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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 in a meaningful and persistent way.
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, off smaller bases, 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 $450 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 $45 million investment by D3 is simply too small to call on 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 experiences as a management consultant, venture capitalist, and corporate director, and the experiences of our two other general partners, the fund has constructively engaged with portfolio companies on many occasions. While we do not seek to engage all the time, we do not shirk persuasion, disagreement, or even occasional confrontation. But we strongly prefer friendly, constructive persuasion, acting as long term partners with capable executives and boards.
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 when they trade 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 between reward and risk.
D3’s portfolio is deliberately concentrated for two reasons, both 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 usually 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.
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