Idea Brunch with Michael Wright of Kehlet Capital
Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Michael Wright!
Michael is the Founder and Portfolio Manager of Kehlet Capital Management, a concentrated microcap fund focused on finding long-term compounders. Before launching Kehlet Capital, Michael worked as an Equity Research Analyst at Bares Capital Management, served as Portfolio Manager for the MBA Investment Fund at the University of Texas, and worked as an Engineer for Owens Corning and H.E.B. He received an MBA from the Texas McCombs School of Business with a concentration in Investment Management and is a CFA charterholder.
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 Kehlet Capital?
Sure. Thanks for having me, Edwin. So, my fascination with the stock market began at a young age. I remember in eighth grade when Yahoo! had its IPO. After school, I would log on to AOL and find chatrooms to talk with people about the stock. However, I never thought of investing as a career and instead chose to study mechanical engineering in college. After graduation, I worked as an engineer for six years, but my affinity for investing remained, and I would frequently travel to Omaha to attend the Berkshire Hathaway shareholders' meetings. Eventually, I decided to go back to school to get an MBA. While there, I applied to be on the student-run MBA Investment Fund, which actively managed $14 million.
Being on the fund opened a lot of doors for me. It allowed me to take investing courses that would have otherwise been unavailable. It gave me real-world experience managing money and evaluating companies. It also introduced me to fantastic professors, one of whom would help me land an internship as an Equity Research Analyst. The internship eventually led to a job offer. It was a fantastic opportunity that allowed me to do what I loved - research small and microcap stocks - while learning from one of the most respected small and microcap fund managers in the industry. But things got off to a rocky start. The fund underperformed its benchmark, my portfolio manager and I did not see eye to eye on which investments were appropriate, and my personality didn't mesh with a few people at the firm. After three years, I was fired.
At that point, I had to consider my options: 1) I could find another job, which would provide financial security but likely require some sacrificing of my investing principles, or 2) I could start my own fund, which would entail significantly more risk, but allow me to invest the way I saw fit. At the time, I had built up modest savings, knew a handful of family and friends willing to back me, and had an amazingly supportive wife. I decided to bet on myself and start Kehlet Capital Management.
Your website emphasizes that Kehlet does “deep boots-on-the-ground research.” What are some examples of what that deep research looks like?
Boots-on-the-ground research can look very different depending on the company I’m studying and the problem I’m trying to solve.
For example, with FONAR Corp (NASDAQ: FONR — $109 million), an MRI diagnostic imaging company, the main concern was declining reimbursement rates. At the time of my analysis, a large portion of the company’s revenue was paid through no-fault insurance and workers' compensation plans out of New York. I did some digging and found a proposal to update the medical fee schedule for these plans. I spent a couple hundred dollars to order both the proposed fee schedule and the one currently in use. After receiving two large binders in the mail, my wife, a registered nurse, helped me sort through the CPT codes to determine the proposed rate changes for various MRI procedures. On average, they were set to increase by 10 – 15%. The analysis convinced me that the company would continue growing and helped solidify my investment thesis.
With Wrap Technologies (NASDAQ: WRAP — $75 million), a public safety technology company that manufactures and sells a handheld device called the BolaWrap, I wanted to know if the device worked as advertised and how well police officers (the customers) were receiving it. I watched hours of bodycam footage online as well as several interviews with law enforcement and eventually flew to the company’s headquarters in Arizona to get “wrapped” myself. About a month later, I sat in on a sales presentation to a local police department. The event gave me a better understanding of the sales process and allowed me to hear directly from officers about their experiences with the device.
With Simulations Plus (NASDAQ: SLP — $933 million), a software and consulting services provider for pharmaceutical and chemical research, the fund had owned the stock for a while. I wanted to stay updated on any changes happening at the company. I followed the business on Twitter and discovered it would be at an industry conference in my town. I contacted Investor Relations, asked if I could attend, and acquired a ticket. At the gathering, I spoke with the CEO, one of the heads of a division, and several of the company's software customers. I also got to preview the latest software update.
With a handful of other companies I’ve researched, I’ve had questions for management I need answered but found it difficult to get a response. On several occasions, I've bought shares in the company’s stock and flown to the annual shareholders meeting. Often, I’m one of the only professional asset managers in attendance.
You reportedly built a stock screening tool from scratch to help with generating ideas. Can you please tell us a little about that and how you filter through your investment universe?
Until recently, the way I searched for ideas was entirely qualitative. Though screening tools for quantitative analysis were readily available online or through third-party software vendors, in my experience, they had two problems: 1) The data was often wrong or improperly adjusted, and 2) the screens were not flexible enough for my needs. In other words, they didn't allow me to screen metrics and ratios how I wanted. However, after reading "Artificially Human" by Robert Whiteman, which discussed the relationship between machine labor, artificial intelligence, and humans, I was convinced I needed to learn to code. I signed up for an online course in Python programming, started experimenting with the SEC's API, and realized I could improve several KCM processes. Motivated by this realization, I spent the next six months creating a customized screening tool, significantly enhancing my ability to find new ideas.
Quantitatively, I look for companies that invest a significant amount of capital at high rates of return. Qualitatively, these are typically businesses that:
Provide a strong value proposition to customers.
Have a defensible competitive advantage.
Are led by a solid management team.
Have meaningful growth opportunities.
Trade at a reasonable price
Though qualitative research has the advantage of being forward-looking, it is extremely slow since it requires reading documents, asking questions, and thinking deeply about a business. On the other hand, quantitative research is lightning fast since it can be automated with computers but backward-looking. So, when I'm searching for new ideas, I try to incorporate the best of both worlds.
Michael, what are some of the first things you do when researching a potential investment? What does that first hour of research look like for you? Do you do anything that few others do?
Typically, this process starts with an investor presentation and the most recent annual report. Initially, I try to understand what products and services drive most of the company's revenue and earnings and why customers purchase them from the company instead of elsewhere. If everything checks out, I’ll review the proxy statement to learn about the management team and the board of directors, how well their incentives align with shareholders, and how relevant their experience is to their current role. Next, I’ll listen to the last three or four earnings calls to better understand management and the business's current issues. If everything still looks good, I’ll schedule a call with management and investor relations to fill in any blanks from my initial research. Generally, this means gaining a better understanding of the competitive environment, the company's competitive advantages, and future growth opportunities.
At this point, I can filter out about 98% - 99% of the ideas I look at. But, for the 1% - 2% of businesses that remain, I’ll turn my attention from information gathering to verification. Despite having a solid understanding of the business and the investment thesis, my source of information has primarily been the company itself. However, companies often paint the rosiest picture possible rather than the one that best portrays reality. So, it’s essential to confirm or deny the thesis by finding less biased sources of information – customers, suppliers, competitors, former employees, etc. This is where the boots-on-the-ground research I spoke about earlier comes into play. It's probably the most challenging part of the process but arguably the most important. Finally, if the company passes all the tests, I’ll run the stock through my valuation models, set a price target, and wait for an opportunity to buy.
What are some of your favorite off-the-beaten-path ideas today?
I’m excited to share two off-the-beaten-path small-cap ideas today!