Small Cap's Big Secret: A Conversation With A Private Equity Fund Manager, Part 2

Image courtesy of Verdad Fund Advisers.

This is the second half of a two-part interview. Click here to read part one.

Dan Rasmussen is a graduate of Stanford Business School, a former analyst with Bain Capital, the New York Times Bestselling author of "American Uprising: The Untold Story of America's Largest Slave Revolt," and the founder of the investment management firm Verdad Fund Advisers. In 2017, Rasmussen was named to the Forbes 30 Under 30 list.

However, Rasmussen might be best known for his analysis on private equity investment, which serves as the basis of Verdad's fund portfolio strategy.

Marketfy Maven Tim Melvin recently had the opportunity to speak with Rasmussen about the business and market patterns that inform his private equity investment strategy. Below is part two of their conversation, edited for length and clarity.

Tim Melvin: One other major advantage over private equity investors is the fact that a private equity investor is paying a very high hedge fund-like fee for participating in the fund. Both in the fund that you manage and as individual investors doing it on their own. That fee would not apply, would it?

Dan Rasmussen: That's right, and the studies of private equity fees that have been done by some researchers at the Harvard Business School said it is actually about 6 percent in aggregate over time. It is 2 percent management fee, 20 percent carry, plus all the deal monitoring and transaction fees the private equity firms charge. Relative to that, we charge a 1.5 percent management fee. Investors who understand the strategy can execute it themselves.

I think as Vanguard and John Bogle have amply shown, lower fees mean better returns for investors. The pitch that I make to a lot of institutional investors is quite simple. You can buy a set of companies for half the valuation, same percent leverage for 1.5 percent management fee and you do not have to lock up your capital and you are in the liquid public equity markets. That is really what we are trying to persuade investors. I think it is a pretty simple bet, and I am pretty confident I am going to win.

Melvin: Does this private equity replication approach work just here in the United States or can we take a more global view when using this strategy? 

Rasmussen: We take a global view. Actually, the best market, or at least one of my favorite markets up by the U.S., is Japan. Japan is a really, really cool market for this strategy.

The reason for that is that Japan has a very deep equity market. There are a lot of companies in Japan that are publicly listed, and by the way, it is a very cheap market, so you have a lot of cheap small companies that are publicly listed. But what is really interesting is that a big risk in the U.S. to this approach is credit cycles, debt, and refinancing risk, and bankruptcy risk. But in Japan, there is essentially no credit cycle. My company which borrowed at 7 or 8 percent in the U.S., borrowed 1.5 percent in Japan and there have been only 9 public companies that have gone bankrupt in Japan in the past 10 years. So you basically have no bankruptcy risk, no refinancing risk, and you get all the same benefits of leverage at a much lower interest rate.

We tested our strategy in Japan back in 1991, what we found is we were able to generate close to 15 percent annualized alpha with 0.8 beta. In the U.S. we are probably at 1.2 or so. It is truly remarkable. You get a lot of alpha with lower beta. So we spend a lot of time investing in Japan, and we also implemented it in Europe, but that is a more similar market to the United States. 

Melvin: I know your main measure of valuation is enterprise value to EBITDA. Do you use any other valuation or measuring tools to select stocks for your portfolio? 

Rasmussen: Absolutely. I think EBITDA is the best for getting from the 12,000 stocks in the world to the 100 or 200 that I really want to look at. It is a great screening tool. But when you are actually analyzing an individual company I really focus on free cashflow yield. But there is a lot of work you have to do to get to what is true or normalized free cashflow yield because an individual company in any individual year or quarter can be so noisy. I like EBITDA because of its comparability, but free cashflow yield is really what I am trying to get at. 

Melvin: Obviously credit risk is your major risk, are you using any tools to measure credit risk in some of these companies.

Rasmussen: One of them is just historical debt paydown. Just like being a credit card company, you would rather the people that paid off their balance than the ones that are increasing their balance every quarter. Part of it is just looking for companies that have been paying down debt. 

Credit ratings are actually predictive as well, so what we have found is that if you look at the equity returns based on credit rating. The worse the credit rating, the better the equity returns. Until you get into C rating, then it plummets. So we try to avoid companies that are C rated and we actually designed the machine learning algorithm which predicts the probability of debt paydown. 

It is basically very similar to the model the credit rating agency uses. We are trying to anticipate which companies are going to get downgraded so we can avoid those. Actually one of the coolest things we have discovered is that by avoiding the heavily shorted cheap levered companies we dramatically improve our results. So essentially we can use the short sellers and all the work that they are doing to stay out of some of the ones that have had near term imminent issues. 

Melvin: We are 2 months away from the 8th birthday of the bull market in U.S. stocks. Are you having difficulties finding a lot of ideas at your price point? 

Rasmussen: What is interesting about my corner of the market is that it really moves with the credit cycle, the high yield bond market. What we saw in 2014 and 2015 was the worst sell off in the junk bond market. So a lot of companies that were issuers of debt really sold off heavily, and we were actually able to pick up a lot of great opportunities. Yes, the bull market in the U.S. equities is broadly 8 years in, but the bull market in levered equities and junk bonds is really only about 11 months old. We are in the very early stages of that cycle, so we are still seeing a lot of opportunity.

What is great is that there is very little low quality credit. A lot of that was wiped out during the 2014 and 2015 credit crisis. We have a long wave as the banks start lending again and they get back into the high yield market. All the banks that are financed by junk bonds, like M&A and private equity deals, they will bounce back from the low points that they had in Q1 in 2016 and Q4 of 2015. 

Melvin: I talk a lot about the investor’s need to use a private equity mindset, not just on valuation, but really on a holding period. Your average private equity firm holds an investment for 5 years or longer. Do you find that is also the case with levered equities that a longer holding period improves returns? 

Rasmussen: I think for the winners, for the companies that are steadily paying down debt and continue to chug along, I think the answer is yes. I think that when you are in sort of deep value world, sometimes the markets rise. Sometimes that company was cheap for a reason and you find out after one quarter after investing that you were wrong and whatever contrarian thesis you had about whatever industry was wrong. I think the virtue of what we do is that we can actually sell a lot of losers, not run them all the way down to zero as the private equity firms used to do. We have an advantage that we can have those long hold periods for the winners just like private equity does, but we can get out of some of the losers and maybe only lose 50 percent of our money, not 100 percent of our money when we are wrong. 

Melvin: That is an advantage of being in the public rather than the private market. You do not really have to go dig up a buyer. There is usually one waiting right there. 

Rasmussen: It might not be at a price you like, but there is a buyer. 

Melvin: Any final thoughts on this strategy and how it has worked and how you think it will work in the future and whether or not it is appropriate for most individual investors?

Rasmussen: I think that investors have to ask themselves, "What is my tolerance for volatility?" I think for investors that can say, "My time horizon on this capital is 3 years or 5 years," investing in this type of volatile strategy is a great way to increase returns and generate a lot of alpha.

On the other hand, behavioral biases are very strong, so a lot of investors are really going to sell out of a strategy like this when it is down sharply in a credit crisis. For those investors, it really is not the right fit. So I think it really depends on your behavioral inclinations. I like that because, again, I am so steeped in the Kahneman and Tversky behavioral bias literature. I love the idea of exploiting all the people and all the traders out there that are suffering from these biases or are too scared of the volatility in order to make money for my clients. But that is not everybody.

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