Unlocking Hidden Value in the Graveyard of Smaller Public Companies
In today’s chaotic market environment, an overlooked opportunity exists within smaller public companies—a sector that has underperformed the S&P 500 for years. While Wall Street focuses on mega-caps and passive investing dominates, these forgotten micro-to-mid cap companies harbor potentially breakthrough solutions to our complex global challenges.
Pythia Capital’s complex systems investing principles offer an innovative approach to discovering value in this neglected market segment. By applying natural ecosystem principles and game theory concepts like the Nash Equilibrium, investors can create win-win scenarios that benefit both companies and stakeholders while generating significant returns.
This article explores how collaborative investment strategies can transform the predatory dynamics currently plaguing smaller public equities, creating sustainable value in an area essential for economic vibrancy. For investors willing to navigate higher risks thoughtfully, these “ashes” may contain the phoenix of tomorrow’s market winners—companies with untapped potential that solve critical problems while delivering exceptional performance.
Systemic Challenges Facing Smaller Public Company Investments
* Passive investing exceeding active investing, which erodes price discovery
* Consolidation of small brokerage firms that previously covered these companies and made markets in them
* Internet message boards filled with predatory short investors
* Exploitative deal terms that make loan sharks look favorable by comparison
* Excessive regulations that harm rather than help smaller companies and high integrity investors
* General indifference to companies’ products and services, with a focus solely on profit
* Retail investors and predatory hedge funds dominating this investment space
* Excessive monetary and fiscal stimulus creating moral hazard in the startup ecosystem
* Higher-quality private companies staying private longer, reserving big returns for elite investors
* Younger investors focusing only on ETFs, index funds, crypto, or popular large companies
* Older investors avoiding this risky market segment entirely
* High operational costs and poor liquidity deterring professional investors
* Volatile price swings caused by quantitative hedge funds operating as “black boxes”
* Growing global macro and micro economic instability making it harder to attract investors to this important area
How Game Theory and Complex Systems Principles Can Support the Davids Over the Goliaths
The article below is a reprint of my original piece from July 20, 2017, which has become even more relevant today. Recently, while discussing game theory with a friend (this time a computer scientist and not a math professor)—exploring how it could positively transform opportunities for smaller companies even in today’s chaotic environment—I was reminded of a similar conversation from years ago that inspired this article. For investors with higher risk tolerance, Pythia Capital’s complex systems investing principles offer a pathway to unlock value in smaller public companies, many of which have been reduced to “ashes” by current market conditions. Our “Phoenix Rising” smaller capitalization investing strategy harnesses the constructive aspects of game theory naturally embedded in our investment principles. Investors can potentially generate positive returns while simultaneously serving as catalysts for positive change, helping transform this typically predatory market segment.
Here is a Copy of the Earlier Article
Investing Using Complex Systems Principles to Enable “NASH” Equilibrium (Optimal/Best Outcome)
Unlocking Value in Micro-to-Mid Capitalization Public Equities
I was riding on the train recently and sat next to a retired math professor. We were discussing how living complex adaptive systems principles could be used as an investment process that is more sustainable for society and also could help to optimize outcomes for all parties. In western financial markets where “Winner Take All” is still the predominant strategy for investing, that previous statement may sound like a fairy tale. It is a misperception that win/win solutions are not possible. There are a growing list of entrepreneurs and businesses that are challenging the status quo with very successful and exciting strategies. There is also a growing number of investors focused on systemic value strategies as a solution to the investing side of the equation.
I chose natural ecosystem principles as the core foundation of Pythia Capital’s investing process to follow Nature’s lead to better optimize complex problem solving, help to create and screen for innovative products/services and also help to determine an investment process that more optimally aligns incentives for all stakeholders. There are very comprehensive and fluid principles. This is actually not surprising as these principles take advantage of billions of years of evolution. Mother nature has done the hard work for us if we just pay attention.
The math professor reminded me of the work of 1994 Nobel mathematician John Nash (from “A Beautiful Mind”). The “Nash” Equilibrium, also known as the “Non-Cooperative Equilibrium” (Game Theory), results in a dominant strategy that rewards non-cooperation. “When everyone’s playing their best move to everyone else’s best move, no-one’s going to move.” The dominant strategy is one that is always the best move for an individual regardless of what the other person does. The famous example often discussed is Prisoner’s Dilemma where 2 men were caught for a crime. Each wants to minimize jail time so each determines it is better to rat on the other. If they cooperated and did not rat on each other, they would have had the optimal outcome but that is not the dominant strategy. In a scenario where each person has perfect information on what the other will do this scenario is not relevant so Nash Equilibriums are often discussed as inefficient.
In academic studies, we learn that the stock market is efficient. If that were something people actually believed was universally true, then there would not be a fraction of the active managers in the world. In the micro-capitalization to mid-capitalization sized public equities investment world (where I have considerable expertise), if we make the assumptions that both inefficient markets do exist and that people will follow through on their perceptions on what they think the other players will do, both our complex systems investing principles and Nash’s theories are interesting, enlightening, and mutually beneficial.
There is little liquidity in the markets these days for smaller publicly traded companies. There is considerable opportunity for investors to make considerable upside on their investments, but these investments are very risky. Stock picking is difficult; as companies will often fail to deliver upside to their investors even if they are well managed, have good products and services. Few would argue the importance of small companies to our economy but this situation is an unhealthy dynamic that discourages investment.
We often find very interesting small public companies with very important products or services but still need to raise capital to grow. As there are fewer and fewer long term, retail investors and smaller funds to take advantage of these opportunities, companies usually have no choice to raise money however it is available. These days that usually means going to a variety of hedge funds and other high net worth investors that routinely invest in these markets, but they often have very short-term time horizons and are self-interested. The predominant investment strategies are predictable. This often means predatory financial terms for these entrepreneurs and misaligned incentives for other investors such as mutual funds and other retail investors that are not part of these investor syndicates.
It is not unusual to see companies trade down dramatically and even go bankrupt due to these toxic investment terms. Though it can be a core part of a strategy for these investors to drive a certain company into bankruptcy, it is often not why investors use these predatory deal terms. The common strategy for the investor syndicates is to minimize their individual risk, which seems very rational to them especially for investing in these risky companies. Also, hedge funds have rich financial incentives to make money over short time frames in all market conditions.
Even if you want to invest in a smaller company that has an exciting and important product or service, not only will you most likely lose money in this investment if you are not part of this syndicate by passively investing in this stock, you will also often find that even the hedge funds will often lose money in many of these scenarios. These types of investments are often very small to many hedge funds and they can be like a free option for many of these funds as they are often quite large. When the investments work they can provide significant upside to performance.
Judging these investors as unethical does not do any good, as their decisions seem quite rational to them based on their incentives and from their personal risk parameters. It prevents large groups of regular people from even wanting to invest in these companies. It is easier to evaluate the situation very dispassionately and strategically and find how you might be able to turn this situation around. After all, finding “alpha” type of performance is much easier in these situations if you can find a way to do it successfully. Smaller companies are important to our economies and collaborating with them to unlock value is a win-win scenario.
The various Nash Equilibrium scenarios provide healthy guidelines for how people will behave in scenarios like this. Here is where it gets fun. Pythia Capital’s complex systems investing principles can help guide investors and companies to win-win collaborative scenarios. These principles are very ethical and naturally align incentives and reward a collaborative process. Knowing how this works, it makes logical and rational sense for a company to reach out to investors who are aligned with their interests. They may be smaller in number but complex systems investors are a great target for these management teams as they often speak the same language and share the same philosophies and goals. In this Nash scenario, these particular investors are more collaborative, longer term, and most likely will lead you to a more optimal business and investment outcome. The predominant predatory investors involved with smaller public companies are not even thinking along these lines. It would seem very counterintuitive to their personal risk management techniques.
Assuming that all the other due diligence checks out, it means that enlightened investors and companies can work together to make sure they are helping each other to better understand these principles. It is quite remarkable that you can find both natural investing and mathematical principles that back up and reward highly integrated entrepreneurial and investment processes to better optimize outcomes for all parties. No one can say every investment will work as these still can be risky investments, but this process should lessen investment risk and maximize performance for the portfolio as a whole. Most investors are rational enough to want to invest in what matters in a way that optimizes their outcomes. For smaller companies that are relatively undiscovered, you can unlock considerable value in this manner. It is also fun and very rewarding to be an integral part of this vibrant process.
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