Idea Brunch with Dave Waters of Alluvial Capital

Uncovering Obscure and Unusual Microcaps

Welcome to Sunday’s Idea Brunch, a weekly interview series with underfollowed investors and emerging managers. We are very excited to interview Dave Waters!

Dave is the chief investment officer of Alluvial Capital Management, a microcap-focused investment firm he launched in 2014 with ~$3 million in AUM. Before launching Alluvial, Dave worked as an analyst at BNY Mellon. Since launching a limited partnership in 2017, Alluvial Capital has achieved a cumulative return of 122% net of fees, compared to 57% for the Russell MicroCap Index. Today, Alluvial manages nearly $50 million in client capital. Dave also occasionally writes about his microcap ideas and stock market oddities on his blog.

Dave, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background, why you decided to launch Alluvial Capital, and your love for obscure microcaps and other securities?

Happy to participate! My background is definitely unusual in the fund management world. I grew up in rural Northwestern Pennsylvania, smack in the middle of the Allegheny National Forest. I mean rural, as in 40 miles to a Wal-Mart, no stoplights, more deer than people rural. Nobody I knew had much money, let alone a stock portfolio. But I caught the investing bug anyway. I discovered the stock market when I was 13 or 14 and I was immediately fascinated. The idea that you could buy some mysterious intangible called a “stock” and someday sell it to somebody else for more money was astonishing to me.

I have always been interested in the obscure and the unusual. As a kid I would spend hours in the woods looking for strange bugs, digging up artifacts like arrowheads and antique bottles, and exploring abandoned barns and cabins. In my early 20s I would spend hours walking every side street and alley of my city neighborhood. I would scour thrift stores looking for unique vinyl records and books. I am intensely curious, and I love learning facts that most would find mundane or tedious. (I have learned to avoid sharing most of these at social functions.)

Given my place of origin and my interests, it makes all the sense in the world that my investing would focus on the same. In stints at a couple of large wealth management firms, I quickly realized they had zero interest in anything outside the ordinary. And why should they? To them, anything besides large-cap blue-chip stocks meant one thing: risk! But I knew I wanted to spend my career digging up ideas from the market’s forgotten and overlooked niches. In 2012, I began writing about the incredible bargains I was finding in the OTC Markets. It was an auspicious time. Investors were still terrified of a Financial Crisis “echo” and many OTC stocks were trading at single-digit multiples. It didn’t take long for my writing to gain an audience, and then the inquiries began. “You are really digging up some great stuff. Nobody else is talking about this. I have some money I’d like you to manage if you’re interested.” Once that happened a dozen times or so, I decided to give it a go. I was 27 with few responsibilities. I knew that if I didn’t make the attempt, I would always regret it. So, I launched an RIA in early 2014 with a handful of clients and just a few million in AUM. And now, here I am!

I am known as a microcap investor, but I want to be clear that I take an expansive view of exactly what a “microcap” is. To me, any security that escapes the market’s notice, exhibiting low trading volume and garnering no attention from brokers or larger funds, is effectively a microcap. There are European companies with hundreds of millions in revenue that trade a few thousand shares a day because of a low float or a listing on an inactive exchange. The “investable” portion of these companies’ shares may be worth only a few tens of millions or less, not so different from some $50 million market value American company. These relatively large companies are often priced just as inefficiently as their minuscule microcap peers, so I gladly buy these securities.

I suppose I am actually an investor in “off-the-run” and less liquid securities, no matter what the reason for that obscurity and illiquidity. But admittedly, their small size is perhaps the most common reason, so I don’t mind the “microcap investor” moniker.

Microcaps are often a starting point for new and small investors. What are some of the common mistakes you see other microcap investors make? Any advice for those who are interested in investing in microcaps?

Investing in microcaps is not a panacea. Just because a company is tiny does not mean it automatically has greater return potential than a mid-sized or gigantic peer. Frankly, the great majority of micro-cap companies will ultimately produce below-market returns for their shareholders. I get frustrated when I see some touting microcaps as a means of generating superior returns without mentioning the risks. The risks are real! Most microcap companies have limited access to capital. Many are dependent on a limited number of customers and suppliers. Management can be clueless at best, predatory at worst. None of these risks are unique to microcaps, but they are significantly more prevalent in the segment.

When considering any microcap security, I like to ask two questions. 1. Why is this company so small? and 2. Why is this company public? If a company has been around for several years but still struggles to generate growth and profits, perhaps something about the company is fundamentally flawed. Similarly, private equity and larger companies routinely snap up smaller companies to bolster their growth or earn a financial return. Why hasn’t anyone bought this company? Could be because it’s not worth buying…

Investing in microcaps is not for most. It requires the time and patience to wade through hundreds upon hundreds of low-quality companies looking for that one opportunity, and the conviction to act when you find it. Patience and a tolerance for frustration are also musts. I can’t tell you how many times I have done all the work and found a great stock, only to watch it sit there or decline because the market doesn’t know and doesn’t care.

Anyone who wants to invest in microcaps should be prepared to invest a lot of time, energy, and mental bandwidth, and to lose money in many and sundry ways. I’ve made a lot of mistakes. Each one was a lesson, and each time I tell myself my next mistake it will be a brand new one, not a rehash of one from the past. I have been successful in that. But there will be more!

About 35% of your investments are in European microcaps. Why go to Europe to look for ideas when there are plenty of candidates in the U.S.? Also, in your most recent investor letter, you said Poland’s stock market “offers an embarrassment of riches” and Alluvial has 7% of its assets invested in the country. Why is Poland a great hunting ground for investors?

Smaller companies with less liquid shares tend to be less efficiently priced than large companies with liquid shares. Not a terribly controversial statement, right? Well, it goes triple in Europe and other markets where there are even fewer funds and sophisticated individual investors looking for value. In the US, even the most obscure stocks and securities have somebody paying attention, even if it’s just me and a couple of my other eccentric investor friends. But I very frequently stumble across European microcaps where I genuinely seem to be the only investor who cares. There isn’t a single blog post, forum thread, newspaper article, or company press release to be found. The investors are out there, of course. Somebody owns the shares. But whoever they are, they are silent and disengaged. The market environment around these companies feels like a desert scene from an old Bugs Bunny cartoon. Quiet. Sand dunes, a lonely saguaro, a tumbleweed bouncing past. Many of these companies are bound to remain in obscurity. However, when you find one of these companies that is making all the right moves, amazing things can happen. Slowly, the market wakes up to their existence. Liquidity arrives and the company’s valuation soars. If you can buy when nobody’s interested and sell when everybody is, you will do very well. That’s why I invest in Europe.

I am a proud Pittsburgher. It’s a wonderful city. But ask an outsider what they think of when they hear “Pittsburgh,” and you might get something like “Unemployed steelworkers. Smoke, smog, and rust. Uh, fries on salads?” But it’s not true at all! Except for the fries. That part is true. Point is, perceptions tend to lag reality. When many investors think of European markets, they think of slow economic growth, high unemployment, stifling bureaucracy, and resistance to innovation. But the truth is several European countries have managed to create dynamic exchanges for small, growing companies. US regulations and costs make going public an unattractive proposition for small American companies, one reason why there are far fewer small public companies than in previous decades. But nations like Sweden, Italy, and Poland have managed to grow the numbers of small public companies through intelligent regulatory relief and tax incentives. Some of these companies offer astounding value! For example, we managed to invest in Intred SpA in Italy shortly after its IPO. We paid just 4x trailing cash flow. Now, 3 years and 500% later, the stock is just getting started.

I think Poland is the new Italy. I see the same opportunities in small Polish companies that I saw in Italy a few years back. There are companies growing revenues at 15-20%, with stellar returns on capital and net balance sheet cash, trading at 6-8x earnings. Yes, there are risks. Currency, political, etc. But if you choose your investments carefully, these are risks you paid handsomely to accept.

What are two or three interesting ideas on your radar now?

My top holding is P10 Inc (NYSE: PX — $1.47 billion).