Idea Brunch with Nat Stewart of N.A.S. Capital

Finding ethical small-cap management teams, investing in MLPs, and uncovering hidden market gems

Welcome to Sunday’s Idea Brunch, your interview series with underfollowed investors and emerging managers. We are very excited to interview Nat Stewart!

Nat is a professional value investor focused on small-caps.  Nat is the author of Stock Picking, a Substack newsletter devoted to finding “hidden gems” overlooked by the market.  He also runs N.A.S. Capital, a Portsmouth, New Hampshire-based registered investment advisor (not accepting new clients). Nat is active on Twitter at @natstewart5.

Nat, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and your love for small-cap investing?

Sure.  I have been investing for close to 25 years, mostly focused on investing my personal and family's assets, which is still true today.  I have been an analyst and was fortunate to set up a special situation strategy at my prior employer.  However, to a large degree, I have mostly functioned as a self-funded prop trader or investor. 

My investing approach is self-taught through experience, including studying the legends such as Greenblatt, Buffett, Peter Lynch, and Soros - my book list is hardly unique!  Soros has some extremely useful lessons for value investors - that inclusion sometimes surprises people, but it is true.

Can you provide an example?

Sure.  Two lessons jump to mind.

First, the idea that stock prices are not just a passive reflection of value, but can themselves be a key fundamental that shapes future events.  At times this dynamic can create incredibly powerful, durable feedback loops.  This is my “value investor” description of what Soros calls reflexivity.  Investors who don’t get this idea (but instead expect stock prices to always revert to a passive reflection of value) can get into an enormous amount of trouble. 

Second, Soros’s dispassionate attitude towards taking losses and admitting mistakes.  The value of this idea is self-evident, so I won’t say much about it.  I have attempted to model his attitude in my own process (with varying degrees of success!)

Ok, so back to your story.  What got you interested in small-cap investing? 

Early on, I experimented with numerous investment styles.  In fact, I was setting up as a CTA (Commodity Trading Advisor) when I discovered value investing in small/micro-cap stocks.  

I don’t recall what got me started reading SEC filings, but it didn’t take me long to realize I could read 8-K filings that contained material disclosure that the market was completely ignoring.  I discovered that very few people actually read small company filings or spent serious time thinking about small public companies. 

The treasure hunt element of researching micro and small-cap stocks immediately fascinated me, and it still does today.  I love finding something the market doesn’t see yet, such as an under-appreciated business model, a beneficial corporate action, an executive change, or a new product launch that is catching fire.  

Where applicable, I love to do “boots on the ground” research and visit stores.  I will find the guy stacking products and ask about restocking rates.  Back when I was following LaCroix and it was an under-the-radar brand, this would drive my wife nuts.    

The small/micro-cap space includes many interesting characters.  I enjoy trying to interpret the actions of executives and board members through a different lens.

A concrete example of this would be my participation in a number of MLP buyout situations this year (BKEP, SRLP, SIRE, SHLX).  My variant view on the incentives was the single most important component of my analysis. 

There are literally tens of thousands of small caps and OTC-listed securities. What are your favorite ways to find new ideas? And what are the necessary ingredients for a great microcap investment?

Good question.  With small or micro-cap stocks it is as much about what you exclude as what you include.  For example, I avoid promoted stocks or highly speculative business models.  Just eliminating the BS stocks substantially cuts the universe. 

My largest source of my new ideas is my watchlist, which is something I have cultivated over a 10+ year period.   These are the stocks that I know well and have accumulated significant intellectual capital on.  I spend more time following my watchlist names than I do looking for “new” ideas.  I have found that this is a higher payoff, lower risk use of my time. 

As to my “top of the funnel” I don’t think what I do is unique.

I have a few screens with basic criteria and go down the list, exchange ideas with friends, read value-related websites and publications, and do searches on specific keywords or word combinations.  There are certain executives, investors, or M&A-focused companies that I follow. 

I look for companies with good core economics that are not widely understood or followed.   I mostly stick with companies that generate consistent operating profits, but not always.

For example, if a loss-making company has good gross margins, some type of potential moat, and is growing revenue, it can be a good setup.  In this situation, it is also critical that the company can build sales at a reasonable cost, over a reasonable time horizon.  I learned that lesson the hard way.

Another case would be the same setup (great gross margins, product with a moat) at a company that is underscale vs. competitors and doesn’t have good distribution (the negative case in the above example). 

In this case, management/board incentives and the initial price you pay matter tremendously.  If the key executives/board will make a windfall if the company is sold to a large competitor and you can buy the stock very cheap, it might be a good setup.  If a potential activist takes a position, it goes from “good” to compelling.   

Many small companies are known for poor governance, insider dealing, uneven treatment of shareholders, and ineffective leadership. Are there any small-cap CEOs that stand out to you as exceptionally strong or high integrity?

This is an awesome question.  The human side of investing is my favorite part to analyze and is something I spend a lot of time on. 

My framework here is that words matter very little, actions and behavior tell all.

One of the best things an investor in small/micro-cap companies can do is to go back and track executive/board decisions over time.  Look at share sales/purchases, look at any and all capital markets activity (equity issuance, etc), read an annual report from 5 or 10 years ago and notice what has changed.   

Small company proxy statements are very important and have been the source of some of my best ideas.  I always read them with the 10-K.

Ideally, I like to see the CEO really put themselves beside investors in terms of exposure.

A positive example of this would be when John Morgan became CEO of Winmark Corp (NASDAQ: WINA — $725 million).  He purchased 13% of the company and received one long-term options package.  He then continued to buy stock with his own funds for almost the entire duration of his time as CEO.  In my view, that kind of behavior is a tipoff that someone is worth investing beside. 

On the opposite side, if you want to find a value trap where management is going to destroy value and fleece shareholders, one of the best places to look is a micro/small cap company where management has a small economic stake, but maintains control through B shares. 

If you are looking at a controlled company, always check to see if they return capital when appropriate. I love to see a company with a track record of paying special dividends, doing tender offers for big chunks of stock, or both. 

Controlled companies that hoard cash and have no record of substantial capital return can be extremely annoying for micro and small-cap investors.  Absent some articulated plan, in my view, it often indicates that the company is not being run for the benefit of all shareholders.  

What are some interesting small-cap ideas on your radar now?

The first I will mention is Natural Resource Partners (NYSE: NRP — $543 million), an under-the-radar MLP that I believe is one of the most unique publicly traded commodity exposures in the world.