap managers give, which we agree with, is that the inefficiencies in the micro-cap universe are much, much larger than they are in large caps, because thereís no following on the Street in micro caps. Thereís relatively little in the way of investment bank research. Thereís relatively little in the way of analyst coverage. Thereís relatively little in the way of large institutional portfolio managers paying attention to these stocks. Therefore, you have a lot of intrinsic value gaps out there that are specifically the result of lack of attention.

The other thing that not a lot of people talk about is that companies under $200 million in market cap, which is our ceiling, represent 60% of the invest-able stock market, according to Market Guide. If youíve got approximately 10,000 companies on the exchanges, youíre looking at 6,000-plus in terms of potential investment. The playing field is just so much larger. Think about the guys who are running $50-100 billion funds -- they essentially have 500 selections where we have 6,000.

THE INCREASING NEED FOR INDEPENDENT RESEARCH: A Message from Our Sponsor

By John Dutton, Director of Research, JM Dutton & Associates, LLC www.jmdutton.com

Independence of research is a goal being pushed by investors and regulators alike at an increasingly fast pace. As an example of this, Wall Street Research magazine honored JM Dutton & Associates in its July issue as one of the leading research boutiques in the US, and wrote a profile on us and our analyst research team. We are the only non-brokerage firm recognized.

Further example was the rapid response by regulators against U.S. Bancorp Piper Jaffray, which had threatened to cease its research coverage of a small-cap biotech firm if it was not named to manage the company's upcoming common stock offering. Writing on the subject, the Wall Street Journal restated on June 26 what we have been saying for some time -- that research in many brokerage firms cannot survive financially without the income attributed to corporate finance transactions. It is a critical strategic moment for many of these brokerage firms as they develop their long-term research department economic plans and company coverage.

Increasingly, brokerage firms are coming to Dutton & Associates for outside independent research on companies of interest. Firms that either commission us to write research or carry our research for their clients include Paulson Investment Company in Portland, RTX Securities in San Francisco (run by Jon Merriman, formerly with Van Kasper), and an increasing number of NIBA members.

This enables Dutton & Associates to provide a distribution network for our research that is unrivaled on Wall Street. For in addition to the traditional avenues of distribution ? Zacks, First Call, Multex ? in whose databases and consensus estimates we appear, we also distribute in ways not available to most Wall Street research departments. Being independent, we have created distribution alliances with multiple investment banks & brokerages, reaching far more investors than any single regional firm could on its own.

Credibility is the key, and increasingly our model is gaining it. As we indicated last month, former SEC chairman Arthur Levitt endorsed our independent research model in an interview with Bloomberg.

Add to that the vast distribution we offer and the result is often a narrowing of the value gap in the under-followed companies we cover.

A link to the Wall Street Research article and access to all our reports are available on our Web site at www.jmdutton.com .

Please read disclaimers at www.jmdutton.com.

How do you avoid the so-called land mines?

We start with the invest-able universe and whittle that down to a universe of 1,000-2,000 companies by essentially taking out all the companies that are under $10 million.

From there, we eliminate companies that are overly speculative. These may be companies that have been funded with a little bit of money to do research on a specific drug theyíre trying to bring to market, or companies in natural resources/mining/minerals where we think that through our research efforts we couldnít add any value to the investment process. I make no bones about that fact that I probably donít know how to value a company with the next great cancer drug or one with some gold formation in Russia. I donít invest outside what Warren Buffet called his ìcircle of competence.î

From there we actually profile each one of those 1,000-2,000 companies looking for any unique competitive advantages or anything about this company that would make it a good investment candidate for the portfolio without regard to price.

Once weíve whittled that list down to about 200-300 stocks, then we monitor those on a price to intrinsic value basis. From there we select the ones we feel provide the greatest potential capital appreciation.

How do you value companies?

We use a discounted cash flow approach, which is pretty standard for a lot of portfolio mangers. We also in some cases make a multiple comparison of what it would be selling for in a private transaction and compare that to the current market price, and hopefully we can find an intrinsic value gap. If company ABC is worth $20 a share and selling for $10, thereíd be a 50% intrinsic value gap or thereíd be a 100% potential upside on the company.

How do you do your research?

Our research is internally generated. We have some third-party research providers that are independent and we like to know what the Street is thinking if they have an opinion on the stock because we want to know why a competitor would be taking a position contrary to our own. But in the vast majority of cases there is nothing to compare it to, and weíre doing everything from the bottom up, starting, of course, with the SEC filings.

We obviously have to exercise a lot of due diligence on the individual selections we make and try to be as accurate as possible in assessing the ability to outperform the market. We probably pay more attention to the predictability of revenues and earnings than most micro-cap managers because we are concentrated -- because we have to place a premium on that and not have a material capital loss in our portfolio.

What are some companies you like?

One of the names we like is Edelbrock Corp. (EDEL), which makes aftermarket performance auto parts. Hereís a company that in terms of predictability is a relatively stable company that is consistently profitable. Their net margins are on the order of twice what a lot of replacement auto parts manufacturers are. The reason they can sell their products for higher prices is they have a strong franchise -- name brand ? as well as reputation for performance and quality among auto enthusiasts. Weíve held onto the stock for a long time and feel they have strong upside potential.

Utah Medical Products (UTMD) is another weíve held onto for a long time. Itís trading at $15 a share right now. We bought the company at $6 and still feel like itís got some room to go. When we bought the company they had on the order of 8 million shares outstanding. Management is extremely talented and, we feel, very shareholder friendly, and they recognized when we purchased the company the value in their own stock. They actually did a self tender and bought back a whole bunch of shares in the company at $8 a share. It gave shareholders an exit strategy for those that wanted to get out of the stock at a higher price, and we, of course, didnít tender our shares because we felt the company itself was very worthwhile holding. Management has reduced outstanding shares now down to about 5 million. For every dollar worth of earnings that they earn for their shareholders, weíve increased our relative ownership of those earnings in a large way over the past 18 months.

Any others you want to mention?

Mity Enterprises (MITY), another Utah company, makes tables and chairs, which is about the most mundane thing. But they operate in a relatively stable industry where the dynamics of that industry donít change a lot. And Mity has a habit of making about twice as much money as their competitors do. If you examine their financial statements youíll see they have no debt on their balance sheet, so theyíre in a better capital position than their competitors, and on top of that they have an extremely talented shareholder-friendly management. Itís a dream to own. The stock price hasnít performed probably as well as the rest of our portfolio, but that just indicates it remains a good value.

Are prices in micro caps, in general, getting overvalued?

Weíre certainly not finding as many values as we did 18 months ago when micro caps were overly neglected. But there are still pockets of value weíre finding out there.

I think weíre still in an environment that favors this asset class and I think weíll continue to be only because itís easier for a company thatís $100 million in total market cap to double, triple or quadruple in size than it is for an Intel or a Microsoft or a General Electric. I mean, the math just works better for these small companies. So youíll continue to see strong performance from micro-cap stocks, but I think that selection is now at a premium. You really have to be careful about which ones youíre purchasing. But the fact that there are so many more of them ? there are 6,000 of them ? gives you the opportunity to actually find some of these values.

Any parting shots?

One thing weíre finding as we try to raise institutional money is that people donít tend to define micro caps as a separate asset class that they allocate a lot of money to. They look at the Ibbotson Associates chart -- a very famous chart showing the returns of large company stocks, small company stocks, government bonds, T-bills and inflation since the Great Depression ? and notice that small company stocks over time have outperformed large company stocks. But they donít realize that the small-company stocks tracked by Ibbotson are actually representative of micro caps and not the traditional Russell 2000 stocks.

In fact, towards the latter stages of this chart, the index used to represent small-company stocks is actually the DFA Micro-Cap Fund. So thatís a common misperception. This means thereís lot of people out there making allocations to small caps based upon the traditional idea of small-cap outperformance, when really they need a representation of micro caps because thatís actually what all this research is based on.