A stockpicker on how to ride the curve of small-cap growth

  • By Leslie P. Norton,
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Jim Callinan, 58, is a consummate stockpicker. Back in 1999, he was Morningstar’s domestic equity manager of the year. Then his firm was purchased by Bank of America. After various gigs, including running his own concentrated fund for sophisticated investors, the San Francisco-based manager joined up in 2016 with Osterweis Capital Management, whose founder, John Osterweis, also believes that managers perform best when they invest only in their most promising ideas.

Last year, Callinan’s Osterweis Emerging Opportunity fund (OSTGX) returned 26.4%, beating both the S&P 500 (.SPX) and small-cap growth funds by several percentage points. This year, despite market turbulence, it has returned 14.3%, versus 3% for the S&P 500 and 5.2% for small-cap growth funds.

Callinan knows his company narratives cold. He is fond of managements that articulate what he calls “stretch goals” and then deliver on them. Such managers use these ambitious goals to motivate employees, not just as guideposts for investors. Callinan looks for 20 to 40 stocks, each offering 100%-plus upside over the next three to five years. He shared some favorites with Barron’s.

Q: Is the selloff over?

A: My historical experience with drawdowns is that they are fast going down and slower coming back. This is minor, unlike the dot-com bust or the housing bust. I call this the Fedspeak bust. There’s nothing fundamental—no real slowdown other than some talk about China, and a lot of the hardware guys, the optical chip companies, have seen this Chinese slowdown since early 2017. It’s already discounted in the stocks. It was just a period of time where valuations, especially in tech, and momentum names, got frothy, and the market waited until October to take things down. The Russell 2000 growth segment has come down so much it has created tons of opportunities. KeyCorp did a piece that showed that 55 software-as-a-service companies’ valuations went from 8.8 times sales to 6.5 times sales, a dramatic correction.

Maybe the market considered the Amazon.com (AMZN) minimum-wage hike (to $15 an hour) frothy, but those jobs are very underpaid and need to be paid higher. Wages have lagged behind for 20 years and really needed to be redressed. You can’t have a recession and inflation. We don’t have the crazy commodity spikes they had in the ’70s. In the 1980s and the 1990s, we had recession when the economy was changing from a manufacturing base to a service economy. Now, we are changing from a service economy to an intelligence economy, but I think we’re in the first inning of that, and there are a lot of growth stocks to use to play that theme. For example, the cloud initiatives mean it costs virtually nothing to roll out software that can improve itself over time with continuous updates.

Q: Why were people reluctant to buy the dip?

A: This huge looming election has frozen the market. People will feel better when we get that uncertainty behind us. There are so many interesting ideas out there. People have been waiting to get the third-quarter earnings reports out of the way, to see which companies are excelling and have competitive advantage. Why not wait for the earnings-per-share print?

Q: Where are we in the small-cap cycle?

A: We’re at the end of the beginning. Since the housing bust, growth has led. You haven’t really had a burgeoning economy where value stocks do well. And you don’t have the goose from bonds that you had for 30 years. The bigger-cap indexes have benefited from a higher percentage of growth stocks in their composition. In the Russell 2000 growth index (.RUO), where all the initial public offerings go, you’re just now getting a greater percentage of fast-growing companies, but recently valuations have risen to levels that are cautionary. However, venture-backed IPOs in this cycle are a lot more disciplined than they were 20 years ago—today, the companies coming public are leaders in their space and close to being profitable. The tepid top line growth in the U.S. economy, represented by the housing, banking, and industrial sectors, causes the relative attractiveness of the small growth style.

Q: Why are you a small-cap manager?

A: Because there are always great, emerging S curves (graphs depicting growth and time) to exploit—new companies or themes you can invest in. We have the best venture-capital community in the world. I like to add value for my shareholders by diving into something that’s really not really known well by the investing public.

Q: What’s the best way to invest in small-caps?

A: You have far greater odds of capital appreciation with fast-growing companies bought at the right price, than by just buying and holding a long-term exchange-traded fund. With small-cap growth, active management really pays off. We want to buy fast-growing companies at or below the market multiple of the Russell 2000 growth index. Companies that are mysterious, that have been mismanaged, so you have an opportunity to buy them at really reasonable prices. So if you have really fast-compounding sales growth and rising margins, and you’re taking a concentrated position, you don’t really have a lot of portfolio managers who are really good at diving in and feel confident enough to reveal the mysteries. We have a 150-stock universe of the fastest organic growth companies in the Russell 2000 growth index. We throw out the companies that do acquisitions. We look at the underwriter that brought them public.

We’re always looking at the highest-quality IPOs, and we track them. We like to pounce when they stumble. We also look for management teams that talk about stretch goals. For example, Square (SQ) went public at $9 in 2015 (and closed the first day at $13) and then went to $8 in 2016. They said they would grow merchant penetration from 2% to 15%, and that each merchant would take a loan for $6,000. That would yield an EPS number of $1.50 in three or four years, and the stock was at eight. Then they added five or six more high-margin, low-capital-intensity products that raised margins, and increased the $1.50 a share to closer to $3.50 a share. We sold the stock when it became a high-mid-cap.

Q: What do you like these days?

A: Etsy (ETSY) is kind of like Square in that it’s misunderstood and went from $40 to $14. New management came in. Rachel Glaser, the new chief financial officer, had been at Move Inc., which I had covered. I knew Josh Silverman, the new CEO, from eVite, which they sold to eBay. He’s a very knowledgeable e-commerce CEO. He said, “You know, Jim, eBay might charge an 8% to 12% take rate (percentage of the value of the transactions they facilitate). We charge 3.5%. We think we could take our pricing up to closer to where eBay’s price is.” And you know, the CEO was an executive for eight years at eBay, and he sold eVite to eBay. Not many CEOs have the confidence to throw out a number like that. But when a CEO has that confidence, we find that really, really attractive. They can raise prices, relative to eBay (EBAY) and Amazon and JD.com (JD). They can add a third subscription tier for better sellers. This company is doing Ebitda margin of 22% today, and it can go to 33%. This mousetrap is doing $600 million of sales now, and it could do $1.6 billion. That could potentially create a fourfold increase in Ebitda to $550 million. If you put a 15 multiple on that, you’d get a $7.5 billion market cap, or a $60 to $70 stock, versus $43 today.

You are also fond of GreenSky (GSKY), the financial-technology company for the home-building industry, which has been hit along with the housing stocks.

Everyone calls it a lender. What they really do is help the contractor close the deal. The contractor has the carry the cost, and take the risk of the client defaulting midway through or canceling the project. The contractors market the loans from the bank to the homeowner. They pay GreenSky 7% of the loans. They use the FICO scores of the client—someone who can afford a $70,000 kitchen is a 700-plus FICO score, right? It’s a good credit. And they pay GreenSky about 7% of the loans.

The company came public at a $4 billion market cap, and it’s now $2.6 billion. It’s in our wheelhouse. Management owns a lot of stock. The company’s stretch goal is doing $400 million or $500 million of sales this year to $1.3 billion within three years. That’s how fast they’re growing. Management says they’re a merchant processor like Square, or like a Visa/Mastercard substitute. The stock is at $12 or $13. They’re earning 75 cents a share on a GAAP basis for 2018. Their revenue is $400 million to $500 million and is going up. They have 15,000 merchants, and they’re adding 5,000 a year. The average transaction per new customer is $8,000. So the revenue transaction volume per merchant is about $340,000 per year, or revenue per merchant of $25,000. They have 664,000 customers. If they can get that to two or three million—two to three million kitchens or window changes—that’s probably doable.

Q: Last pick.

A: Cavco Industries (CVCO) is the No. 2 player in the manufactured housing industry. The No. 1 player is Berkshire Hathaway’s Clayton Homes. This is a population that’s underserved in the U.S., folks that drive trucks or work in an Amazon warehouse, with an average compensation less than $50,000. It’s a huge market. It’s probably 50 million Americans. About 80% of homes under the price of $150,000 is manufactured housing. The peak was in 1999, when 375,000 manufactured housing units were sold. This year, the total market is about 100,000. It’s still technically cyclically depressed, but the available market to them has grown tremendously. Their No. 1 buyer is the first-time home buyer—a millennial couple. The second buyer is someone moving up from a condo. The third largest is recent immigrants. The biggest problem is there’s no secondary market for this type of mortgage paper. So that’s restricted capacity.

They’ve expanded by acquisition and have very little incremental spend to satisfy what could be a quadrupling in demand. They have a great management team. They’ll probably do 15,000 to 16,000 units this year. If they keep their 15% share or grow it a bit, and the market grows to say, a couple of hundred thousand units in five years, you’re talking about a number that could go to 30,000 units a year, with revenues going from $800 million this year to $1.4 billion in 2023.

Q: What happens in a recession?

A: They benefited from the last recession. The subprime mortgage guys, who caused the recession, were buying normal houses in Florida, built by developers. A lot of it was fraudulent. It took demand from manufactured housing. Since the subprime bust, they’ve been regaining share. It would have to be a really serious recession. We just had 4% unemployment. Amazon just raised the minimum wage. Trucking is already short 100,000 drivers. This segment is on fire. They’ll earn $6.92 a share this fiscal year. They can do $15 in 2023, a doubling because of margin expansion. If the industry just goes back to 125,000 units, and Cavco increases its share by 2%, their units will go from 16,000 to 23,000.

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