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[With over two decades of underperformance to their larger brethren, small-cap and micro-cap stocks are due for a deep dive review and reappraisal. This divergent performance has created significant relative valuation benefits and has opened up some compelling investment bargains in the small-cap stock universe. This may be a good time to rethink your overall portfolio asset allocation strategy.
To explore these markets more deeply, we were introduced to Eric Kuby Chief Investment Officer of North Star Investment Management – a Chicago-based investment and financial planning firm with family office services. While many money managers have focused their investment analysis on the larger complexities of the market and large-cap stocks, North Star built an expertise on applying a value lens to the intricacies of the small and micro-cap markets and developing non-traditional small-cap investment strategies.
Besides just having traditional exposure to the small-cap market, North Star seemed to keep finding other opportunities in that area of the market. Their small-cap North Star mutual fund investment line-up includes their Small-Cap Value Fund, Micro-Cap Fund, a small-cap focused Dividend Fund, and a Bond fund focusing on fixed-income investments primarily from small-cap companies with an equity capitalization of less than $2.5 billion. This specialized knowledge has also helped them shape their overall “micro to macro” investment approach in their more broad-based Opportunity Fund and separate account investment strategies.
We asked Eric questions to better understand their unique perspective on micro- and small-cap companies and how that informs their overall investment strategies.]
Hortz: Can you give us a brief overview of the micro-cap and small-cap marketplace from your vantage point? Are there any particular misconceptions about these markets that you feel investors should be aware of?
Kuby: The micro- and small-cap landscape remains some of the most overlooked but opportunity-rich areas of the public equity landscape. These companies operate across every industry, from logistics to specialty manufacturing to household name consumer brands. The universe of publicly traded small- and micro-cap companies is far larger than that of mid and large caps, yet most investors focus exclusively on those larger companies, particularly the mega cap darlings such as the “Magnificent 7”.
A common misconception is that small-caps are inherently more fragile or financially stretched. In reality, many small-cap companies we research have strong balance sheets with appropriate debt levels and disciplined capital allocation. Another myth is that small-caps operate only in obscure markets. Companies like Boot Barn (BOOT) and Build-A-Bear Workshop (BBW), or ABM Industries (ABM), are nationally recognized; others like Barrett Business Services (BBSI) and LSI Industries (LYTS) operate in large, growing markets that provide long runways for expansion.
Hortz: Can you share with us what led you to spend decades analyzing companies and developing investment strategies in these markets? What are the overriding benefits you see that focused you into the small- and micro-cap markets?
Kuby: My interest in investing started early. A close friend, mentor, and high-school basketball teammate first sparked my curiosity about the stock market – and specifically about small-cap investing. He was fixated on opportunities that exist in the less followed corners of the market.
A few years later when I was a student at business school, Rolf Banz of the University of Chicago published research pointing to a so-called “size effect.” The research showed that smaller-capitalization stocks in the US tended to have higher returns than larger-capitalization names. Additionally, my career progressed during the Warren Buffett and Benjamin Graham era, when value investing and bottom-up fundamental research were at the forefront of investment thinking. All those factors together shaped the framework for me as a small cap value investor. It has been four decades now, and whereas the methodology has evolved, the core principles remain the same.
Small- and micro-cap investing rewards hands-on research and allows you to develop a true informational edge. These companies often fly under the radar with little or zero Wall Street analyst coverage, yet many fit our framework of purchasing durable businesses with strong balance sheets, capable leadership, attractive long-term growth prospects, and reasonable valuations.
Our research team embodies somewhat of an entrepreneurial spirit. We build relationships with the management teams, ask detailed questions, and pursue ongoing conversations that inform our portfolio management process. With literally thousands of companies to evaluate, we are always learning something new anchored by our repeatable framework.
Hortz: How do you apply your value investing approach to these markets? Is there a meaningful differential in selecting companies in the micro-cap versus small-cap universe?
Kuby: The core principles do not change. We focus on quality companies with strong balance sheets, consistent and transparent cash flow, seasoned leadership, and attractive valuations. What does differ is the size of the universe and some level of inefficiency.
Particularly in the micro-cap space, inefficiencies abound. Information can be scarce, but this creates an opportunity for those willing to do the work. We require greater discounts to our expected values for the micro caps to compensate for the illiquidity challenges.
Hortz: Has the growth of private equity affected the dynamics of the micro- and small-cap investment markets?
Kuby: Private Equity has certainly changed the landscape. There is more competition for choice businesses, which has pushed buyout multiples higher in certain sectors (like services, technology, and healthcare), where recurring revenues, scalable platforms, and strong customer retention attract aggressive bidding.
Many small-caps grow through bolt-on or tuck-in M&A, targeting smaller private businesses to expand. PE buyers force higher deal multiples, but we remain confident in our portfolio companies’ long-term ability to identify accretive deals and practically deploy capital.
At the same time, many of our holdings have directly benefitted from strategic partnerships or joint ventures with private equity sponsors. We have seen this many times even in the last 6-12 months with companies like GATX and AZZ engaging in transactions that help fuel growth in creative ways.
Another important dynamic is that being a public company carries meaningful regulatory and financial costs. For many companies – especially in lower middle markets – reporting tasks, compliance requirements, and short-term performance pressures of public markets can be a strain. As a result, some companies choose simply to remain private, which has also contributed to the shrinking number of listed micro- and small-cap companies over time.
Hortz: What was it about the dividends and fixed-income instruments of small-cap stocks that made you integrate a large proportion of small-cap companies into your Dividend and Bond strategies?
Kuby: Many investors do not realize how many small-cap companies pay meaningful, sustainable dividends. When the Fed took interest rates down to near zero percent in response to the 2008 Financial Crisis, yield-oriented investors flocked to the large cap “Dividend Aristocrats” as an alternative to bonds.
We did a comprehensive study and identified a universe of small-cap dividend payers that offer attractive yields, strong free cash flow, and controlled payouts. It turns out that there are far more companies with market caps under $2.5 billion with those characteristics than those with larger market caps. From that universe we created the North Star Dividend Fund.
Beyond common dividends, many of our holdings are sophisticated users of the capital markets. We often see them issue attractive preferred shares, high-grade corporate bonds, or other hybrid securities. In essence, there are several ways investors can participate in high-quality small-cap businesses while diversifying income streams. This depth of capital market activity often goes underappreciated in the small-cap space, but it provides a valuable layer for income-oriented investors which we look to capitalize on in our North Star Bond Fund.
Hortz: Any companies you can discuss as good representative type of companies you look for in micro versus small cap markets?
Kuby: Here’ a few examples:
Acme United (ACU) is a great example, and one of our longest held positions (we have owned it since 2013). Acme operates in niche consumer and industrial markets with highly defendable positions, particularly in first aid, cutting tools (most notably the Westcott scissor brand), and other school/office supplies. The business itself is highly resilient, with over 100 years of operating history and steadily growing both organically and via tuck-in acquisitions, deepening relationships with major distributors and retailers and building market leadership in the first-aid space. They have introduced service elements of their business model through technology that automatically restocks first aid supplies for business customers, adding recurring revenue and customer stickiness.
Valuation remains attractive – shares trade at roughly 15x normalized earnings and 8x EV/EBITDA. Free cash flow is stable and has consistently funded acquisitions. Walter Johnson, the long-time CEO, owns 8% of the company. What has kept us invested for over a decade is consistency: simple business models, excellent stewardship of capital, diversified end markets, and a well-positioned balance sheet.
Westwood Holdings Group (WHG) is another micro-cap name we know particularly well because its core business model closely resembles our own business at North Star. WHG is a boutique asset manager with growing wealth management and institutional franchises with no debt and roughly $45 million in net cash.
Importantly, the business is inflecting positively across multiple fronts: 1) They successfully launched several alternative energy investment products, gaining strong traction with institutions and RIAs; 2), client retention is at an all-time high; and 3) the new account pipeline is robust with significant onboard activity underway.
Valuation is attractive as the stock trades at less than 0.7x AUM, 1.3x book value, and 10x free cash flow with insider ownership of 28%, including 5% personally held by the CEO. This provides strong alignment.
Postal Realty Trust (PSTL) is a small-cap REIT that exclusively owns and manages U.S. Postal Service-leased properties – a highly unique asset class. They own 1,720 properties with only one vacancy currently. The core attraction is the extremely stable tenant profile – the USPS operates strategic mission-critical facilities that are essential to maintaining nationwide logistics infrastructure. Lease payments represent less than 1.5% of the total USPS budget, a fact management consistently highlights when discussing potential policy risk under new administrations and why USPS facility leases are not likely to be meaningfully impacted by political changes.
In terms of growth, PSTL operates in a highly-fragmented market, creating a long runway for continued acquisitions while maintaining a low-leverage, predictable cash flow profile with newer and transitioning lease agreements being written with annual rent escalators, steadily improving embedded rent growth across the portfolio.
Financially, the balance sheet is in excellent shape with no maturities until 2027 and the average cost of debt being approximately 4.5%. The ~6.5% dividend yield is well-covered by AFFO, providing a stable and growing income stream for shareholders.
Cantaloupe Inc (CTLP) is a small-cap name where our thesis recently played out. CTLP provides payment processing software and hardware solutions for the unattended retail market (vending machines, kiosks, micro markets, etc.) where cashless adoption continues to expand. As part of a deliberate effort to add more technology exposure to our small-cap strategies, we added CTLP.
In February, reports emerged that Cantaloupe was exploring strategic alternatives which ultimately culminated in the agreement to be purchased by 365 Retail Markets for $11.20/share, almost a 34% premium to its trading price at the announcement. The takeout reflects the value of CTLP’s SaaS-like recurring revenue model, technology leadership, and growing leadership across multiple verticals.
Hortz: Does your expertise in the micro and small cap markets inform or provide a relative perspective that supports and benefits your overall “micro to macro” investment approach?
Kuby: We believe the deep research we do at the company level often gives us early insight into wider market themes. While many “all-cap” strategies technically include small caps, in practice, they tend to gravitate and weight analysis towards the more liquid, well-known names. Because we are willing to do the work, we often see emerging trends before they show up in the broader indices.
Hortz: Any thoughts or perspectives that you can share with investors about investing in the microcap and small cap markets at this juncture?
Kuby: We think this is a compelling time to allocate to small- and micro-caps. Balance sheets are strong, business fundamentals remain healthy, and we could be entering a period of moderating interest rates.
Historically, small caps have often outperformed coming out of periods of tighter monetary policy, particularly when investors begin looking for growth outside of the mega-cap FAANG trade or COW trade. For long-term investors willing to be selective, there are plenty of high-quality small-cap companies trading at compelling valuations today.
This article was originally published here and is republished on Wealthtender with permission.
About the Author
Bill Hortz
Founder Institute for Innovation Development
To make Wealthtender free for readers, we earn money from advertisers, including financial professionals and firms that pay to be featured. This creates a conflict of interest when we favor their promotion over others. Read our editorial policy and terms of service to learn more. Wealthtender is not a client of these financial services providers.
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