A Massively Underpriced Small-Cap Deep Value Play

Premium Flagship Update

There are moments in this business when the tides go out so far that you can see the entire ocean floor. You can see every blemish and every abandoned boat anchor. You can also see the treasure chests that nobody has bothered to pry open.

We are in one of those moments right now in small-cap deep value. It is the kind of environment that rewards patience, cash, and the willingness to look in places the algorithms will not touch with a ten foot pole.

Most investors have abandoned the lower reaches of the market. They have convinced themselves that liquidity is the only protection against uncertainty and that the right place to hide is in the big names with large research coverage and comfortable narratives.

The small-cap world has been left to drift without sponsorship. The gap between perception and reality has become so wide that it creates exactly the type of asymmetric situations that I like to hunt.

When fear and neglect combine, they create price to tangible book ratios that do not make sense. They create enterprise value multiples that imply the business is in permanent decline even when cash flows remain healthy and balance sheets are solid. They create the type of bargains that Peter Cundill, Walter Schloss, Marty Whitman, and Ben Graham would have picked up by the handful.

Investing at this end of the market always demands a bankers mindset. Tangible book value matters. Cash matters. The ability to survive a hostile economic cycle matters. In a world obsessed with stories, I continue to focus on numbers.

When I can buy a profitable company with insider ownership, clean financials, and a simple business model for less than tangible book value, I know the market is giving me a gift. When I can find a company that generates consistent operating cash yet trades at five or six times enterprise value to earnings before interest and taxes, I know I am being paid to wait.

These opportunities are now everywhere in the small cap universe.

The United States is not the only place where mispricing has become absurd. Europe is quietly offering even deeper discounts to investors who think like bankers. The continent has dealt with years of slow growth, geopolitical anxiety, energy shocks, and a steady outflow of capital toward the United States. Sentiment toward European equities has never really recovered from the financial crisis.

The result is a market filled with small companies trading at half of book value, one third of book value, and in some cases below the cash on the balance sheet. There are profitable industrial companies in Germany and Italy priced as if they are on the verge of liquidation. There are specialty manufacturers in Scandinavia generating real free cash flow while trading for enterprise value to earnings before interest and taxes multiples that would have made Marty Whitman laugh out loud. There are French and British companies selling at valuations that assume no growth forever even though order books and backlogs remain healthy.

Europe is offering classic cigar butts, clean net nets, asset rich firms, and stubbornly profitable small companies that have been ignored for so long they have fallen completely out of institutional ownership. This is exactly the type of market where patient capital is rewarded.

But Japan may be the richest deep value universe of them all.

Let’s take a look at why, and at our new addition to the Small-Cap Deep Value Portfolio.