D³ focuses on micro-caps for four reasons.  First, although the large cap segment of the market obtains and processes information so efficiently that it is hard to beat large cap indices, micro-caps remain an island of informational imperfection where insightful stock picking can produce sustained superior performance. This is possible because most micro-caps are not well followed by securities analysts, if at all. Trading volumes in, and investment banking for, micro-caps are not lucrative enough to command Wall Street’s attention. Therefore, a diligent micro-cap investor may develop sufficient insight to outperform the market.

D³’s performance demonstrates that good analysis of micro-caps, combined with contrarian instincts, a time horizon five years longer than Wall Street’s, and a constructive activist approach, can produce superior results in this under-followed niche:  In the five years ending December 31, 2007, D³ investors gained an annualized 23.4% per year, net of management fees and carried interest.  By comparison, D³’s benchmarks, the Russell 2000 (the index for small and micro-cap companies) gained 16.25% annually during the same period, and the S&P 500 Index gained 12.8% annually (all numbers are total return).  Moreover, during the 2000-2002 market debacle, D³ gained a total of 25.3% while the Russell dropped 24.1% and the S&P 500 fell 36%. Over the past ten years, D³ has gained an average of 17.2% per year.  The average annual ten year return for our benchmarks was less than half of ours:  only 5.9% on the S&P and 7.1% on the Russell 2000.

The second reason for D³’s micro-cap focus is that academic analysis shows that small company stocks on average outperform large stocks by one percentage point per year.  This may result from the informational imperfections just discussed or perhaps because it may be easier for small businesses to grow faster than large ones.

The third reason we focus on micro-caps is for better access to senior management and boards of directors. Because we believe that a thorough evaluation of people, process, and governance is as important as quantitative financial and competitive analysis, we insist on interviewing management and directors before investing.  When one manages only $650 million (the current size of the D³ funds), allocated among 10 core investments, it is difficult to gain private access to senior executives of large cap companies; a $65 million investment by D³ is simply too small to warrant their time.  But the CEO, CFO, or board chair of a micro-cap, by contrast, are accessible because D³ typically would be among their largest   investors.  On average D³ owns approximately 10% of each portfolio company today.

Fourth, D³ focuses on micro-caps because our typical investment usually makes us large enough to defend or advance shareholder interests.  The fund can catalyze the sale of an underperforming company; instigate changes in management, strategy or governance; or fight attempts to shortchange shareholders. Using general partner David Nierenberg’s training as a lawyer, and his experience as a management consultant, venture capitalist, and corporate director, and the experiences of our three other general partners, the fund has played an activist role successfully on many occasions. While we do not seek to be active all the time, we do not shirk persuasion, disagreement, or even confrontation.  We prefer friendly, constructive persuasion.  That is our normal mode of engagement.

Within the micro-cap segment D³ is a growth-at-the-right-price (GARP) investor.  This means that D³ invests in growth companies but only at low valuations.   An example might be a 15-20% grower, with extra cash on its balance sheet, bought at a forward net price-earnings ratio of only eight because the company missed a quarter or because investors disliked or misunderstood its industry. Studies have demonstrated that value investing outperforms growth investing by three to four percentage points per year.  Being a GARP investor enables us to position our portfolio opportunistically along the growth-value spectrum, wherever we find the optimal balance of reward and risk.  At this time, for example, we are tilted towards undervalued growth because the growth style is regaining favor after seven years when markets favored value.    In 1999, conversely, we sold all our technology growth stocks, believing that they were too richly priced, and focused instead on deep value in other industries.  This explains our 2000-2002 gains.

D³’s portfolio is deliberately concentrated for two reasons relating to “return on time.”  First, it takes considerable time to learn enough about a company, its people, and its industry to develop and maintain a proprietary level of “insight information” relative to other market participants. Second, when we seek to influence our portfolio companies, our efforts can consume substantial time.  (This illustrates why most professional investors, who have far more investments than we do, cannot influence their companies.)  A good model for the optimal size of the D³ portfolio therefore might be that of a professional director:  one may know and do enough to be effective on 10 boards, but certainly not 30 or 100.