Communicating with Sophisticated Microcap Investors Part 2: Capital Allocation

As discussed in Part 1 of this series, the highest strategic priority of any microcap is finding “product-market fit,” and the company’s progress should be articulated to shareholders as it grows from an “Embryonic Company” into a “Formative Company,” and then finally a “Scaled-Up Company.” During this maturation process, typically accompanied by more robust financial metrics, capital allocation becomes the next important aspect that must be conveyed to shareholders.

So, what is capital allocation? According to Will Thorndike, author of The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success, it is “the process of deciding how to deploy the firm’s resources to earn the best possible return for shareholders.” There are a TOTAL of five ways to deploy a firm’s financial resources and ONLY three ways to generate capital. Specifically, they are:

5 uses of investment capital:

• investing in existing operations

• acquiring other businesses

• issuing dividends

• paying down debt

• repurchasing stock

3 sources of investment capital:

• tapping internal cash flow

• issuing debt

• raising equity

For most microcaps, which are commonly in the “Embryonic” stage, their capital allocation options are limited. In order to become publicly-traded, they have typically sold part of their company’s equity and invested the funds into their existing business operations. More specifically, they use their product offering to generate revenue and ideally reap profits over time, if it has enough margin and volume.

The highest priority is to find a good business model and then scale it, profitably. However, most microcaps never reach that stage. Usually, the product doesn’t work quite as well as planned; they can’t find the right market, or there isn’t enough margin to scale.

But, for the esteemed microcaps that find product-market fit and establish a successful business model, they inevitably face a new challenge that must be well-articulated to shareholders: capital allocation. 

However, this isn’t always easy. As Warren Buffett said in his 1987 Berkshire Hathaway letter to shareholders, “The heads of many companies are not skilled in capital allocation. Their inadequacy is not surprising. Most bosses rise to the top because they have excelled in an area such as marketing, production, engineering, administration or, sometimes, institutional politics. Once they become CEOs, they face new responsibilities. They now must make capital allocation decisions, a critical job that they may have never tackled and that is not easily mastered.”

Building a Moat

Once the microcap has found traction, it must build a moat around its initial business, usually further investing in operations and possibly making acquisitions. In order to do this, it will typically tap cash flow, sell more equity, or even issue debt, if it's available. All of this is perfectly fine but should be explained clearly to shareholders.

Warren Buffett touched on this topic in his 1995 shareholder letter, when he said, "What we're trying to find is a business that, for one reason or another -- it can be because it's the low-cost producer in some area, it can be because it has a natural franchise because of surface capabilities, it could be because of its position in the consumers' mind, it can be because of a technological advantage, or any kind of reason at all, that it has this moat around it."

New Growth Avenues

After the core business has been constructed and protected with a moat, the microcap must allocate capital differently in order to spur new growth. Sometimes, this is in adjacent markets, or it can be entirely new verticals where management feels that it has a competitive advantage. For example, one interesting microcap trying to grow through savvy capital allocation is Kingsway Financial Services (Nasdaq: KFS). Its core business is the ownership of warranty companies, in addition to real estate assets, but the microcap is now looking to grow through its Kingsway Search Xcelerator, which is effectively a publicly-traded search fund. Mostly funded through cash flow and debt, it recently announced its second acquisition, CSuite Financial Partners.

Risks of Poor Capital Allocation

If microcap leadership doesn’t allocate capital well, it runs the risk of being pressured by activists. For example, an interesting scenario has been unfolding with Schmitt Industries (Nasdaq: SMIT). In 2018, an activist named Mike Zapata took control of the Oregon-based microcap. Next, he generated cash by liquidating assets, which he invested into an ice cream business called Ample Hills Creamery, a beloved brand that he acquired and resurrected out of bankruptcy. Time will tell if his capital allocation will pay off, but this is a common scenario for microcaps that fail to keep growing or wind up on the wrong end of creative destruction. In fact, this is analogous to what Warren Buffett did with Sanborn Maps and later with Berkshire Hathaway.

As a microcap finds more success, capital allocation becomes increasingly complex and important, particularly building a moat to defend its core business and then finding more avenues for growth. Microcaps must do this well and also communicate it to their shareholders. If they don’t, not only will their shareholders likely lose confidence but the microcap may even face pressure from activists. Because if a microcap REMAINS a microcap for too long, something is probably wrong.

Disclosure: I currently own positions in the stocks mentioned and have no plans to sell some or all of the positions in the stocks mentioned over the next 72 hours.