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An interview with Brian Bares
I’m a big admirer of the work Bares Capital Management (BCM) and its founder, Brian Bares, do when researching companies. And I know a couple of institutional investors that have spent more time with the firm and feel the same way.
The company has recently done something very interesting—they’ve launched a mutual fund. While mutual funds have become less popular, and many managers the size of BCM have made it harder for individual investors to invest with them, BCM has gone the other direction and launched BCM Focus Small/Micro-Cap Fund (ticker: BCSMX) that is accessible to just about everyone with an initial investment of $10,000.
But they’ve done it differently than most mutual funds. Instead of having a fund that is accessible through intermediaries like Schwab, Fidelity, etc., investors invest in the fund directly. This helps serve as a reinforcement for investors to think of their investment in BCSMX as a long-term commitment, and to create a long-term mindset that serves both the clients of a fund and the fund manager when dealing with the inevitable ups and downs of the stock market.
BCM has also created a hardbound Owner’s Manual that gets sent to new investors so that they understand the firm’s process and philosophy. In this interview with Brian Bares, we’ll discuss the new fund and some key aspects of how BCM manages investor capital.
Disclosure: The information and discussion in the interview below is for educational and entertainment purposes only, and is not a recommendation to buy or sell a security. Please do your own research before making an investment decision, or consult a qualified financial advisor. For further information and disclosures relating to the BCM Focus Funds, please refer to the Prospectus and Summary Prospectus for important information about the Fund, including investment objectives, risks, charges, fees, and expenses, which can be found on the firm’s website.
Let’s start with the why questions. Why a mutual fund? Why focus on small and micro-cap stocks? And why now?
Hi Joe, thanks. Smaller company stocks have been the focus of our firm since its founding over 23 years ago. Aside from some well-known benefits of participating in the space, like the return premium historically generated by the smallest 20% of the market and the relative lack of professional competition in the category, which we think can amplify the edge we seek with our qualitative research, the potential for growth of smaller companies can surpass that of the mega-cap names that currently make up a disproportionately large percentage of popular market indexes. These companies have surprised many of us given their size with the persistence of their growth in recent years, but as they measure their market cap in the trillions of dollars, it seems intuitive that matching their historical returns is going to be more difficult. We are trying to find the next set of compounders that currently reside in the small-cap and micro-cap space.
A conversation about the benefits of investing in smaller companies is reinforced in the current environment. The “why now?” question is related to relative valuation. While the market, as crudely measured by Price-to-Earnings, appears to be above historical norms, there is a substantial premium for large-cap names. In fact, mega-caps were trading in excess of 20x P/E coming into 2023, compared to a low-teens multiple for small-cap and micro-cap stocks. This is a valuation disparity that we haven’t seen in a long time. For the first time in almost two decades, we were finding high quality ideas trading at relatively low earnings multiples. It was almost as fruitful an environment as I witnessed in the early years of my firm after the dot-com bubble. So part of the “why?” question has to do with the environment and the opportunities we are seeing. Another part of the answer to the question is that our firm hasn’t had a commingled vehicle historically that would allow for investor access to our small/micro-cap strategy, especially those who weren’t accredited or who lacked access to some specialized funds we have managed.
We are acutely aware that the world doesn’t need another mutual fund. In fact, new fund launches under the ’40-act (the regulatory structure for investment companies in the US) have migrated away from the traditional open-ended mutual fund for years. Most fund sponsors opt for ETFs for a number of logistical reasons which have to do with ease of access and trading. Yet in small-cap and micro-cap stocks, the traditional open-ended mutual fund still makes counterintuitive sense for a number of nuanced – but critically important – reasons. First, our strategy is capacity limited. As assets in the fund accumulate, we are highly likely to limit new inflows to ensure that we do not sacrifice compounding potential. Staying sized flexibly to attack our opportunity set is paramount for our long-term success. Furthermore, our strategy is relatively concentrated. Our approximate target of 20-30 names means that staying flexibly sized will require limiting fund assets at lower levels than our peers who hold hundreds of names. A second reason for our structure is that we want our investors to have a daily tradable NAV that is used as a basis for fund transactions. Had we launched an ETF or a closed-end fund, there could be the potential for disparities between shareholder market transactions and our portfolio’s underlying net asset value. A traditional open-ended mutual fund is also available more broadly than a private partnership, which would typically require an accreditation attestation and limitations on the number of investors. With BCSMX (the ticker for our fund), an investor with $10,000 can put money with us by filling out simple account forms downloaded off our website, e-mailing them to our team, and completing a wire, ACH or check deposit.
Despite the sameness of the mutual fund world, we are actually trying to create a somewhat differentiated experience by avoiding some structural elements of our peers. We want an investment in BCSMX to “feel” like an investment in a private partnership. New investors receive a hardbound Owner’s Manual that articulates expectations, details BCSMX’s unique structure, and emphasizes our concentrated and qualitative investment approach. We try to write detailed communications to our investors about the underlying positions in the portfolio in a way that I think is more comprehensive than our peers. All of this activity is designed to induce a long-term partnership between the Fund and the investor. A long-term perspective in smaller companies is critical given that markets are volatile. It often requires patience over extended periods for per-share business value to be reflected in stock price. The emotions resulting from difficult short-term price declines can scare investors into dumping stocks and funds at the wrong time. Our hope is that by detailing our philosophy and process – why we own what we own – and setting proper expectations, we can mitigate capricious and counterproductive trading activity. We are also inviting direct investment with the Fund. Many investors obviously love the consolidation of their investments on an account statement from Fidelity or Schwab. But my opinion is that this ease of access enabled by technology investments by these firms (real-time stock quotes, portfolio values, and trade execution) has exacerbated emotionally driven transaction activity. Not only can this be counterproductive to the return objectives of the investor, but it can also be disruptive to other fund shareholders, who bear the cost of flows-related fund transactions. We don’t want to encourage disruptive flows into or out of BCSMX with the push-of-a-button capabilities of typical brokerage accounts. Direct investment with BCSMX is more likely to encourage the type of investor – and behavior – that patiently maximizes our collective chance for success.
A final structural note is that as of now, the principals of BCM are by far the largest investors in the BCSMX, paying the same fees as all investors and sharing a common destiny.
Our goal in the sea of sameness that is the open ended mutual fund universe is for our investors to participate in BCSMX as a capacity-limited and concentrated small- and micro-cap portfolio of potential compounders with an at-scale operating expense ratio that compares favorably with our category and with direct shareholders who understand our approach, embrace our philosophy, and who have a suitably small allocation of their portfolio invested with us.
A couple of things that I associate with your firm are a focus on ‘quality’ investing and a ‘boots-on-the-ground’ approach to performing due diligence. What does quality mean to you? And how does that boots-on-the-ground approach help you identify quality? To avoid discussing any current ideas, if you can give a past example from before the mutual fund was launched, where BCM's approach helped you identify a quality business early, that would also be helpful.
Sure. And you are correct that we seek qualitatively excellent companies. A first principle of public company common stock investing that we embrace is that stock price returns over the long term should follow internal compounding of business value per share. Absent dividends and distributions and multiple expansions and contractions, common stock prices should reflect business value compounding. If that is true, and we believe that it is, then it follows that the search for above-average stock price performance over the long term is really a search for above-average business compounding. And in a competitive economy, where supernormal returns on capital are typically competed away, it should be rare to find companies that are able to sustainably earn returns above their cost of capital. Our search is for the factors that could enable a company to outearn their cost of capital and keep competitive pressures at bay for extended periods. These factors are qualitative, and we think they generally coalesce around three categories: (1) “moats,” or competitive advantages enjoyed by a business, which may take the form of high customer switching costs, structural cost advantages, network effects or other forces that make life difficult for well-resourced competitors; (2) management, the people running the business, their incentives, ownership, operational execution, and capital allocation ability; and (3) growth, the future potential for the company through internal or external reinvestment of the capital their business generates. These factors are qualitative. We study the qualitative because the determinants of a businesses compounding value over time are qualitative.
Why aren’t other managers engaged in this activity like we are? I like to frame the discussion for people by telling them to imagine starting an investment management firm with the objective of investing in 20-30 small-cap stocks. The natural inclination is to look at an unwieldy dataset of thousands of small public companies with a blank stare. Where to start? An overwhelming number of managers begin by applying quantitative screening and filtering. I was a math major, and so I understand the inclination to apply ranking, sorting, filtering, and other formulas to whittle down the universe to something more manageable, especially given the ubiquity of information available. But there are a number of problems with this approach. The first is that any recipe for filtering or sorting is subject to competitive arbitrage in the marketplace. That is, well-resourced funds using advanced quantitative techniques have likely committed significant capital to just about all available screenable “alpha.” Second, many screens for the things we might care about, like Return on Equity for example, simply tell us what has happened in the past. And one of the fundamental challenges with public markets investing is that everything you know about a business – especially the accounting data – is in the past, but everything that determines the value of a business is in the future (equal to the present value sum of future cash flows). It has been somewhat helpful to us to identify exceptional ROE or ROIC categorically, which helps us understand if a particular industry consistently serves up meaningful qualitative exceptionalism to most industry participants. This has been the case for areas like precision instruments or software companies. But quant screening on backward-looking accounting data is, we think, like driving by looking through the rearview mirror. A final problem with attacking the sorting process in small-cap is that once a process is baked, it is difficult to change. Most managers have pitched their process to investors, which creates increasing inertia. As they grow their firms, they become locked in with quantitative elements of their process that may need to change as a dynamic marketplace renders much of it obsolete.
In our qualitative process, we feel like we have cracked a “chicken and egg” problem whereby methodically starting with “A” in small companies and getting to “Z”, which took us over eight years by the way, and by constantly renewing our understanding of the universe, we were able to amplify a comprehensive “go and see” approach through increasing asset-based resources. In short, we grew our firm enough to fund substantial research analyst efforts. Our team of researchers is continually on airplanes, in rental cars, attending trade shows, engaging in customer events, undertaking competitive analysis, and speaking with management teams and industry contacts in an effort to isolate the aspects of businesses that might indicate qualitative exceptionalism in the three categories I mentioned. This is the bulk of our work. And when we find a company that we think qualifies as one of the top businesses we have come across, contrasted against more than two decades of this work, then we present it internally with the intention of answering the question “Would we buy this business?” If the answer is “yes” then it internally goes on our Focus List of approved businesses for purchase and is then appraised by our team.
A final contrasting idea of quantitative versus qualitative investment processes is that many investors use market price as an input to their sorting and filtering. Common proxies of “cheapness” for many managers are factors such as price-to-earnings or EV-to-Adjusted EBITDA. By using these factors early in an idea isolation process, investors can end up with value traps in their portfolio. Our contention is that the market is reasonably efficient, and that a low P/E or EV/EBITDA is probably indicative of a business that is underearning on its capital base or is in some qualitatively important economic decline. In short, cheap stocks as measured by these factors in an efficient market are likely deservingly cheap. This is why we do not use price as an input to our process. We approve Focus List-quality businesses independent of price, and only then are they valued. Our buy discipline certainly contrasts our valuation with market price when we are constructing our portfolio, but to re-emphasize, market price isn’t an input to our meticulous process of vetting which companies are on-limits for potential purchase.
An example of a smaller company investment for us that was successful was Heska Corp., which was recently acquired by Mars. It is a veterinary diagnostics and imaging company with a compelling value proposition that allowed vets to essentially subsidize equipment purchases via follow-on consumables. This allowed them to compete successfully with much larger companies. Heska’s success was an “encore performance” by CEO Kevin Wilson, who had built and sold another company in the space to VCA Antech. The company checked all of our qualitative boxes with an aligned owner-operator, a suite of high-margin products with a unique go-to-market approach, and a large market being addressed with both internal innovation and thoughtful strategic acquisition.
Let’s jump to portfolio concentration next. Why do you believe a portfolio of approximately 20-25 stocks is a good number? How big of an individual position size would you consider having? And why do you plan to invest at least 25% of the portfolio in software and information technology services companies?
Great questions. To maintain the Fund’s status as an investment company, even with our election as a non-diversified fund, we must hold a minimum number of positions. Almost all existing research on portfolio diversification points to a declining marginal benefit of adding more positions to your portfolio. Research from a paper published in 1970 is commonly cited to reinforce the concept of being about 80% diversified after 8 stocks.* Newer research points to more like 20-30 positions to achieve this result.** Under ’40 Act rules, the most concentrated portfolio we could theoretically implement at cost is twelve stocks with ten 5% positions and two 25% positions. But rather than thinking about diversity as simply the number of stocks in a portfolio or exposures to various industries, we strive to consider what drives the fundamental value of the companies in our portfolio. Twelve regional bank stocks is clearly not a diversified portfolio. Yet, twelve software companies that have exposures to different geographies, industry verticals, customer types, go-to-market approaches, and capital allocation strategies may be adequately diversified. Furthermore, conglomerates may be a collection of businesses within one publicly traded stock, yet the underlying exposures are diverse enough to provide incremental specific risk reduction. We want to concentrate in our best ideas – eschewing asset raising for the sake of increased fees – while maintaining statistical diversity across a variety of fundamental value drivers. BCSMX will typically hold a conviction-weighted portfolio of between 20-30 positions. Our highest conviction weightings at cost might be 10-15% of the portfolio by weight, but a more typical position is 4%-7%.
We are also forthright in our recommendation that any allocation to BCSMX be a small part of an investor’s overall portfolio. An exclusive allocation to smaller company stocks shouldn’t be 100% of anyone’s portfolio, and so most investors will achieve overall portfolio diversity with exposure to other funds and investments, which obviates the need for our strategy to be excessively diversified.
The last important point here is that investment company regulations limit the industry exposure in mutual funds unless you make industry-specific elections. We have elected to focus on the Software and IT Services industries, which not only allows the fund to exceed the 25% threshold that applies to non-industry funds, but also mandates that we keep a minimum of 25% exposure to this category. As I mentioned before in my discussion about certain industries that naturally allow for exceptional returns on capital for most participants, the Software and IT Services industry group is a large subset of tech companies whose constituents often have attractive qualitative characteristics in our view and – importantly – service a disparate group of end markets and customers. The industry election for BCSMX allows for concentrated exposure to many of what we believe to be the most qualitatively exceptional businesses while maintaining the potential for fundamental portfolio diversity.
BCM tends to be more of a "buy and hold" investor. Can you talk a little about how the intersection of price and quality factors into your firm's buying and selling process?
Many of our peers blindly rank-order their portfolios on a price-to-intrinsic value basis. They will sell their positions when valuation gets to 100 cents on the dollar and buy when an idea is 60 cents on the dollar. This “sell the top and buy the bottom” sort rank implies a qualitative equivalence among positions that is simply not true. Appraisals do not adequately capture the qualitative differences among people and competitive advantages. There could be instances in our portfolio where a 60-cent-on-the-dollar appraisal compares unfavorably to a higher conviction company trading at 80-cents-on-the-dollar. We may rationally prefer the latter for purchase. So this qualitative conviction plays heavily into our process both when buying and selling. We are more apt to hold a business whose prospects are rosy, and whose management is aligned and acting rationally, and whose competitive entrenchment is unquestioned even when it trades above 100-cents on the dollar. Our experience is that appraisals tend to bounce around with changes in outlook, economic conditions, and competitive pressures. Furthermore, varying the quantitative inputs in an Excel spreadsheet can substantially change a point estimate of intrinsic value. We have also found that our reliance on estimates of intrinsic value tends to correlate with the predictability of the company’s free cash flow. For fast-growing companies accreting economic power in vast end markets with manifold pathways to reinvestment of company capital at exceptionally high rates, we are even more cognizant that our appraisal is simply a “ballpark” estimate. And if that is the case, then basing portfolio management decisions purely on a quantitative sort-rank strikes us as irrational.
As you state in the Owner's Manual, an ideal allocation for a potential investor in your fund would make up a small portion of that investor's overall portfolio due to the fund's concentrated exposure to a limited number of small-cap and micro-cap stocks. So if someone reading this does desire to make such an allocation, what's the process to make that direct investment in the fund?
People interested in the fund can visit bcmfocusfunds.com. There are instructions for direct investment on the website. Either downloading forms and e-mailing them to BCMProcessing@umb.com or clicking through on the website to set up an online application will provision a new account. From there, investors can send in a check, wire, or ACH to fund their account. If people have questions or need assistance in setting up an account, feel free to call us at 888-885-8859.
Thank you, Brian.
For those that would like to learn more about Brian and Bares Capital Management, be sure to check out the firm’s website at bcmfocusfunds.com. I’ve also enjoyed watching, reading, and learning from the following links during the last few years:
* Fisher, L. & Lorie, J. H. (1970). Some Studies of Variability of Returns on Investments in Common Stock. The Journal of Business
** Brealey, Myers, & Allen. “Introduction to Risk and Returns.” Principles of Corporate Finance, McGraw-Hill Irwin, 2011. p 169.