S4E30 – Kyle Mowery – Earning 25% with a small cap hedge fund

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Key Timecodes

• (00:52) – Show intro and background history
• (01:37) – Deeper into his background history and business model
• (02:59) – Understanding his funds investment model
• (05:23) – Deeper into his business strategies
• (06:03) – What he is looking for in his investment tactics
• (09:01) – A bit about his numbers
• (10:33) – Some examples of his investment strategies
• (13:27) – His big business success
• (15:07) – Is he using the 4M analysis?
• (17:48) – What type of businesses he tend to avoid
• (18:51) – Deeper into his hedge funds strategy
• (19:48) – A guest takeaway about B2B selling
• (23:51) – What is the worst advice he ever received
• (23:59) – What is the best advice he ever received
• (24:38) – Guest contacts

Transcription

[00:00:00.320] – Intro

Hey, this is Sean Tapper, the host of Payback Time, an approachable and transparent podcast on building businesses, increasing wealth, and achieving financial freedom. I’d like to bring on guests to hear authentic stories while giving you actionable takeaways you can use today. Let’s go.

[00:00:17.150] – Sean

In Tykr, we tend to look for more mid-cap, large-cap, and mega-cap stocks because they tend to be a little safer. Well, my next guest has a hedge fund that specifically invests in small-cap stocks. Stocks. Now, to give you context, he’s been able to beat the market for the last 12 years, and most hedge funds, believe it or not, they last between three and seven years at most. So beating the market for that long tells us he’s doing something right. So in this episode, he talks about what companies he looks for, what companies he avoids, and what metrics are most important. Please welcome Kyle Mowery. Kyle, welcome to the show.

[00:00:54.430] – Kyle

Good day. Thank you for your time.

[00:00:56.240] – Sean

Thanks for joining me. So why don’t you kick us off and tell us about your background.

[00:00:59.950] – Kyle

Well, my background is certainly nontraditional. Today, I am managing a small-cap equity portfolio. Long and short, I’ve been doing that for 12 years, so there’s a certain longevity there. But originally, I grew up playing sports. I grew up playing baseball out in California, played through high school, college, and then wrapped up my career and said, Boy, I sure like doing competitive things, and I like numbers, and And investing just spoke to me, and a couple of stops along the way, and I launched Grizzly Rock Capital in 2012.

[00:01:37.430] – Sean

Nice. Now, prior to starting this fund, you worked in hedge fund, is that correct?

[00:01:44.250] – Kyle

Yeah, I had a pretty nontraditional path. I started at a fund of hedge funds called Pamco, which is now Pamco Prisma out on the West Coast in an analyst training program, but definitely not the traditional investment banking, private equity background. But then from there, I worked in high-yield credit. I really liked how the credit managers thought about risk versus return, focusing on a downside mitigation first. Last couple of years, people only thought about that in 2022, But it’s worth thinking about it. And if you’re as old as I am, you were investing in the great financial crisis of ’08. So we think about risk every day here, regardless of whether the market is thinking about it or not.

[00:02:27.390] – Sean

I’m doing the math here, going back 12 years. So you started your fund right there, about ’09, 2010, somewhere there? Yeah.

[00:02:35.100] – Kyle

So I graduated business school, let’s see, December of 2011. I went in the evening, actually. Same program, same degree, just in the evening. And so then I launched right then. I was 29, married, but no kids at the time, and no mortgage. So you can take a lot of entrepreneurial risk when you’re 29 with no kids and no mortgage.

[00:02:59.600] – Sean

Right on. So I have to point this out, and you can correct me if I’m wrong here, but I know the average lifespan of a hedge fund, it can be like, what, about three years, four years. Is that correct?

[00:03:10.610] – Kyle

It depends on how biased of a source you want to cite. I’ve heard seven. So I told my wife when I hit eight that I was at least above average in this one category. And I didn’t have the guts to put that in my letter to clients, but it’s a good It’s a good verbal joke.

[00:03:31.530] – Sean

Right on. Playing a little money ball there, getting above your averages. But at 12 years, that says something, like you’re doing something right there. Now, for context with the audience here, if you guys don’t already know, Tykr is really focused on investing in strong value stocks. We like to look at more like mid-cap, large-cap, mega-cap. So we do gravitate away from those small-cap and micro-cap. But this is your area. This is your specialty. So I want to learn, what are you looking at when you look for small cap?

[00:04:02.810] – Kyle

Yeah, I will try and keep this brief. So we, fundamentally speaking, are free cash flow oriented. We’re looking for businesses that are mispriced and misunderstood, businesses that can grow and generate on our earnings and significant cash flow, not only now, but inflecting higher in the out periods. Specifically, as it relates to large mid versus small and micro, I would say that Small caps are a bit of the Wild West. The management teams are usually subpar vis-a-vis mid or large cap. The boards can be absolutely awful. They’re there for a salary many times. And we’re not activist investors, by the way. These are just broader comments, things to be aware of. But I think for us, the reason I chose this asset class was it’s just less efficient, right? And it’s a good way, in my opinion, to have active management into small caps vis-a be some of the… You go back to David Swensen and some of the looking for asset classes that require active management, and what are those? Certainly, real estate, private assets, private equity, private credit, et cetera, where it fell in that bucket. Some of the other things, I don’t know much about, like crypto, but commodities or whatnot.

[00:05:18.930] – Kyle

But small caps are straddling that landscape, in my opinion.

[00:05:23.490] – Sean

So I was just going to touch on asset class as a small cap. So that does include businesses and real estate?

[00:05:28.840] – Kyle

No, we don’t do real estate. I was just using as an example of where it’s really hard to use passive, passive indices. There’s a case for passive, there’s a case for active for each asset class, but I think it’s a lot stronger in, obviously Private equity on one side and QQQ on the other side. There’s just more correlation in a large cap manager and QQQ than between, say, private equity return streams, middle market, Large market, tech versus industrial, stuff like that.

[00:06:03.350] – Sean

So my audience, they can be quite technical and just give you a little context on what we’re looking at within Tykr. And you touched on free cash flow. We do look at that. We also look at the revenue. We want to see that increasing year over year for about five years. Same thing with net income and EPS. And then going over to the balance sheet, we like to see the assets and equity increasing. So what are you specifically looking for? It sounds like free cash flow is one, but what else?

[00:06:30.130] – Kyle

Yeah. So for us, our holding period is two to four years. So what we’re looking for is an inflection in earnings. And so for us, we would not require five years of trailing growth. We do a lot in cyclicals. We do a lot in businesses that all of a sudden screen poorly for whatever reason. Businesses that are coming out of a period of debt pay down and now are entering a period of capital return to shareholders. Businesses where it’s an operational turnaround that’s been in play, going for a year or two. And you can really do the work, understand the industry, products, the gross margin profile, the business, and then have a sense for what the business could or should look like over the next, again, two, three, four years. And then that’s something that we, after diligence, which is significant, as significant as possible in the public market with public information, that’s how we make our return.

[00:07:32.300] – Sean

I very much align with your strategy there. Although I don’t love small cap and micro cap, can be very risky. But the inflection point of earnings, that is something I have talked about our audience a lot, is pay attention to those finance. If you see a EPS go from negative three up to a dollar and five cents, it’s like, whoa, what’s going on here, right? So that’s awesome. How do you keep your finger on the pulse of these stocks? Because they’re not in They’re not the high-flying newsworthy stocks we hear every day, like the Magnificent Seven. So how do you keep your eye on these stocks?

[00:08:08.260] – Kyle

Well, we got a great team. We have my partner, Mike Holt, here in Chicago, and then Jake Miller, who’s out in New York. So there’s a post-COVID, COVID-enabled virtual company with Jake in New York. And we’ve all been doing small caps, basically our whole career. And so we have a folder on 800 companies where we’ve done real work. Now, we’re not up to speed on 800 companies today with respect to our pencil being sharp, but yeah, probably 150, 175. That would be longs plus shorts. I mean, yeah, but there’s three of us, right? And we’re all work very hard and have a good knowledge base. So we don’t get them all right. Sure. Landscape changes. There’s a lot going on in the macro economy, Fed, etc. But if you get more right than wrong, that That’s staying power and longevity.

[00:09:02.150] – Sean

That’s it. Can you share with us what returns you’re usually returning for your customers?

[00:09:07.500] – Kyle

Yes. So we run private funds, so I can’t disclose that. But let me just say that we are targeting businesses that are going to earn 50 plus % over two to four years. Fifty would be something more like a two year return. So some of those won’t work, some of them do work. So if you do a little math there, you can get into… We would aim for a double digit return, but never get quite exactly there, sometimes higher, sometimes lower. Sure. But yeah, reductions of… Drawing down is the worst possible thing you can do. You go backwards, clients get nervous, put stress on the team. So our approach is two steps forward, one step back, two steps forward, zero steps back. You just keep moving forward in that manner.

[00:09:57.850] – Sean

That’s the game of small caps for sure. So I’m hearing about two to four year holding period, returns of about 50 % over two years. Do the simple math, about 25 % a year, as you said, double digit returns. That’s pretty good. I mean, that’s beating the market.

[00:10:12.460] – Kyle

Oh, yeah. Well, I mean, we get… Some of them It’ll get wrong, right? So that would come away from that 25 %. But yeah, I mean, just directionally, that’s the type of thing that we’re working on when we’re doing our fundamental diligence upfront.

[00:10:26.400] – Sean

Our audience loves hearing lessons learned so they can avoid the same pitchfalls? You said you don’t get them all right. Can you share with us maybe a lesson learned or a stock you shouldn’t have invested in and why?

[00:10:40.010] – Kyle

That’s a great question. I mean, we definitely have had a number of these, whether the industry has changed or sentiment has changed. Living in a public market requires being able to deal with getting a mark every day and a mark set by the marginal buyer or seller, which may or not be thinking about the same things that you are on a company. I think that for us, some of the mistakes have been in getting into names that are over by the hedge fund community, things that are very, very popular. And then when everyone wants to exit, everyone’s trying to exit once. They’ll had a very similar thesis. These are areas that can lead to a quick loss in a public market setting where you got to know not only why the person is selling it when you get in, but who’s going to buy it on the way out. And so we think about that a lot more than we used to. Fundamentals still, ultimately, the earnings power for most businesses who are not narrative-driven or story stocks are driven by earnings. And so if you get the earnings right, you’re going to get a lot of the move right.

[00:11:56.750] – Kyle

But at the same time, if you can enter at a low multiple of earnings and earnings that are rising, that’s a double whammy. Sometimes when it’s clearly seen, it’s priced in. Even if earnings goes up, you don’t make much money and your return on time is lower. My contribution to the industry is a metric called ROAS, and that would be return on analyst stress. If something has a low ROAS, we try to avoid it. I did not do that my first five or six years in the business, and Yeah, lost a few hairs in the process, but we’ve learned our lesson.

[00:12:34.370] – Sean

I love that. A little humility there. All right. Let’s take a quick commercial break.

[00:12:41.440] – Sean

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[00:13:02.630] – Sean

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[00:13:36.920] – Kyle

Yeah, so I don’t want to cherry-pick, so I’ll pick something we presented publicly. We’re down in Chicago, and in Chicago, there’s a wonderful, terrible organization called Invest For Kids. It’s Chicago’s version of the Ira Stone conference. For here, it raises money for underprivileged communities, kids through different organizations. It’s a wonderful organization. The organizers sponsor 100 % of the cost of putting it on. So every dollar that’s raised goes directly to the kids. So they asked us to come and present an idea. So in the fall of 2019, before the world rolled over into COVID, we presented darling ingredients. I believe the stock was in around 19 or 20 at the time. It’s now at 50 by by the way, of 75 or 80. So we were right for the right reason with respect to what we disclosed, which was renewable diesel, changing business from diesel, diesel trucking, primarily in California, to running on chemically identical diesel, which was derived from used greases, fats, and whatnot. So carbon-reducing fuel, better for the environment, and certainly profitable for an early mover, such Starling Ingredients. So that was a name that we presented publicly that had ultimately worked out.

[00:15:07.080] – Sean

To drill into that, I do talk to the audience a little bit here, breaking the fourth wall. What Kyle places a lot of emphasis on is, you guys know me talking about the four Ms, Kyle. So you know that’s the first M is the margin of safety. It’s the math part of investing. Then we look at that, meaning, mode to management. Meaning is a business model. How many revenue streams are scalable? Are those streams moat? How does it compare to businesses in the same sector and industry management, of course, as a track record of that CEO or leadership team. So you, in a hedge fund, you really have to place a lot of emphasis, especially when you’re looking at small cap on those other three Ms, that meaning Moat and management, which you just described there really sounds like that’s exactly what you’re doing.

[00:15:53.400] – Kyle

Yeah, that’s the goal. I mean, the unit economics, if you can’t distill that down on the product or service and really get your arms around it, we don’t even try, right? Sure. So something we don’t do would be a lot of emerging battery technology because we don’t know what the economics are going to look like in, say, 5 to 10 years. So that would be something where we just, even if the story was great, we can’t get our arms around it. We might look at it and keep it on our watch list and our radar, but that’s not something that’s going to get actually into the portfolio for us.

[00:16:28.920] – Sean

I was going to dive into what you look for and what you avoid. So that’s good to know, like emerging battery tech you probably avoid. Do you gravitate towards a certain industry or type business model more than others?

[00:16:42.320] – Kyle

Yeah. So we’re midwestern in geography and Midwestern in approach. We do a lot in industrials. We do a lot in business services, consumer. There’s many, many funds out there that specialize in tech and and healthcare, and those tend to be really good sectors for specialists. But we’re generalists, so we run pretty broad, and that would be real businesses, things that we can understand, products and services, and And technological innovation is always there in every industry, but there’s some industries that have it more than others. And if you can get your eyes out a few years and you don’t have to go out a decade or more, that is a lot easier for us, for our style scale and our proclivities. I think that’s really important as an investor, focusing on what you’re good at, because one investor who’s great at VCs or growth equity is going to be completely different than, say, me. They shouldn’t try and play my game, and I shouldn’t try and play theirs. So I think sticking to that lane is so important.

[00:17:47.360] – Sean

Right. Is aside from the battery example, is there maybe another industry you tend to avoid?

[00:17:53.580] – Kyle

Well, health care is just very challenging for a nonspecialist, right? I mean, especially pharma or some of these these things. There are some extremely intelligent… A lot of ex-doctors who end up being investors, end up in these health care funds, and you don’t want to compete with them unless you have that background. I mean, the skill and talent there is just mind boggling.

[00:18:16.300] – Sean

That’s a really good perspective. In our audience, I joke with, I’ve been in tech about 20 years, so I know that industry. I tend to invest in it a little heavier, but do I know pharma? No, I don’t know much about pharma, so I avoid it like the plague.

[00:18:31.320] – Kyle

For asset classes like that, if you’re thinking about an overall broader asset allocation model, there’s a lot of wonderfully cheap indexes for things that you can active where you can add value index where you don’t. And I think that meshes well together overall.

[00:18:51.210] – Sean

Let’s switch gears slightly here. Hedge funds can invest in private and public companies. Do you have a mix of both or are they all public?

[00:19:01.180] – Kyle

We do a few privates here and there. We also do some high yield credit, which is where I got my start. So yes, those would be in our sweet spot. But primarily, it’s public equity.

[00:19:13.320] – Sean

Public? Nice. Good for you. Okay. And then with your fund as your requirements, you’re drawing a blank on the name here.

[00:19:24.510] – Kyle

Yeah, it’s an accredited investor. Accredited. Yeah, it’s not for everybody, but we We tend to have a lot of family offices and high net worth that have been with us for a long time, and we work with certain institutions on a bespoke basis.

[00:19:40.120] – Sean

Got you. And then do you have a minimum investment size?

[00:19:43.670] – Kyle

It’s about a quarter million dollars.

[00:19:45.660] – Sean

Okay. Got you. To get in. Cool. All right. Well, before we jump to the rapid fire round, is there maybe an investing tip or takeaway you can give our audience?

[00:19:55.350] – Kyle

Well, it’s funny. We’re sitting here on December the 14th, and the Fed has just come in and said they’re going to cut and stocks are going straight up. Everything is going straight up. I think the more business-like investing for us, it makes more sense. Find the market sentiment game can be profitable for a while, but it tends to… Things tend to zig when you expect it to zag. You and I, Sean, have been doing this a long time. And there’s many times where you think you got it dead to rights, and then everything changes. And I think thinking about portfolio optimization and compounding returns over decades requires a process. And so the more process-driven and more business-like the investing process is, that for me has been an area of success historically.

[00:20:51.220] – Sean

Because some people at a surface level might not know what that means, could you go a layer deeper and explain that from a tactical standpoint, like processes? Maybe explain your process a little bit.

[00:21:02.910] – Kyle

Yeah, well, not too dissimilar from 30,000 feet from yours. You’re looking for a a growing earnings stream, whether it’s revenue, profit, whatnot, as you enumerated a bit ago. For us, It’s similar, but we can have a little bit more esoteric companies because we’ll do cyclical companies, companies that are cyclical. But just at its base level, it’s understand a product, understand a margin profile, understand how that’s going to translate to earnings, and then understand the management and the board, because when you’re investing in a public security, those people are allocating your capital. And a lot of times you go online and punch in a Tykr and hit buy. That’s great, but there’s actually people running that business. So who are the people and what are the capital allocations decisions they’re making? I’d say many small caps that appear attractive are actually wildly unattractive due to poor capital allocation. You see it everywhere all the time, if that’s what you do, is steady small caps all day, which we do. So I would just say, steady the business, steady the capital allocation. And if you believe that the market is missing something, that’s when that margin of safety, the difference…

[00:22:20.280] – Kyle

Margin of safety is just a difference in prices, what you pay, values, what you get, to quote Buffett. That’s the fundamental tome of value investing.

[00:22:29.850] – Sean

Right on. Right on. Awesome. I love the strategy here. Thanks for the insight on small cap investing. But let’s transition to the rapid fire round. This is the part of the episode where we get to find out who Kyle really is. If you can, try to answer each question in 15 seconds or less. You ready?

[00:22:46.270] – Kyle

Oh, boy. Fifteen. Okay. Rapid fire.

[00:22:49.240] – Sean

Yes, indeed. All right. What is your favorite podcast?

[00:22:52.750] – Kyle

Well, I’m personally friends with Bill Brewster, who hosts the business Brew. So I would probably select that one.

[00:23:02.440] – Sean

Okay. What is a recent book you read and would recommend?

[00:23:05.820] – Kyle

Yeah, I read mostly for investing, but over the summer, I read Peter Atia’s Outlive. Phenomenal book, and actually really deep on the mental and emotional side at the end. So definitely read the full thing.

[00:23:18.800] – Sean

Okay, good to know. All right, we’ve got the movie question here. What is your favorite movie?

[00:23:23.720] – Kyle

Oh, man, there’s so many. To pick one single movie, probably Probably. I don’t even know.

[00:23:35.700] – Sean

Okay, we’ve heard that one. Let’s narrow it down to… Because you’re a sports guy, what is your favorite sports movie?

[00:23:41.570] – Kyle

I used to watch Major League before every baseball season started. Now, that’s dating me.

[00:23:49.240] – Sean

It’s a great movie, classic Charlie Sheen, right? All right. What is the worst advice you ever seen?

[00:23:55.980] – Kyle

If you’re smart, you don’t have to sell.

[00:23:59.080] – Sean

And flip that What is the best advice you ever received?

[00:24:02.140] – Kyle

One of my investors has been a partner over here for over a decade. Very successful individual. Everyone would have heard his name. He said, be true to who you are. Be true to yourself. And most people have these skills, and a certain skillset, and if they apply it, things go well for them.

[00:24:21.490] – Sean

Right now. All right. And last question here is a time machine question. If you could go back in time to give your younger self advice, what age would he visit and what would you say?

[00:24:30.220] – Kyle

Oh, I go back to 2012 and I started the fun and say, go along big tech.

[00:24:35.720] – Sean

Right on. Sweet. All right. Well, where can people reach you?

[00:24:41.030] – Kyle

Yeah, our business is private, but info@grisly. Com. Esleyrockcapital. Com if you want to get on our list, assuming you’re accredited. Also, we have a sister business that has a Twitter handle, Covest Select, on the Twitter machine, that business is I invest in single-name public equity.

[00:25:03.030] – Sean

Awesome. All right, Kyle. Well, thank you so much for your time.

[00:25:06.160] – Kyle

Thank you, Sean.

[00:25:07.260] – Sean

All right. We’ll see you.

[00:25:08.480] – Sean

Hey, I’d like to say thank you for checking out this podcast. I know there’s a lot of other podcasts out there you could be listening to, so thanks for spending some time with me. And if you have a moment, please head over to Apple Podcasts and leave a five-star review. The more reviews we get, especially five-star reviews, the higher this podcast will rank in Apple. So thanks for doing that. And remember, this show is for entertainment purposes only. If you heard any stocks mentioned on this podcast, please do not buy or sell those stocks based solely on what you hear. All right. Thanks for your time. We’ll see you.