A Mighty Microcap? The Case for ScanSource, Inc. (SCSC)

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We do this for two reasons. First, the portfolio managers who write this newsletter run money and are all too familiar with the blizzard of “never-wrong” newsletters that dominate the financial landscape. Aside from being potentially misleading, they can cost investors dearly due to their misplaced confidence and lack of real-world accountability.

The second reason is because the heavy emphasis our models place on fundamentals means that after periods of underperformance, eventually the math matters. In that first piece and its companion piece, we explained that the model’s poor performance over the last year had left the portfolio primed to outperform. Quite simply, the model portfolio was a group of ignored and overlooked stocks that typically had prodigious cash-flows and healthy growth runways.

The chart above shows the returns to the various sizes and styles since our April publication through the end of December. So far, we have been vindicated. But this piece is not meant as some sort of victory lap.

Quite the contrary. What we find remarkable is that the universe of microcaps is so entirely overlooked that even after this 21% tear, our Micro Model Portfolio has continued to source wildly mispriced (too cheap) stocks from the universe. At the moment, our Micro Model has a FCF Yield of 10% compared to the Russell 1000 Core ETFs’ holdings which have a FCF yield of less than 3%.

In these days where a trillion dollars’ worth of large cap market cap can vanish due to five-day old news about some powerful and cheap AI out of China, KCR recognizes that keeping track of magnitude can be challenging. To state the obvious, with a 3% FCF yield, the popular large cap ETF is trading at a ~400% premium to our holdings. Micro Caps are an illiquid and volatile asset class that are not suitable for everyone – be sure to discuss with your Financial Advisor before investing.

With that said, the data continues to suggest that KCR’s Micro Model should be able to deliver powerful upside returns with a much higher margin of safety than the expensive and concentrated large cap index funds. This is only true however if investors recognize that the volatility in the asset class is the heart of their appeal. In this era of “volatility laundering” where many private equity and private credit strategies manufacture low volatility and use that to inhale capital, nobody should be surprised that the most volatile listed equities also offer some of the biggest opportunities, in our view. Another reason micro caps have become such a fertile opportunity set? With the indexing bubble continuing to inhale capital for listed equities, the commercial money management complex now needs billions to make a product worthwhile.

KCR and its principals, who have launched and invested our own capital in a modified version of our KCR Micro Model portfolio, suffer no such constraints. Since publication we have published numerous pieces of deep-dive fundamental research on these stocks including ARIS, OSG, EE, PSFE, and today we add to the list via our work on ScanSource. Like so many of the holdings in KCR’s Model Portfolio, ScanSource (SCSC) looks like the type of unloved, uncovered, and misunderstood stock that could potentially double.

Summary

ScanSource, Inc. (SCSC) is a distributor of technology devices and services from 500+ suppliers. With a strong reputation in specialty technology hardware, SCSC is a one-stop shop for sales agents who create customized applications for end users. While not as large as some in this competitive space, ScanSource is considered a major player, with the ability to quickly and reliably deliver what customers want.

Recognizing the need to go beyond its established low-margin, hardware-based distribution business, over the past eight years SCSC has become a leader in higher margin hybrid technology solutions and is leveraging its traditional strengths to generate recurring revenue. It is poised to benefit from the opportunity represented by AI’s impact on tech spending.

Why we are bullish on SCSC