180 Degree Capital Corp. (NASDAQ:TURN) Q3 2023 Earnings Call Transcript

180 Degree Capital Corp. (NASDAQ:TURN) Q3 2023 Earnings Call Transcript November 14, 2023

Daniel Wolfe: [Call starts abruptly] Third Quarter 2023 Financial Results Update Call. This is Daniel Wolfe, President and Portfolio Manager of 180 Degree Capital. Kevin Rendino, our Chief Executive Officer and Portfolio Manager, and I would like to welcome you to our call this morning. All participants are currently in a listen-only mode. Following our prepared remarks, we will open the line to ask to questions. [Operator Instructions] I would like to remind participants that this call is being recorded, and that we are will be referring to a slide deck that we have posted on our Investor Relations website at ir.180degreecapital.com under financial results. Please turn to our Safe Harbor statement on Slide 2. This presentation may contain statements of a forward-looking nature relating to future events.

Statements contained in this presentation that are forward-looking statements are intended to be made pursuant to the Safe Harbor provisions of the Private Securities Litigation Reform Act of 1995. These forward-looking statements are subject to inherent uncertainties and predicting future results and conditions. These statements reflect the Company’s current beliefs and a number of important factors could cause actual results to differ materially from those expressed herein. Please see the Company’s filings with the Security and Exchange Commission for a more detailed discussion of the risks and uncertainties associated with the Company’s business that could affect the Company’s actual results, except as otherwise required by federal securities laws, 180 Capital Corp undertakes no obligation to update or revise these forward-looking statements to reflect new events or uncertainties.

A close-up of a corporate businessperson using a modern laptop to manage the company’s finances.

I would now like to turn the call over to Kevin.

Kevin Rendino: Thank you, Daniel, and good morning, everyone. I want to leave you with a few key thoughts this morning. Our business transformation is essentially complete after this past quarter 97% of our assets are now in public companies. While it took over six years to get to this point, it is over. For those that are keeping track, since I arrived and 180 came to be in 2017, we have generated nearly $3 per share or specifically $2.77 in gains from our new strategy. We have had losses over the same period of time of $2.28 from the historic legacy positions of Harris & Harris. To be candid, this business probably wouldn’t exist if we hadn’t changed our stripes in 2017. And while the last seven quarters have been a challenge for our public holdings, the market and specifically the microcap indices, we now have a liquid easily transparent balance sheet to be able to understand our NAV is easy to calculate.

Therefore, as we said from day one, the discount our stock trades at relative to our NAV should be far less than it was when our book was 80% privates. To that end, we announced a discount management program that Daniel will speak to later in this call. It’s important that the reality of our discount mirror, the thesis we had for it when we first started. To be clear, the most important thing we can do is invest in companies that rise in value, so the absolute value of our NAV climbs. There is a reason our stock traded at close to $9 per share at the end of 2021. It was because we grew our NAV to over $10 per share from where it was when we started, and while the last seven quarters have been a challenge for our holdings in the micro-cap index in general, we believe this period has set us up to once again grow our NAV as we look beyond this incredibly volatile and bearish market.

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Q&A Session

In fact, we’re going to use the rest of this call to show you an illustration form why we believe this is the right time to be invested in microcap and as a result Turn. We’re going to show you a series of charts and data that highlight just how undervalued we believe our investment universe is, and therefore how much upside we believe there actually is for the companies that we own. I think this is one of the better buying opportunities for what we do than at any time since I’ve been here. The rest of this call will offer the rationale for why I think that is the case. As for the topics that we normally discuss on these calls, I recommend reviewing our shareholder call slides that are posted on our Investor Relations website. I won’t speak to every chart included in this presentation, but I’ll speak to a bunch of them and encourage you to flip through the presentation and shareholder letter for a complete discussion.

On Slide 4, this shows that the ratio of the U.S. small cap performance to large cap performance is it at the lowest level in almost a quarter of a century. And yet at the same time, this level of under performance is nothing about the fundamentals of the businesses that comprise each index, given the fundamentals have actually held up better for many micro cap companies that the index performance would suggest. On Slide 5, this argues that not only have the stocks of smaller companies underperformed, the relative price to earnings ratio are back to levels not seen since 1978. What’s interesting about 1978 was that was also a time of inflation, as has been the case in the last two years. The question for us is, has the CPI peaked and are we at the end of the fed tightening cycle?

The answer that we have for both of those questions is yes, and yes. I do know the CPI has gone from 9.1% to 3.7% and perhaps like 1978, which was the bottom for small caps. This is the bottom for small caps today because the CPI has long passed peak, you can review these CPI numbers this morning they were a little softer than expected. Slide 6 shows that not only are small cap value in small cap core equities, the cheapest segment of U.S. equities on a relative basis, it’s also remarkable that these two categories are the only ones that are below their 25 year average valuation. Every other index in this charge shows that those indices traded premiums to their 25 year averages, but small caps don’t. Slide 7 shows that small caps trade not only at a discount to their large cap peers, but the discounts are incredibly high.

For example, the performance cap is 41% on a trailing PE — 30% on price to sales. This is neither normal nor justified based on the actual performance of the Company’s fundamentals. Slide 8 shows the historical returns of market indices. At least in 2008 when the economy actually did melt down, most indices were down about the same amount. Back in 2008, the S&P 500 index was down 37%. The NASDAQ Composite index was down 40. The Russell 2000 index was down 34, and the Russell Microcap index was down 40. How is it that today the NASDAQ 100 can be up 37% while the Russell Microcap index is down 10? How can the S&P 500 be 3% from its all time high when the Russell Microcap index is down 38% and the Russell micro cap growth index is down 49% from the high?

While we understand the bearish effect of today’s world of higher interest rates, it has had a significantly greater effect on small caps relative to the 2008 economic environment where nearly $1 trillion of losses occurred from categories of loans and related securities issued in the United States secured primarily by residential real estate. 2008 was an economic Pearl Harbor, as Warren Buffet said, and 2023 is not the same economic calamity. The disparity of performance between the size of companies is the widest it has ever been and makes no sense to us, this is not 2008. Skipping ahead to Slide 10, the above chart depicts bearer sentiment. Are there problems in the world? Yes, there clearly are number of pressing issues, higher interest rates, a war in the Ukraine now a war in the Middle East.

Inflationary pressures, there’s many concerns, but bottoms and stock markets nearly always occur when bearishness is at its highest levels. And the opposite, of course, is true of tops in markets. We are near the high end of bearish sentiment as depicted in this chart. Skipping ahead to Slide 13, this shows that historical PE ratios of the Russell 2000, it isn’t only about relative valuations of one asset size to the next. The above chart from Royce Investment Partners shows that the actual PE for the Russell 2000 has gone down measurably over the last few years. Now, one would expect that higher interest rates would lead to lower PE multiples, but the multiples are now lower than the long-term growth rates arguing for an inexpensive asset class.

Additionally, given we believe that the fed is likely near the end of its interest rate hiking cycle, it is possible that rates have hit or are close to hitting a peak, and therefore multiples should be close to or at a trough. Again, referring back to my prior comments, while one would expect multiples to be given lower — to be lower given interest rates are higher, why is it that the only small cap — why is it that the only indices, the small cap universe has lower multiples while every other asset size company has higher multiples based on its 25-year average, that is completely incongruent. Slide 16 shows flows in different ETFs for 2023. Never underestimate the effect of flows of investor capital on the value of public market assets especially equities.

As you can see above, there was $5.1 billion of inflows into the iShares Core S&P 500 ETF and the Vanguard S&P 500 ETF, while at the same time there was a combined outflow of a billion dollars from small cap funds. In the case of the Russell 2000 Value ETF, the outflow has been a staggering 11.4% of the entire asset base. There is almost no question that the price dislocation that we have seen in the small cap universe is a direct result of indiscriminate selling by ETFs and other funds facing redemptions. Again, this trend is normal for equity market bottoms, not tops. Slide 17 shows, U.S. indices returns by size. And in this chart, you can see the effects of the outflows on specific performance of stocks based on size. Through September 30, 2023, there is a historically large 3000 basis point disparity between small and large industries.

I have yet to see that in all my career of investing. Slide 18, what is the most important explanatory power — sorry about that, over long-term returns for an index. We have long stated that the price you pay for the business you buy is a key factor in determining one’s ultimate success in an investment. If you buy a good business at the wrong time, you may lose money. If you buy a less than good company at the right time, you may make money. The above chart is published by Bank of America and shows that while valuations tend to be a poor short term timing indicator, they do matter for longer term returns. Note that this chart represents the relationship between the relative PE for the Russell 2000 versus the Russell 1000 and subsequent rolling return differentials.

Simply put, valuation has the highest explanation power over long term returns and we know today that small caps are historically attractive using that metric. And finally, on Slide 20, the above chart above and commentary below is again attributed to Royce Investment Part Partners. I love any statistic which has a 100% success rate in this one does. Small caps historical return patterns show that below average return periods have been followed by those with above average return periods with a much lower than average frequency of negative return periods. Specifically, the Russell 2000 had positive annualized three year returns a 100% of the time. That is in all 86 periods averaging an impressive 17.5% following five year periods of less than 5% annualized returns.

At the same time, five year returns at positive annual returns a 100% of the time that is in all 81 periods averaging 14.9%. So while the future may be different than the past, it’s hard to ignore this trend given its accuracy to date. We can debate opinions, but we can’t debate facts. Every chart depicted above shows historically low valuations and significant underperformance for small cap stocks. While we are very comfortable with our view that our stocks have discounted a lot of bad news that quite simply has not occurred in 2023 maybe the news will come next year and maybe they won’t. Either way, we expect the management teams of the companies we own to adapt to whatever environment we are in and we will use our collaborative and collegial activism, if need be in an effort to unlock value for all our stakeholders.