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 fallen3, 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.5

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