Dector rides the small cap roller coaster

When you catch the up-cycle in small caps, the rewards can be high. But catch falling stocks and the results are ugly. Michael Dector should know. The president of LDIC, a Toronto-based investment counsel firm, opened the Redwood Global Small Cap Fund in August 2008, “the worst possible time to start a small-cap fund,” he says.

He’s since enjoyed outsize success. “The first four months weren’t good. We were down about 50% and then we had two stellar years in ’09 and 2010. So, up 152% and then up 74%.”

The Redwood portfolios (he manages three) grew out his investment counsel business, which consists in separately managed accounts. But less wealthy members of a given family wanted the same kind of professional management—something impossible to offer with a small asset base. Hence the three Redwood funds he manages; they are a way to give the same stock selection as he chooses in the individualized portfolios for accounts wherein the diversification costs would be prohibitive.

Mostly, Decter manages buy and hold large-cap portfolios. Typically “most of our money is in really boring utilities and income trusts and stuff that pays big dividends. The small cap fund is quite markedly different.”

And it is. “It represented a way of giving our clients some exposure to a much more volatile market and it represented a way of diversifying them.” Although the fund is up on the year, the recent downturn has cut into the gains. “This year we’re off a bit. It’s just a kind of roller coaster way to get there, but that’s the nature of small caps.”

Unlike his other portfolios, Decter does not see small caps as a buy and hold. He frequently sells stocks to add cash. “Last year, we went to 70% cash three times. And we still made 74%. We made almost all of that in the last half of the year.”

That helps contain some of the downside, but not all, he notes.

“We’ve learned how to mitigate some of the downside risk. But you don’t mitigate all of it because, these things trade with a much higher beta than large caps for the understandable reason that they don’t have the balance sheet or in some cases don’t have the revenue that a large cap would have.”

That makes them extremely vulnerable to certain phases of the economic cycle—and in the financial crisis and its aftermath, the solvency of its creditors, since small-caps often depend on friendly banks.

For a global portfolio, Decter is heavily concentrated in specific sectors—metals and materials. Most are based in Canada, but have operations elsewhere. It’s not so much the business he likes, as the people who run it.

“Our comfort level comes from probably seeing 10 companies for every one we invest in,” he explains “We’ve got good deal flow. These companies, a lot of them get acquired. So you invest at a certain stage. They build them up; they get sold; and then the management team, who did a good job with Company A, moves to start another small cap Company B. So, we get a lot of ideas from the management teams.”

It’s not that he’s investing in micro-caps; but the stocks would be considered very small by American standards, with a market cap from $20 million $500 million. “We tend to be willing to put money to work fairly early on. Our favourite situations tend to be when something hasn’t come to the attention of the Street yet. And if we really like the story, one of the questions we always ask are ‘Is this the first day you’re doing meetings or is this the last?’ “

Decter also likes to ride a trend, up or down, he says. “I guess some people tend to average down. We tend to average up. If we like something, we’ll start with a 1% or 2% position. And then if it performs—if it does what we thought it was going to do, we’ll add to it. So it might come up to a 5% or 6% weighting.”

On the downside, he’s willing to hold through some losses, but once they hit 20%, he’s out. He has exercised similar discipline this year.

“We have gone to 20%, maybe 30% cash on occasion. So our thesis in the small-cap world is really to succeed you have to do two things well. You have to pick companies; that’s the primary thing. But you also have to avoid losses. So, cutting your losses, protecting your downside is, in our view, hugely important.”

Cutting the losses can be hard, because Decter looks for an outsized upside return. “We’re of the belief that we make a lot of our money on the five-baggers and occasional ten-baggers. So, you want to be very careful not to have too rigid a sell-discipline.”

He wasn’t always this flexible. “I think it was Algoma Steel that changed my mind, because we bought a lot of Algoma at $9, and our sell was $20. And, in fact, it was rising so quickly that we put in the orders to sell when it was $20 but I think we got out at $22. And then I started thinking, yes, it went through $30, so maybe this wasn’t the best plan of all time. We bought it back and got out in the $40s. So, we tend now to be more of a ‘sell part of it.’ We’ll sell a third or half to get our original capital back.”

It’s a concentrated portfolio, Decter says, with about 30 names that take up 2% to 6% each. But he does have other holdings—what he calls “trading positions: either things that we’ve decided to get out of and we’re working our way out or things that we’ve bought for a particular trade reason, some event we saw happening that could be a catalyst.”

A catalyst could work either way. “I would say we’re old-fashioned, bottom-up stockpickers on the fund. We will buy companies that don’t fit a particular basket, just because we really like them and we think management are going to generate real gains for shareholders, even if they’re not in what would be seen as the most popular space.”

Which is just as well, since small-caps are not always the most popular space.