Michael Melby has written up a litany of small and micro caps on SumZero over the last several years. In the course of his SumZero membership, he has been ranked in the top 5 analysts on the site across our All-Time, LTM, Deep Value, Long, North America, and Micro-Cap ratings.
Melby holds a Bachelor's degree from the University of Notre Dame and an MBA from the University of Chicago's Booth School of Business. Prior to founding Gate City Capital Management, Melby worked at Crystal Rock Capital Management, Coghill Capital Management, and the University of Notre Dame's endowment.
Kevin Harris from SumZero sat down with Melby to discuss his investment background, micro-caps, and Gate City Capital Management.
SumZero: During your membership on SumZero, you’ve topped the Deep Value rankings, and have been ranked in the top 5 on Micro-Caps, North America, Long, Last Twelve Months, and All-Time. How would you describe your investment philosophy and process?
Michael Melby, Gate City Capital: Thank you for having me – I appreciate your interest in our firm. Gate City Capital manages a concentrated portfolio of micro-cap value companies. Even though we are only purchasing shares of companies, our investment philosophy and process is focused on the price we would pay for the entire company. We have a long-term investment horizon and invest almost exclusively in companies with clean balance sheets.
Our investment process is research intensive. We complete a full due diligence process including company visits before making any investment. We value companies using a discounted cash flow analysis and incorporate a floor value analysis to understand what a company’s assets might be worth if the company was liquidated. We only add a company to our portfolio if we believe it has at least 50% upside with minimal downside. We construct our portfolio so companies with the best upside/downside ratios have the largest weights in our portfolio.
SumZero: During your investment career, you’ve been an analyst at several hedge funds, the Notre Dame endowment, and now manage your own fund. Could you walk us through the qualitative differences being on an investment team in these different environments?
Melby: I was fortunate to work under several great investors before founding Gate City Capital. My experience at Notre Dame was tremendous, and I felt the team was at the forefront of many advancements in institutional investing. My time at Notre Dame also gave me the opportunity to work and interact with some of the best hedge fund and private equity fund managers in the world. The time horizon of an endowment is extremely long, which also helped me understand the importance of being a patient, long-term investor.
My experience at other hedge funds was also helpful. Each had a fundamental, long-term investment approach with a thorough due diligence process. My experience at these firms helped develop my analytical skills that are important when valuing a business.
SumZero: What is the story behind the launch of Gate City? What led you to strike off on your own?
Melby: Gate City started from humble beginnings. I was fortunate to have a handful of friends and family members support me at an early stage. I decided to strike off on my own for two main reasons. First, I was confident that an investment process could deliver attractive absolute returns over the long-term. Second, I had saved enough capital to invest most of my net worth in the fund while also having enough capital leftover to manage both the fund expenses and my personal expenses for three years even if no other investors decided to invest. This helped reduce the pressure of the fundraising process and allowed me to focus on the long-term.
SumZero: What does your due diligence process look like for the deep value micro-caps that Gate City focuses on?
Melby: The due diligence process at Gate City Capital starts with a thorough review of the company’s financial filings including the 10-K’s, 10-Q’s and Proxy Statements. We supplement this with industry research by undertaking a similar process with the company’s competitors, suppliers, and customers. We build out a full financial model and use this information to construct a discounted cash flow analysis. We then calculate a floor value for the company approximating what we think the company would be worth if the operating business was discontinued. After completing this initial process, we arrange a conference call with company management and focus our attention on the business model and how the company generates cash. If everything goes well, we visit the company’s management at their headquarters. While some investors find that management teams are overly promotional, one of our big focuses with company visits is to gain a better understanding of the downside risk of the company. Building conviction around the quality of the assets and management teams through a visit has been very helpful to us – especially when a portfolio company’s share price declines. For our portfolio companies, we make it a point to attend annual meetings. This helps build our relationship with the entire management team and board of directors and establishes Gate City Capital as a long-term investor.
SumZero: Could you give us a case study on how this kind of intensive scuttlebutt style due diligence has paid off?
Melby: One of our largest investments is AMREP Corporation (AXR). AMREP owns 18,000 acres of owned land in the city of Rio Rancho, New Mexico. Our team has travelled to Rio Rancho multiple times and we have met with AMREP’s management team, other land owners, homebuilders, developers, and local government officials. Seeing and meeting everyone in person has given us a strong understanding of the amount of activity taking place in Rio Rancho and has provided us with additional conviction on the merits of our investment.
SumZero: What advice do you have for investment professionals who may want to launch their own funds? What is the best advice you received on launching Gate City, and what would you advise your past self to do differently?
Melby: Starting a fund is hard and can be stressful. I would only pursue it if you are certain that is what you want to do and have a high degree of conviction in your investment strategy and process. There is also a large amount of financial uncertainty associated with going out on your own. I also encourage investors that are considering launching their own fund to prepare for the financial uncertainty that comes with being a business owner rather than an employee.
SumZero: Gate City recently filed a schedule 13-G form disclosing a 17.5% ownership in Optex Systems Holdings Inc. (OPXS). When Optex reported their quarterly earnings less then a month later, the stock popped ~50%. Could you walk us through your Optex thesis?
Melby: Optex Systems manufactures optical sighting systems primarily for the defense industry. Optex is the largest manufacturer of laser-protected periscopes for the U.S. military and manufactures sighting systems for armored land vehicles and rifle scopes for commercial customers. We thought the company’s free cash flows could show dramatic improvement as the United States and other allies expand and upgrade land vehicles including the Abrams tank and Bradley fighting vehicles. Additionally, several of Optex’s primary competitors have recently exited the market, which should allow Optex to command higher margins over time. Prior to the recent earnings announcement, Optex had a market capitalization of under $9 million and an enterprise value below $7.5 million. We thought the company’s valuation provided us with limited downside and the potential for substantial upside if our thesis played out.
SumZero: What did your primary research on OPXS look like? How does one do effective due diligence on military hardware or other goods/services that aren’t available to the lay-consumer?
Melby: Our diligence process started after meeting CEO Danny Schoening at an investor conference. Danny had a strong industry background, and we were impressed with his intelligence and work ethic. We analyzed the company’s historical financials, researched the weapons programs Optex was involved in, and projected the company’s future cash flows. We also traveled to the Dallas area and visited the company’s two facilities. We came away with a better understanding of the manufacturing process and gained an appreciation for the challenges a competitor would have to enter the industry. On the commercial side, we researched the rifle scope and spotting scope markets and spoke with the commercial and retail customers. Through our research process, we developed a high level of conviction in the company’s products and the management team.
SumZero: What amount of risk do you assign to OPXS’s relatively undiversified revenues? (39% US Govt., 27% US Defense Contractor, 22% one commercial customer)
Melby: Optex is highly dependent on military spending for the company’s revenues and profits. The U.S. budget sequester in 2013 was a hard time for the company. Although this risk cannot be diversified away, we take some comfort in the planned increase in military spending by the current administration. Planned upgrades of existing land vehicles and the planned roll-outs of new land vehicles provide additional comfort.
SumZero: Who or what have been your biggest inspirations in micro-cap research?
Melby: I am not sure if I can identify any one person or event. I find it exciting to learn about small companies and the industries they operate in. Applying knowledge gained during the research process to invest capital in a company that is undervalued to be what capitalism is all about.
SumZero: What role do online research tools like SumZero play in your research process?
Melby: I have found SumZero to be a helpful part in my research process. I found the feedback provided by SumZero members to be important in identifying parts of the thesis I might have missed. I have also found the research on SumZero to be high-quality and have used it for idea generation. SumZero has also helped me build a network of like-minded investors that I have found useful in exchanging ideas and industry insight.
SumZero: Your medial annualized return across your SumZero ideas is 32.95%. What do you ascribe your investing success to?
Melby: I have been fortunate to have had some great mentors and teachers over the years. I also feel fortunate to now be working with two partners at Gate City that share an enthusiasm for deep value investing in micro-cap equities. Through these prior experiences and collaboration, I have discovered an investment process that works best for my skills and abilities. I have found success thus far by adhering to the investment process that I believe can add the most value to our partners over the long-term.