Idea Brunch with Michael Melby of Gate City Capital

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

Michael is the Founder and Portfolio Manager of Gate City Capital, a Chicago-based micro-cap fund he founded in June 2014. Before launching Gate City Capital, Michael worked as an analyst at Crystal Rock Capital and prior to that at the Notre Dame Investment Office and Deutsche Bank Securities. Gate City Capital is named after Michael’s hometown of Glendive “Gate City,” Montana and is up approximately tenfold since inception. 

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

Thank you very much for having me.  I grew up in Eastern Montana in a small town called Glendive.  Glendive was nicknamed the Gate City, and our firm’s name and logo pay homage to my hometown.  My father was a high school business teacher and did a lesson each semester on investing in the stock market.  This led to my initial interest in investing. 

I did my undergraduate studies at Notre Dame where I majored in Finance.  After graduating I worked at Deutsche Bank in their Debt Capital Markets group and later at the Notre Dame Investment Office, which manages the endowment assets for the University of Notre Dame.  I then returned to school to get my MBA at the University of Chicago Booth School of Business.  After business school, I worked as an equity Research Analyst for Crystal Rock Capital Management before launching Gate City Capital to outside investors. 

I launched Gate City Capital because I had conviction that an investment process of building a concentrated portfolio of deep-value microcap stocks could provide superior long-term returns to potential investment partners.  I had saved enough capital to ensure that I could both invest the majority of my net worth in Gate City Capital while also reserving enough cash to fund my business and personal expenses for a period of three years, even if no outside capital was raised.  This level of conservativism was designed to help me maintain a long-term investment time horizon and allowed me to be selective in choosing the right long-term investors. 

Today, the Gate City Capital team has four partners consisting of three research analysts (including myself) and a CFO/COO.  We manage a concentrated portfolio of micro-cap value companies that are located in the U.S. or Canada.  Our team looks for companies with clean balance sheets, an owned base of real assets, and that generate large amounts of free cash flow.  The margin of safety of each investment is also a focus, and we conduct a floor value analysis that estimates what the company would be worth in an orderly liquidation.  Gate City Capital looks to purchase companies that have at least 50% upside based on our discounted cash flow analysis while also trading at or below our floor value.  We target 15 companies in the portfolio and plan to hold our investments for a period of at least two years at the time of investing.  We are also committed to keeping our asset base small and have been closed to outside investors for several years. 

Both microcap and value strategies have not performed great over recent years, yet you have done phenomenally. What are the keys to success when it comes to deep-value microcap investing?

Over the last decade, both microcap and value investing strategies have generally underperformed the broader market.  I attribute this to the outsized positive performance of a handful of large technology companies, which have delivered stellar returns to their investors (and deservedly so).  Over a much longer time period, microcap value companies have handily outperformed all other equity investment styles.  It can be argued that due to the pace of technological change or other factors that this long-term outperformance of microcap value companies will disappear or reverse.  I expect microcap value to continue to outperform well into the future, as investors demand higher returns to invest in small, out-of-favor companies.  Investors that are willing to take that risk should be rewarded with additional long-term returns. 

I am pleased to have thus far delivered attractive absolute returns to our investment partners.  There are many different ways and processes for making money as an investor, and I think it is very important to stick to your perceived competitive advantages and what you do best.  For us, we have maintained our investment philosophy and process regardless of what has happened in the broader market.  I think our focus on margin of safety is one of the most important factors that differentiate us from our peers.  This includes generally avoiding companies with leveraged balance sheets and maintaining a strict discipline in valuation metrics.  The term “value trap” is often used to describe some of the pitfalls of value investing.  To me, it simply comes down to buying a company that does not have the value you thought it would.  The easiest way to avoid this is to not buy levered companies where forecasting errors can prove particularly painful.

You’ve mentioned that you always try to meet with management teams and even attend most company annual meetings. What are you looking for when meeting with management teams and attending annual meetings? Who are some of the operators you admire most in the small-cap space today?

We make it a priority to meet with company management at their place of business prior to making an investment.  When we meet with management, we are looking for three things: intelligence, work ethic, and integrity.  In board members, we are looking for independence and an alignment of interests.  Although we do not claim to be experts in any sector, we can observe a lot about a company, the management team, and its culture by being there in person.  This can include everything from the cleanliness of a facility, whether a company is thrifty or spendthrift, and the way management interacts with employees. 

In most cases, I think the interest we show regarding meeting in person is appreciated by management teams and reinforces both our status as long-term investors and our desire to be good partners to the companies we invest in.  The two primary critiques I hear about in-person visits include the time and expense associated with travel and the potential that an overly promotional management team can fool us.  It is my view that the personal relationships and contacts we have made through our travels provide significant long-term value to our firm, which increases in value each year.  While we are also susceptible to being tricked, our team members typically come away with similar opinions on management’s intelligence, integrity, and work ethic.  Without naming specific companies, we think top-performing management teams share these characteristics. 

In your great 2022 presentation at the MicroCap Summit, you said that one of your key investment tenets is to “Take the time to know the company – information is not free.” What did you mean by this?

It is interesting you picked up on this bullet point.  The investment tenet highlights that the information we obtain through our research process is valuable and can be utilized to make better investment decisions.  Additionally, the point indirectly highlights my view on the Efficient Market Hypotheses, which might come as a surprise to readers.  The Efficient Market Hypotheses basically states that all information is incorporated into stock prices, thus making both fundamental and technical analysis useless in predicting future stock prices.  In contrast to many fundamental investors, I am in basic agreement with the Efficient Market Hypothesis with the caveat that the market for information is also efficient.  Essentially, someone will only obtain information if they think it is in their best interest to obtain and utilize it.  I expect that many individuals do not believe that it is worth their time to obtain information on microcap stocks.  For sell-side analysts, many microcap companies provide little in the way of trading revenue or investment banking fees.  For many institutional investors, micro-cap companies are too small to have a meaningful on their portfolio.  Given our relatively small size and concentrated portfolio, I believe the information we gather through our research can provide value to our investors. 

What are some interesting ideas on your radar now?

I’m excited to share with your readers two unloved off-the-beaten-path small caps that we own today.