VIMCO solely focuses on one of the most inefficient asset classes among public markets – U.S. small capitalization companies. We search for opportunities strictly within our circle of competence, which excludes certain industries not conducive to our investment philosophy (i.e., industries that generally do not produce cash flow such as Biotech or whose fortunes are primarily determined by global macro forces such as E&P or most materials companies). We employ both quantitative screens and qualitative approaches to select candidates for further evaluation.
A critical component of our investment process is our research engine. A potential investment is subjected to a rigorous, detailed and team-oriented, in-house research evaluation, including an exhaustive review of all pertinent financial and operating documents, as well as thorough industry, competitive, customer and supplier analysis. Management evaluation is another key component of the investment process and is assessed through company visits, interviews, conferences and/or management calls. We invest only in companies run by management teams who we trust with our capital and who act in the owners’, and not their own, best interests. As a part of our comprehensive analysis, we build and stress test a meticulous and conservative model which results in an internal rate of return (IRR) calculation for each investment candidate. A unique feature of our company research is the creation of a “qualitative scorecard” in which a numerical value is assigned to each company based on seven qualitative factors. Each potential investment is assigned a proprietary classification category: compounder, discount-to-value, or special situation.
Consistent with our focus on downside protection, another member of the team then attempts to develop a short thesis in a quest to investigate any opposing viewpoints which must be discredited before investing. Strictly adhering to our process, only those companies which pass a threshold for IRR, possess attractive qualitative business characteristics and have minimum potential for permanent capital loss are considered for inclusion within the portfolio. A targeted weighting is determined by an assessment of the quantitative (i.e., the IRR) and qualitative “Scorecard” factors, as well as relative liquidity and correlation. We also consider the historical downside capture of the stock. Investments are continuously monitored for changes to the original thesis.
We refer to compounders as companies that compound their enterprise value over an extended period of time (years) through organic growth opportunities and the deployment of capital at attractive rates of return. Compounders exhibit the following characteristics: superior business models with massive and sustainable competitive advantages, secular growth drivers leading to above average long-term growth rates, generally stable, steadily increasing and visible earnings over a full business cycle, superior returns on invested capital with numerous opportunities for capital deployment, attractive cash conversion models, lower economic sensitivity and resistance against external shocks, less capital intensive, under-levered balance sheets and best-of-breed management teams. By investing in compounders, we expect to generate returns from increasing private market value as well as potential multiple expansion.
We view Discount-to-value companies as those that trade at significant current discounts to our assessment of their current private market value. These companies exhibit many of the same characteristics as compounders, but might have limited growth profiles (but are not secularly declining), greater economic sensitivity, higher earnings variability and lower returns on invested capital. We expect to generate returns mostly through multiple expansion.
Special situations are unique and complex investment opportunities stemming from extraordinary circumstances. These opportunities generally cannot be screened for, but are discovered through our deep knowledge and familiarity of the small cap investment universe. This category among others includes mergers and acquisitions, spin-offs, second-step conversions for banks, sum of the parts, emergence from bankruptcy and net asset value. Even special situations must have sound business models with sustainable competitive advantages, strong cash flow generation, under-levered balance sheets and solid management teams with rational capital allocation policies. We expect to generate returns from the market eventually recognizing the apparent value of the special situation.