February 8, 2018

Leveraging Active Investing with Small-Cap Stocks

By Julie Hammond, CFA

Elizabeth M. Lilly, CFA, finds her investment opportunities in unusual places. After breaking her iPhone screen in 2016, she did some research and discovered ZAGG, an under-the-radar stock that produced replacements. It turned out to be a serendipitous find.

That general curiosity about the world and how it works has served Lilly well during her 25 years as a small-cap stock portfolio manager. She believes that small-cap stocks offer a tremendous opportunity to those willing to do the research: Small-cap investors can generate returns if they dig deep into a company’s financials, conduct multiple valuation analyses, meet face-to-face with management, and have a patient, long-term focus.

Lilly, who recently founded the small-cap value manager Crocus Hill Partners, outlined her investment approach at the 2017 CFA Institute Equity Research and Valuation Conference.

The Case for Small Caps

Even after a quarter-century in the space, Lilly said she is amazed that inefficiency still exists in the small-cap market. If anything, the sector may have gotten even more inefficient over the years. Lilly explained that the stocks she invests in are sparsely covered by Wall Street analysts, are more volatile, and have lower valuations.

Lilly believes a number of market trends will continue to propel the sector:

  1. Small caps typically outperform in rising interest rate environments.There’s a misperception that all small-cap companies are burdened with a lot of debt, Lilly said. In fact, many continue to actively deploy cash through dividends and stock buybacks.
  2. M&A activity is often a catalyst for growth. M&A activity targeting small- and micro-cap companies has continued at a robust pace. This has been driven by activists encouraging companies to unlock value and large firms seeking growth through acquisitions.
  3. Small caps outperform over long periods. The idea of a “small-cap premium” has been challenged in the past but has not been disproved. Aswath Damodaran has noted that small companies are more likely to be overlooked and the undervalued ones likely to have bigger payoffs.
  4. Volatility equals opportunity. Small-cap investors can often use market turmoil and liquidity events to their advantage.

Valuing the Business

Lilly enjoys rolling up her sleeves and doing the hard analysis necessary to value small businesses. She looks for off-the-radar companies, conducting intensive qualitative and quantitative analysis to uncover hidden value. “We look closely at the balance sheet, income statement, cash flows, and margins and the interrelationships among them — five years back and five years forward,” she said.

Valuation is an imprecise art, but Lilly explained, “Our aim is to buy $100 worth of value for $65. We look for enough downside protection through a margin of safety with significant upside potential.”

She also looks for a catalyst that will ultimately unlock the stock’s value. This catalyst could be a new leadership team, a new market in which to sell products, the selloff of underperforming businesses, renewed focus on high-achieving ones, or exogenous factors like industry consolidation. “You need a catalyst to surface value,” Lilly said, echoing a bit of wisdom she learned from working with Mario Gabelli.

Lilly is most interested in management’s long-term strategic vision for a company. That means at least a three- to five-year time horizon. Her questions for management focus on its process for allocating capital and whether all its business segments are earning their cost of capital. She also likes to see incentives that keep the board and management focused on the long term.

The most crucial piece is her assessment of the C-suite: “You’ve got to visit the headquarters and look in the whites of the eyes of the management team,” she said. “This is something you cannot get from quarterly conference calls.”

Sound Advice

Earlier in her career, Lilly learned value investing techniques under the tutelage of Robert Bruce, founder of the Bruce Fund, and Warren Buffett. “The best advice I ever received from Warren was to know what you own and really understand the business you’re investing in,” she said. Her mentors also conveyed the importance of working with good people and emphasized that management can make the difference between a good investment and an outstanding one.

In the end, Lilly said, “You have to ask yourself: Do you believe in management and do you want to be their partners?” Understanding the goals and incentives of company leadership is essential to evaluate whether it can execute on its vision and whether it’s focused on creating value or becoming big.

“If you ask me why I love what I do,” Lilly said, “it’s because you can generate very high returns over long periods.” She thinks that small-cap stock investing is an excellent way to leverage active management, if you do the research and are guided by your curiosity.

Like Buffett, Lilly clearly enjoys her work. And who wouldn’t? It’s a rare opportunity to transform iPhone mishaps into alpha.


CNBC Interview   
November 15, 2017



April 23, 2017

Elizabeth Lilly opens her own investment shop in St. Paul

Lilly has been a well-regarded stock picker for a generation. 

For the past 15 years, Lilly worked from the Twin Cities for New York-based Gabelli Asset Management Co. (GAMCO), specializing in Wall Street-unloved-or-unnoticed small firms.

“It’s always been my vision to open a firm that focuses on my particular value-investment philosophy in the micro-capitilization and small-cap sectors,” Lilly said. “We buy them when they are ‘Rodney Dangerfields’ and they [sometimes] become ‘Bob Hopes.’

“I’m marketing to high net worth individuals and family offices. I could imagine five years from now, with the performance I’ve generated in the past over that of the [benchmark] Russell 2000, I could grow the firm to $500 million.”



Lilly managed the $1 billion-asset Mighty Mites Fund and had a hand in GAMCO’s small-cap value fund.

Lilly made millions for investors with her acquisition several years ago of 400,000 shares of Brooklyn Park-based Mocon. The rebounding maker of testing equipment for the packaged-food industry last week agreed to sell at a rich premium to Ametek, a much larger Pennsylvania-based consolidator for $182 million.

Lilly also was a long-term believer in Toro, Deluxe Corp. and SurModics as they went from unloved to shareholder-huggers, significantly beating the market in recent years.



Lilly, 53, began her career on Wall Street, followed by a stint at Fund American Companies in Connecticut, under the tutelage of Jack Byrne and his buddy, Warren Buffett, who would visit for homemade lunch at the office every couple months to talk value investing.

“Warren would drive up in a rental, and we would cook burgers there in the kitchen and drink cherry Cokes,” she recalled. “He was brilliant, fascinating, humble. He makes complex subjects easy to understand. That formed my philosophy.”



Lilly came home to the former First Asset Management (FAM) in Minneapolis and started Woodland Partners with two FAM colleagues in 1996. Gabelli acquired Woodland in 2002.

Last year, in a pointed centerpiece talk at a conference sponsored by Minnesota CFA Society, Lilly lamented the small minority of women in the investment trade even though studies show female-run portfolios outperform the average and industry benchmarks.

According to Girls Who Invest, less than 10 percent of investment managers in the U.S. industry are women.

As more investors, frustrated with more-expensive “active” asset managers turn to huge, cheap market index funds, Lilly has demonstrated that a smart woman can find diamonds in the rough and often beat industry benchmarks.

Lilly likens her career to part analyst, investigative reporter, number cruncher and management psychologist.


“People need to view the investment industry as a creative field,” she told her mostly male listeners in 2016.


Lilly applauds the mission of Girls Who Invest to have 30 percent of the world’s investable capital managed by women by 2030. It focuses on education, industry outreach, accessibility and career placement.

“I think what they are trying to do is very impressive,” Lilly said.

The only way to build a more diverse pipeline of talent, she added, is to tie compensation for managers to developing diverse teams.

Lilly, who lives with her family in St. Paul, acknowledged that motherhood and societal pressures can pull women in different directions.

She added that she benefited from good male mentors in the early years and she believes in a mixed-gender approach to investment teams.

Her partners at Woodland were two men. And GAMCO founder Mario Gabelli long has praised her work and tried to get her to stay.

But it was time for Lilly, a St. Paul native, to put out her own shingle. And also easier to speak her mind as an independent business owner.


“I’m coming at this from a capitalist viewpoint,” Lilly insisted. “Women are great investors so we need to have more women in the industry.


“At the end of the day, the firms will generate higher returns from their portfolios, and clients will be happier.”

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