Investing Off the Beaten Path

January, 2014







Alluvial Capital Management, LLC
Web-Site: alluvialcapital.com
E-Mail: info@alluvialcapital.com
Phone (412) 368-2321




Why Invest Beyond Traditional Equities?
Most equity investors limit their investments to relatively large, liquid
companies. The reasons for this are many, but three factors stand out.
1. Institutional Constraints Investing vehicles like mutual funds and ETFs
manage massive pools of capital and require extremely high liquidity at
all times. These vehicles are unable to invest enough capital in micro-
cap companies or thinly-traded issues to have a material impact on
returns, regardless of the potential returns these securities can offer.

2. Unfamiliarity Most investors are simply unaware of the existence of
micro-cap and/or thinly-traded companies. These companies rarely
make the news headlines, even though many have been operating
profitably for decades and are highly respected in their niches. Whats
more, few of these companies generate investment banking revenues
for Wall Street, resulting in minimal coverage by sell-side analysts. In
the absence of news flow and Wall Street-provided analysis, few
investors possess the time or inclination to seek out lesser-known
companies.

3. Perceived Risk To many investors, small size and reduced liquidity are
synonymous with increased risk. While many small companies are
indeed under-capitalized and lacking viable business models, many
others have strong liquidity, low debt, solid returns on capital and
potential for earnings growth. Actual investment risk, defined as the
chances of permanent impairment of a companys intrinsic value, is
mainly a function of balance sheet strength, managerial competence
and industry prospects, not a companys size or liquidity.

By limiting their investments to well-known, widely-held equity securities
strategies, investors must accept market-level returns, on average. While the
majority of investors may be perfectly satisfied with the returns on offer in
conventional strategies, non-traditional equities such as micro-cap companies,
thinly-traded issues and complex situations offer opportunities for enhanced
returns.
To succeed in investing in micro-caps, thinly-traded securities and complex
situations, an investor must be willing and able to perform extensive research
and to tolerate reduced liquidity. Alluvial Capital Management, LLCs mission
is to identify attractively-priced, unknown securities and to use them to create
portfolio strategies with strong return potential.




Investing In Micro-Cap Equities
As of January 2014, investors in American stocks can choose from among
nearly 4,000 different companies with market capitalizations over $250
million. By contrast, there are over 6,000 domestic companies with market
capitalizations below that threshold. The micro-cap segment of the market
offers a more diverse set of opportunities, though the small size of the
components makes the segment nearly uninvestable for institutions and
others with hundreds of millions under management.
Historically, investors have been well-rewarded for investing in these smallest
companies. From June 30, 1926 to November 30, 2013, the smallest decile of
US stocks returned 12.91% annually, while the largest decile returned 9.37%.
1

The reasons for this out-performance are hotly debated, but Alluvial believes
this excess performance can be largely attributed to certain factors that
persist in todays market.
Limited Investor Demand Many investors cannot or will not invest in micro-
cap companies. This results in reduced demand for shares, which in turn
results in lower valuations and higher returns.
Neglect In a related fashion, small company size results in less attention and
awareness from potential investors. Hence, lower valuation and higher returns.
Growth Opportunities Micro-cap companies frequently possess
opportunities for revenue and earnings growth. Working from a small base of
each, micro-cap companies can pursue growth projects that would be
immaterial to large companies.
Mergers & Acquisitions Activity Micro-cap companies have natural buyers in
larger competitors. When wishing to expand or capture a new technology or
product line, these competitors may find it cheaper to purchase a tiny
company rather than develop the new resource internally.
Owner/Manager Alignment Insiders at micro-cap companies frequently own
a large percentage of shares outstanding and are thus incentivized to create
value for shareholders, rather than extract value through salaries and bonuses.
As pointed out by Horizon Research Group, these owner-operator
companies frequently provide better returns than the market.
2

These factors interact to create opportunities to invest in businesses that
trade well below conservative estimates of fair value. Alluvial Capital
Management, LLC seeks out micro-cap securities that offer the best risk-
adjusted return potential.



Investing in Thinly-Traded Securities
Investors value liquidity and prefer the ability to liquidate any holding within
minutes. As a result, securities that require days or weeks to liquidate in an
orderly fashion often trade at significant discounts. In Alluvials view, the
magnitude of this discount has increased over time as average holding
periods have fallen
3
, affording patient investors with a long-term view the
opportunity to purchase less liquid companies at extremely attractive
valuations.
Historically, the market has rewarded investors willing to purchase thinly-
traded securities. A study by Roger Ibbotson, et al. revealed an average
annual return premium of 5.34% for the lowest liquidity quartile of the 3,500
largest US companies stocks over the highest liquidity quartile of the same
stocks, from 1972 to 2011.
4

Investing in thinly-traded securities is an exercise in patience. Because days
may pass between trades, it can be frustrating to watch illiquid positions hold
steady when the market is soaring. It is helpful to remind oneself that an
equity investment represents ownership in a real business, not merely in a
ticker symbol on a screen. Though the share price may not be moving, the
business itself is (hopefully) earning money and making productive
investments that will inexorably be reflected in the share price in the long run.
Long periods of boredom can be interrupted by sudden leaps, as the stock
adjusts to news releases or the company is acquired.
Less liquid securities often trade with a wide bid/ask spread. Patient investors
should view this as an opportunity to purchase at a discount or sell at a
premium. By carefully placing orders to buy at the bid or sell at the ask, astute
investors can collect a spread from impatient buyers and sellers in thinly-
traded securities.
Though thinly-traded securities can offer attractive potential returns, liquidity
needs are real and investing the majority of a portfolio in thinly-traded
securities would be unsuitable for most investors. Alluvial Capital
Management, LLC balances investors liquidity needs against the potential for
enhanced returns in thinly-traded securities.




Investing In Complex Situations
While the market is fairly efficient in general, Alluvial believes that investors
regularly fail to properly price stocks where accounting or business
complexity obscures the true value of earnings or assets. This complexity can
take many forms.
Understated Assets Equity-accounted minority holdings in other companies,
real estate held at historical cost, LIFO reserves and other assets can appear
on the balance sheet (or only in financial statement notes) at a value that is
much lower than the actual market value of these assets.
Net Operating Loss Carryforwards Accumulated losses can be used to
shield future income from taxation, significantly increasing a corporations
future earnings power, yet the full value of NOL assets frequently does not
appear on the balance sheet.
Non-Recourse Debt Some companies, especially those that deal in real
estate, use non-recourse subsidiary-level debt to fund projects. Investors
often fail to distinguish between company-guaranteed and non-recourse debt
and may misinterpret the parent companys actual debt burden.
Obscured Profitability Sometimes, strong profits in one of a companys
segments can be disguised by losses in another. Shutting down or selling the
loss-making segment can suddenly reveal a companys true worth.
Identifying these hidden sources of value requires in-depth study of company
filings and disclosures. Alluvial seeks to identify and invest in these companies
before their true worth becomes apparent to the market.





Finding Value World-Wide
As of 2010, American investors exhibited a strong bias toward domestic
investing, with 72% of their equity investments dedicated to American
corporations, while US stocks represented only 43% of the worlds total equity
value. Australian, Canadian and UK investors invested even more strongly in
their own domestic corporations.
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Failing to consider stock investments in other jurisdictions can result in
missed return opportunities. Alluvial endeavors to find opportunities in
markets around the world, subject to a few constraints:
Stability and Legal Protections Nations and regions that have autocratic
governments, high risk of armed conflict, weak contract law and legal rights
for investors should be approached with extreme caution. Equity investors in
companies operating in nations like Russia, China, Venezuela, Argentina and
many others face a high risk of permanent loss due to nationalizations,
capricious taxation and theft by company insiders. Alluvial prefers to invest in
national exhibiting stability and strong legal systems. If an investment in a less
stable region is to be considered, its discount to intrinsic value must be
extremely high and its weighting in the portfolio will be very small.
Tax Considerations Many nations levy high taxes on dividends received by
foreign investors. Alluvial avoids investments where the bulk of returns are
expected to be generated by dividends subject to high tax rates.




About Alluvial
Alluvial Capital Management, LLC is a registered investment advisor, able to
provide investment management services in the US and many other domiciles
worldwide.
Alluvials sole member is David Waters, CFA. Mr. Waters is the author of the
well-regarded blog OTCAdventures.com, which focuses on micro-cap, thinly-
traded and complex equity securities.
Alluvial offers separately-managed accounts through its custodian and
broker-dealer, Interactive Brokers. Accounts are open to accredited and non-
accredited investors. Qualified retirement accounts are accepted.
For more information, please contact David Waters at info@Alluvialcap.com
or (412) 368-2321 during US Eastern business hours.


References
1
On Long-Term Returns of Micro-Cap Equities
Data derived from
http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html#HistBenchmarks
2
On Long-Term Returns of Owner-Operator Companies
http://www.frmocorp.com/_content/essays/The_Owner_Operator_Company.pdf
3
On Average Stock Holding Periods
http://www.businessinsider.com/stock-investor-holding-period-2012-8#ixzz22uVvTEmg
4
On Long-Term Returns of Illiquid Stocks
http://www.ibbotson.com/US/documents/MethodologyDocuments/ResearchPapers/LiquidityAsAnInve
stmentStyle.pdf
5
On Allocations to Domestic Equities
https://advisors.vanguard.com/iwe/pdf/ICRRHB.pdf