The Case for small and miCro-Cap Value inVesting

APRIL 2012

introduCtion
The purpose of this paper is to make the case for small and micro-cap value stocks as an advantaged asset class. We believe the historical body of evidence shows just such an advantage, and that a rational analysis of that past performance provides evidence that this outperformance is likely to continue. While there are also plenty of risks that accompany investing in small and micro-cap stocks, we believe the inherent advantage embedded within this space makes it a fruitful pond for investors to fish in, and one in which skilled investment managers have the potential to make a big difference in performance over time.

Benjamin Graham, the father of value investing, once noted that “Price is what you pay. Value is what you get.”

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H i s to r i Cal e V ide n Ce
Small and micro-cap STockS aS an advanTaged aSSeT claSS
Numerous studies have been done that show the performance of small company stocks versus larger company stocks. All of these studies come to the same basic conclusion: the smallest segments of the market outperform the largest segments over time. To help illustrate this point, see the table below. Both Ibbotson Associates and the Center for Research in Security Prices compile performance data on different segments of the market going back to 1926. The table below shows the annualized returns and growth of $1,000 in starting value for the different market capitalization segments for exchange-listed stocks from the beginning of 1926 through 2011. Although 1 to 4 percent per year may seem like a small amount, it makes a big difference in the total value of a portfolio when compounded over a long period of time, as Albert Einstein may have realized when he said that “compound interest is the eighth wonder of the world.”

APR IL 2012 | C H A N T I C L E E R A D V I S O R S , L L C

Market Cap Decile

Annual Average Total Return
(rounded)

Growth of $1,000

1-Largest Companies 2 3 4 5 6 7 8 9 10-Smallest Companies

9.0% 10.4% 10.8% 10.7% 11.3% 11.2% 11.2% 11.4% 11.5% 12.9%

$1,687,186 $4,878,338 $6,646,606 $6,391,607 $9,910,859 $9,496,585 $9,171,424 $10,792,122 $11,234,376 $34,900,635

Source: center for research in Security prices (crSp) and ibbotson.

Value of $1,000: 1926-2011
$40,000,000 $35,000,000 $30,000,000 $25,000,000 $20,000,000 $15,000,000 $10,000,000 $5,000,000 $0
1-La t rges 2 3 4 5 6 7 8 9 10-S mall est

Source: center for research in Security prices (crSp) and ibbotson.

2 APR IL 2012

p ot e n t ial a dVantage s
of Small and micro cap SecuriTieS
We believe that there are several advantages smaller market cap companies have that contributed to this outperformance over time. We’ll explore the following advantages – which we believe to be important and sustainable in the future – below: • Less Competition from Other Investors (Especially Institutions) • The Inefficiency of Illiquidity • Less Analyst Coverage • Lack of Abundant Information • Room to Grow • Simplicity and Flexibility in Managing the Business • More Likely to be Acquired • Higher Level of Insider Ownership leSS compeTiTion from oTher inveSTorS (eSpecially inSTiTuTionS) Small and micro-cap stocks are less well known and followed than larger companies and that creates greater inefficiencies in the smaller market. One of the reasons for the lack of eyes following the space is the size and illiquidity of the companies. Institutional ownership of U.S. stocks has gone from less than 10% in the mid-1950s to almost 70% today (source: John C. Bogle, “Restoring Faith in Financial Markets,” The Wall Street Journal, January 2010). With institutions – especially mutual funds – making up such a large part of the stock market, these smaller companies usually get overlooked because it isn’t practical for such a large fund or institution to invest in small companies. Not enough shares are available for them to acquire to have a meaningful impact on a large portfolio. In fact, many asset management firms prohibit investment in small and micro-cap stocks.

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Institutional Ownership
80% Average % Owned 70% 60% 50% 40% 30% 20% 10% 0% Large Cap Mid Cap Small Cap Micro Cap Market Capitalization

Source: capital iQ. micro cap = under $250mm market cap; Small cap = $250mm - $1b; mid cap = $1b - $5b; large cap = greater than $5b.

Annualized Return: 1972-2011
16% 14% 12% 10% 8% 6% 4% 2% 0% 4-More Liquid 3 2 1-Less Liquid

Source: center for research in Security prices (crSp) and ibbotson.

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The inefficiency of illiQuidiTy The lack of liquidity turns investors off to small stocks as well. Many investors – whether individual investors or institutions – will only invest in companies with ample liquidity to make the buying and selling process easier and quicker. This fact helps to create further inefficiency as a large group of those who could be investing in smaller, illiquid stocks refuse to consider them. This characteristic is reflected in the subsequent performance of illiquid stocks, as can be seen in the chart above which compares the performance of stocks on the NYSE, AMEX, and NASDAQ broken down into quartiles based on liquidity. A dollar invested in the most illiquid quartile of the market would have been worth $261.08 at the end of the above period, compared with just $20.49 if it was invested in the most liquid quartile. leSS analyST coverage Less coverage from research analysts also makes the pricing of small companies more inefficient than the well-covered larger companies. A small or micro-cap company’s lack of institutional awareness and sponsorship benefits the investor that understands the smaller-cap space and thus contributes to small and micro-cap outperformance over time. Analyst coverage is important both because investors and institutions tend to act on their recommendations and because they are an efficient conduit for those investors to receive new information on the covered companies. So if fewer analysts cover a certain area of the market, the greater the chance for that area to get overlooked and for profitable opportunities to develop. As you can see from the charts below, this advantage is especially prevalent in the micro-cap space. lack of abundanT informaTion It is easy to find information on large, well-followed companies. This is not always the case for small companies, especially if those companies are listed on the Bulletin Board or on the Pink Sheets. While the possible lack of information will turn a lot of people off, it can create big opportunities for those willing to put in the effort to track down information and talk to management teams, which are usually more accessible among smaller companies. Because this general lack of information doesn’t mean lack of investment merit, it can create large price-to-value discrepancies in the small and, especially, micro-cap space. This has especially become true since the passage of the Sarbanes-Oxley legislation, which drove many small companies – of which a good portion of those have long histories of profitability – to the Bulletin Board and Pink Sheets to avoid the increased costs of being listed on an exchange. Larger-cap companies also get more press coverage. The news outlets tend to spend more time reporting the results of the more well-known, larger companies in an industry and generally ignore many – if not most – of the smaller companies in the same industry.

APR IL 2012 | C H A N T I C L E E R A D V I S O R S , L L C

Average # of Analysts Covering Company
20 18 16 14 12 10 8 6 4 2 0 Large Cap Mid Cap Small Cap Micro Cap

% of Companies with No Analyst Coverage
80% 70% 60% 50% 40% 30% 20% 10% 0% Large Cap Mid Cap Small Cap Micro Cap

Source: capital iQ. micro cap = under $250mm market cap; Small cap = $250mm - $1b; mid cap = $1b - $5b; large cap = greater than $5b.

Source: capital iQ. micro cap = under $250mm market cap; Small cap = $250mm - $1b; mid cap = $1b - $5b; large cap = greater than $5b.

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room To grow As Warren Buffett has said of Berkshire Hathaway, its performance going forward will not be as good as its performance in the past because large size inhibits growth. Small and micro-cap companies don’t have this inhibition and this often allows the emerging small and micro-cap companies to experience higher average growth rates compared to the larger-cap companies. Big companies often run out of attractive places to reinvest their capital, but small companies often have a much longer runway in which to reinvest profits and sustain their growth. When this growth can be purchased at a value price, large returns are possible. As Peter Lynch – one of the greatest mutual fund managers of all-time – has said: “I think you have to learn that there’s a company behind every stock, and that there’s only one real reason why stocks go up. Companies go from doing poorly to doing well or small companies grow to large companies.” SimpliciTy and flexibiliTy in managing The buSineSS Another favorable characteristic of the small companies is that they can be nimble and seize opportunities such as market expansion and new product development while larger corporate organizations are often impeded in their ability to react to market conditions quickly. This ability to focus and clearly understand the realities of the businesses they are running can allow the managers of those businesses to avoid overlooking important opportunities and weaknesses that may limit the growth or success of the larger business. It may also allow small companies with good balance sheets and astute management teams to take advantage of volatile markets and recover more quickly than larger companies coming out of a crisis. more likely To be acQuired Another significant characteristic of outperformance is that merger and/or acquisition opportunities are far greater for smaller companies. There are both more suitors to acquire a small or micro-cap company, and also more potential candidates for a small or micro cap to acquire a company that could have a meaningful positive impact on its business and value. The simple fact that there are more small and micro-cap companies than large-cap companies and acquiring them takes less capital to do so makes this benefit one that will always be present in the small and micro-cap space.

APR IL 2012

Insider Ownership
20% 18% 16% 14% 12% 10% 8% 6% 4% 2% 0% Large Cap Mid Cap Small Cap Micro Cap

Source: capital iQ. micro cap = under $250mm market cap; Small cap = $250mm - $1b; mid cap = $1b - $5b; large cap = greater than $5b.

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higher level of inSider ownerShip Small and micro-cap companies generally have a higher level of insider ownership. It takes less capital to acquire a large stake in the company a manager is running if the company is small and, often times, the managers also helped start the company in its current line of business. This higher level of insider ownership better aligns management interests with shareholders and can be an important driver of outperformance as management has better incentives to drive the business and only take on higher levels of risk if they are accompanied by a significantly higher level of potential return. The incentives with having the insiders on the side of shareholders can create more opportunities to partner with good management teams at an attractive price. As Charlie Munger has said, “Never, ever, think about something else when you should be thinking about the power of incentives.”

APR IL 2012 | C H A N T I C L E E R A D V I S O R S , L L C

H i s to r i Cal e V ide n Ce
value over growTh
Many studies have been done showing the advantages of buying value stocks – usually defined as stocks trading at low price-to-book ratios or low price-to-earnings ratios – over growth stocks. A well-known study by Roger Ibbotson in the mid 1980’s sorted all of the stocks on the New York Stock Exchange into deciles based on price-to-book ratios from 1967-1984. On December 31 of each year, the stocks were repositioned into their respective deciles based on the year-end price-to-book value. The results of the study showed the advantage of buying the value stocks. The three deciles with the lowest price-to-book ratios produced a compound annual return over 14%. The three deciles with the highest price-to-book ratios produced a compound annual return just under 6%. Indices and databases have been constructed and studies performed to test the thesis that value outperforms other strategies. Nearly all of the studies – when performed over a long-enough period of time – show that buying stocks at low price-to-book, low price-to-earnings, and low price-to-cash flow ratios outperform other strategies over time. One of the big reasons for this is the investor tendency to put too much emphasis on future growth. If a company has been growing recently, investors tend to expect that growth to continue far into the future. Those investors anchor their expectations on recent data and project that the good times will continue indefinitely. They are willing to pay dearly for those rosy expectations by bidding up the multiples to earnings and book value.

RETURNS ON PE RATIO CLASSES – 1952-2010
30.00% 25.00% AVERAGE ANNUAL RETURN 1952-1970 20.00% 1971-1990 15.00% 10.00% 5.00% 0.00% 1991-2000 2001-2010 1952-2010

Highest

2

3

4

5

6 PE RATIO CLASS

7

8

9

Lowest

Source: aswath damodaran (raw data from ken french)

PBV Classes and Returns – 1927-2010
20.00% 18.00% 16.00% 14.00% 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% Lowest 2 3 4 5 6 1927-2010 7 8 9 Highest

1927-1960

PBV CLASS 1961-1990 1991-2010

Source: aswath damodaran (raw data from ken french)

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Besides projecting recent growth far into the future, investors may also pay for expected future growth in sales and earnings even if it is nonexistent today. The technology bubble of the late 1990’s is a good example of this. Many businesses were bid up to very high multiples of earnings (if they had any) or book value because the growth of a new, revolutionary technology – and the Internet was, indeed, revolutionary – promised so much growth that the future earnings potential of related businesses were worthy of high prices. However, investors paying those high prices were greatly disappointed when the bubble burst and much of the growth that was expected to show up never came. As an example of the advantage of using a value philosophy, consider the table below and chart above showing the performance of three popular small company indices from December 1978 through December 2011. The Russell 2000 Index measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000 Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It includes those Russell 2000 Index companies with higher price-to-value ratios and higher forecasted growth values. The Russell 2000 Value Index measures the performance of small-cap value segment of the U.S. equity universe. It includes those Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values. Benjamin Graham, the father of value investing, once noted that “Price is what you pay. Value is what you get.” This is an important principle of a value philosophy because value investors do not shun growing businesses. In fact, value investors prefer growing businesses as long as the businesses are producing economic profits as they grow and as long as they don’t pay much, if anything, for expected growth, especially if the growth is uncertain.

APR IL 2012

Russell 2000

Russell 2000 Value

Russell 2000 Growth

Cumulative Return Average Annual Return Growth of $10,000

3,254.0% 11.2% $335,399

5,592.2% 13.0% $569,224

1,636.1% 9.0% $173,607

Source: royce & associates

Value of $10,000: December 1978-2011
$600,000 $500,000 $400,000 $300,000 $200,000 $100,000 $0 Russell 2000 Russell 2000 Value Russell 2000 Growth

Source: royce & associates

“All intelligent investing is value investing – acquiring more that you are paying for.” - Charlie Munger

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combining value wiTh Small and micro-cap advanTageS With the vast amount of information now available in the investment world and the increased role of sophisticated investors from all around the globe in all types of markets, the investment business has become far more competitive than it used to be. Finding an edge in the way one invests has become more difficult, but as we have briefly demonstrated, focusing on small and micro-cap value investing can provide that edge to superb performance. For a more recent example, consider the chart below, which shows the annualized returns of the S&P 500 (larger companies), Russell 2000 (smaller companies), and Russell 2000 Value (small-cap value companies) indices since the turn of the century. As the chart shows, the 2000’s have been better for small stocks compared to large stocks and, better yet, for small stocks bought at value prices. Furthermore, investors willing to look beyond small and micro-cap stocks listed on exchanges can gain even further advantages and open up a universe of even greater inefficiency. The majority of small and micro-cap stocks – over 4,000 of them – trade on the Bulletin Board or the Pink Sheets. Investors willing to acknowledge the opportunity and develop an expertise in those areas of the market have the potential to earn returns that far outpace the averages over time.

APR IL 2012 | C H A N T I C L E E R A D V I S O R S , L L C

Annualized Return (From 1/1/2000 - 12/31/2011)
8.30%

4.61%

0.50% S&P 500 Russell 2000 Russell 2000 Value

Source: russell investments. The russell 2000 index measures the performance of the small-cap segment of the u.S. equity universe. The russell 2000 value index measures the performance of the small-cap value segment of the u.S. equity universe.

Co n C l u s i o n
8 APR IL 2012

“Finding money managers who can effectively pick stocks has long been a good way for investors to build wealth, and I think that will be true for the future.” -Peter Lynch, January 2010 To summarize, we believe that one of the few advantages in the competitive world of investing is in the small and micro-cap value segment of the stock market. We also believe that because of the reasons outlined above, these advantages are likely to remain in place for the foreseeable future. Investors willing to “turn over many stones” and really try and find undiscovered values in this area in the market can achieve great returns without having to take on greater risk. For our part at Chanticleer, we spend much of our time looking for small and micro-cap gems and have set ourselves up to try and turn that hard work into profits for our investors.

CHANTICLEER ADVISORS, LLC |

Chanticleer Advisors, LLC | Mike Pruitt, President & CEO/CO-MANAGER Matthew Miller, Analyst/CO-MANAGER | Joseph Koster, Analyst/CO-MANAGER

for more information on chanticleer advisors please contact us at (704) 366-5122. you may also visit our site at www.chanticleeradvisors.com

Chanticleer Advisors, LLC 11220 elm lane suite 203 charlotte, nc 28277 (704) 366-5122 www.chanticleeradvisors.com

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