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Assessing Cultural Risk in Micro-Caps

- By Rupert Hargreaves

Value investing involves finding securities that have been mispriced by the market. More often than not, the quest to find mispriced securities leads you into the small-cap arena of the market, and for good reason; small-cap stocks are generally volatile and uncovered by Wall Street, which means most investors avoid these companies. Because they are generally avoided by the rest of the investment world, value investors need to be prepared to invest in these unloved companies.


Unloved

Unfortunately, the rest of the market avoids small-caps for a good reason. Often, these companies mislead shareholders, struggle to grow and are reliant on capital markets to keep the lights on. Small-cap and micro-cap investing can seem a bit like a lottery considering all of the things that can go wrong for these companies. To make sure you don't lose the lottery, a strict risk management program is required.

Manage risk

There are many different ways of managing risk. From complex quantitative risk models to the simple strategy of just having a well-diversified portfolio, managing risk is critical in the investors' quest to maximize returns but minimize risk.

One area of risk management that is not usually considered is that of cultural risk. Former superstar hedge fund manager Bill Ackman (Trades, Portfolio) found out the importance of assessing cultural risk when he decided to bet on Valeant (VRX). The company's toxic corporate culture has ultimately proven to be its undoing as a management chased profits at the expense of customers and shareholders.

To avoid making the same mistake assessing a company's cultural risk is key. There are several ways to assess this risk indicator. For example, non-GAAP earnings in incentive compensation is a red flag. If management is being paid to achieve a nonstandard metric of returns, why should it seek to achieve the best returns for all stakeholders involved?

Surely, pumping up adjusted earnings would be better than actually trying to put the business on a sustainable path to growth. By having executive compensation tied to non-GAAP earnings, other aggressive cultural practices may exist such as aggressive accounting.

Considering insiders

Another red flag to consider on the same topic is insider ownership. If management owns no stake in the business aside from a few hundred basis points, its fortunes are unlikely to be aligned with those of investors. What's more, if management hasn't purchased any shares of the company via the open market, it shows it has little faith in its own company's success.

Management can acquire a stake in the business using options awarded through executive compensation plans, but if most of the stake in the firm is via stock options, there's even more incentive to manipulate earnings growth, use aggressive accounting techniques and disregard the opinions of all other stakeholders.

Key to managing risk

Understanding a company's management and its goals as well as ambitions should be a key part of managing risk for small-cap investors. If you stick to Benjamin Graham's idea that by owning a stock, you are owning part of the business, then surely you would want your business to be run by the best? If instead of a stake in a public company you are buying 50% of a private company, the first thing you would do is investigate how much you trusted management and whether it can be trusted to look after your investment.

Public company investing requires just as much scrutiny. While it isn't possible for average investors to meet with every public company management team they would like to, it is feasible to get some idea of the directorate's intentions and culture by taking a look at quantitative factors. The level of executive compensation, insider ownership relative to management salaries and how compensation contracts are structured are all ways to gain insight to this crucial risk management factor.

Disclosure: The author owns no share mentioned.

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This article first appeared on GuruFocus.