Idea Brunch #2 with Lawrence Creatura of PRSPCTV Capital

Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Lawrence Creatura!

Lawrence is the managing partner of PRSPCTV Capital, a long/short equity fund that he founded in 2016. Before that, Lawrence was a portfolio manager at Federated Investors and Clover Capital for 20 years. Lawrence is also the author of Long and Short: Confessions of a Portfolio Manager: Stock Market Wisdom for Investors and was previously featured on Idea Brunch back in October 2021.

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Lawrence, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and why you decided to launch PRSPCTV Capital?

Hi Edwin, thank you for having me on Sunday’s Idea Brunch.  I began my professional career as an optical engineer in Australia, designing CO2 surgical lasers.  I decided to transition to finance via business school, which, looking back, was a hasty decision because at the time I didn’t know the difference between a stock and a bond.

Fast forward three years, and I was given the opportunity to incept a mutual fund with $650k of seed capital.  Eventually, this strategy grew to greater than $1.6 billion, and along the way I had an opportunity to meet and work with many very smart, creative members of our industry.  Over a 20-year period, I had a chance to conduct research in every economic sector and manage several different investment styles and strategies.

I also made a lot of mistakes, and I believe that this has given me some domain expertise which is now very valuable.  Simultaneously I know that the stock market is not a deterministic system.  We are not baking a cake with a fixed recipe.  The research requirements of our industry can shift and change over time.  For this reason, my market education continues every day, which is a gentle way of saying that I still make mistakes…

There is a very big change that is occurring in the market structure right now.  When I entered the industry, the vast majority of equity allocation was active, and fundamentally driven. Human market participants propelled prices toward their correct levels.  This was the mechanism that pushed the market toward efficiency.  The first passive ETF, the SPY, began in 1993, and since then the passive industry has never looked back.  Some estimate that passives now control greater than 60% of equity assets.  On top of this, it is estimated that quantitative funds control approximately 20% of equity assets. So that’s 80% of all equity assets.  The reason these strategies were able to succeed is because the previous system – with humans making the allocation decisions – had error in it, and because the new passive/quant systems were a smaller percentage of market activity, so they could take advantage of that error.

But now these systems are the market.  They dominate the equity ecosystem, and just like the old human system, they have some shortcomings too.  Specifically, they can only use information that has been quantized.  Also, they can only integrate real-time and historical data, and for this reason have trouble looking forward.

We think a gap has been created where forward-looking, qualitative inputs are not being correctly priced.  PRSPCTV Capital was created to take advantage of this gap. 

You have had over 10,000 conversations with small-cap management teams in your career. What do you look for in these meetings? Are there any common red flags or positive signs you have noticed over the years?

The red flags are easiest to describe.  Arrogance. Toupees. Personal residence in a different city than company headquarters. Excess jewelry, or bling in general. Moustaches. Cosmetic surgery. Anyone who gives you a Tchotchke.  None of these individually is enough to push the ejector-seat button, but there is information in these attributes.

Another red flag is a C-level type who won’t answer a question. Oftentimes it will sound something like “What we do is standard industry practice,” or “Let me put it in a simpler way for you,” or “Our auditors are comfortable with this treatment.”  Sometimes when you ask a particularly good question, they just get angry.  (“Why would you ask that?  Let’s move on!”)  All of these “answers” are really non-answers, and red flags.

Positive signs are tougher to spot.  The problem is that the CEO is not a person who has been chosen at random.  Instead, they are at the top of the org chart because they have survived a Darwinian battle of ascendency, and they have succeeded at this exactly because they are Olympic-level communicators.  Good CEOs tell stories in a charming, intoxicating way.  Their optimism can be infectious… And dangerous. 

If you have a history of observing a management team, one dependable positive sign is a change in disposition.  Being the CFO of a public company can be a stressful, joyless slog.  But if you ever see a grouchy CFO smiling, take heed.  Tone, word selection, and body-English matter.  You might spot the change at a conference or during an earnings call.  During an in-person meeting, it can be entirely non-verbal.  This can be more of a Spidey-sense thing, but you should not ignore it.

Frustration can be another positive sign.  Sometimes a management team feels like they have been putting up good results, but investors aren’t recognizing and rewarding the company’s stock.  This annoys them, and in the past we have heard multiple CEOs say things like “I just don’t get it” or “This is stupid” when referring to their own share price.  Some start buying their own stock out of pure anger. 

The reality is often that these managers have been improving results, and are continuing to improve, but the financial statements aren’t showing the full effect yet.  As time passes, investors can gain visibility of the underlying change, and price the stock accordingly.

You mentioned to me recently that now is one of the best times ever to be an investor in small-cap stocks. Why is that?

There have been three major small company valuation dislocations in the last 40 years:  The 1974 “Nifty Fifty” era, the 2000 dot com bubble, and 2020’s coronavirus pandemic.  The fourth one is happening right now.

Although I wasn’t around for the 1974 event, I did manage small-cap assets during the other two, and those periods were remarkably similar to today.  During these periods the market narrows, and a small number of mega-cap companies begin to dominate.  The market becomes like a pyramid, with the smaller number of large companies at the top of the pyramid driving benchmark returns higher, while the many names lower in the pyramid lag behind.  At the bottom of the pyramid are the small capitalization companies, and these post the worst relative performance.  As this happens, the smaller companies also become relatively very inexpensive. This is exactly what is happening today.

What is really important to recognize is that this narrowing is driven by emotion and capital flows.  The true nature of the smaller companies hasn’t really changed at all. 

When this reverses it can be very dramatic.  The lack of liquidity in small-caps now begins to work in reverse as investors reallocate back from large to small, but there isn’t enough capacity to take on this new capital without impacting price.  If investors were to shift 1% of Apple’s current capitalization toward other companies, that would be a $28 billion shift.  But the median market cap of a Russell 2000 stock is only $970 million.  It’s like pouring water from buckets into shot glasses — even minor reallocations can move small-cap share prices suddenly higher.  In past cycles, just as it took years to build the valuation imbalance, it took years to unwind it, and smaller companies outperformed for an extended period of time. Although the timing is uncertain, we think small-caps may be setting up for a similar period today.

Years in the future, today’s market will be recalled as the FANGM era.  In past similar moments, the mega-cap darlings were called “one-decision” stocks, and some of the names are still familiar:  IBM, Cisco, Eastman Kodak, and General Electric.  Today’s “one-decision” stocks are excellent companies, but perhaps less-excellent stocks at current valuations.  In contrast, there are many excellent, growing, relatively inexpensive smaller companies in today's market, and we think it is a very good time to have a look at these.

What is an interesting idea on your radar now?

Let me first say that this is not investment advice and that everyone should be sure to do their own research.

The Children’s Place (NASDAQ: PLCE — $290 million) is a company that we are very interested in right now.  People “look-off” this stock very quickly, and I have actually had several investors audibly groan when I mentioned the company name to them.  Everybody has their mind made up:  This is a dying brick-and-mortar retailer on its way to the mall-hallway graveyard along with Sears, Francesca’s, Men’s Wearhouse, Dress Barn, Charlotte Russe, and Pier 1.

We think that perspective is wrong.