As someone who has been ‘getting a kick out of small-cap value investing’ since 1983, Eric Kuby, chief investment officer at North Star Investment Management, is a faithful follower of Warren Buffett’s warning that size is the enemy of excellence.
The $1.3 billion Chicago-based value shop, which invests in undervalued and often overlooked small- and micro-cap companies, offers three equity strategies – the North Star Dividend fund, the North Star Micro Cap fund and the North Star Opportunity fund – and one fixed income strategy, the North Star Bond fund.
Kuby is named on all four strategies, including the firm’s flagship offering, the $83.7 million North Star Dividend fund, alongside chief executive Peter Gottlieb. The strategy, which is also available as a separately managed account, is one of the few funds in the small-cap investment category that invests in dividend-paying stocks with market caps of less than $1 billion.
‘Basically, our core belief is that small companies outperform large companies, that value stocks outperform growth stocks, and that higher return-on-equity companies outperform lower return-on-equity companies,’ Kuby said.
To scour the universe for small- and micro-cap companies that also pay a dividend, Kuby and the investment team start with data from providers such as Bloomberg and YCharts.
‘It always starts with the data. We are big believers that when you are investing in a company, you want to get a cash return on your investment. You want the company you are investing in to be generating the free cash flow that you as a shareholder are entitled to,’ he said.
Once the team identifies a company that is undervalued and generating high levels of free cash flow versus the enterprise value of the company, then it becomes a matter of trying to analyze and understand the company itself.
‘First and foremost, [our aim] is to make sure that we understand what they do and how they make money,’ Kuby said.
The last part of the investment process is an onsite visit, which helps to verify the quality of the company’s management team. ‘We meet with management and try to have them explain the business to us, what they think the opportunities are and what the challenges are. We try to get a sense of whether we think the company fulfills all the criteria we would want to have in the portfolio,’ he said.
The dividend strategy was born out of the team’s effort to sort through attractively valued small- and micro-cap stocks that they were already familiar with, but that they had not yet invested in.
Kuby said that small- and micro-cap investing is usually associated with growth companies rather than dividends. Sometimes, though, the conventional wisdom is wrong. ‘It’s a fascinating thing. When people think of small- and micro-cap companies, they think of biotech and technology companies. They think of these growth companies where they are reinvesting the money around the growth initiatives,’ Kuby said. ‘That’s true, but there are 4,000 of these companies. Some of them have been around for more than 100 years and they are stable businesses that pay nice dividends.’
One such company is Collectors Universe, which provides third-party authentication and grading services to retail buyers and sellers
of collectibles. With a market cap of around $150 million, the firm has a dividend yield of more than 4%. But what Kuby likes the most about the firm is the ‘moats around the business’ and the passion of the management team.
‘If you are a collector of baseball cards or rare coins, your collection has no real value without it being graded and authenticated. So this is a necessary value-added business for collectors, because once the item is graded or authenticated, something that you got for $10 might be worth $1,000,’ he said.
‘I went out there and visited them and just really thought that this was a terrific company with huge moats around the business because their authentication services are the gold standard,’ he said. ‘The people who work there are experts, and the customers all know them. Everyone just loves what they are doing.’
Another example is Douglas Dynamics, which manufactures and sells snow and ice control equipment for light trucks, including snowplows, salt spreaders, and related parts and accessories.
‘They have this great dealers’ network. It’s a terrific thing because the parts wear out,’ Kuby said. ‘It’s a nice replacement cycle. It’s a brand name that people trust, and it’s a business that is very hard to replicate.’
With a $1 billion market cap and a dividend yield of 2.4%, the company has been a ‘stress-free’ investment for Kuby. ‘Every year, the earnings go up, and the dividends go up. And they’ve made a couple of acquisitions along the way that fit really nicely into the company,’ he said. ‘And you know what I saw yesterday morning? I saw the snowplows were out.’