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Small caps Michel Pireu     | Business Day Tuesday, March 5, 2019
Philip Carret was born in 1896, the same year the Dow Jones Industrial Average was launched. When he was 32 years old, he started the Pioneer Fund, one of the first mutual funds in the US. He managed it with great success for 55 years. Warren Buffett has said of Carret that he should be studied by every investor and if there was ever a hall of fame for investment advisers, he'd be among the first ten in it. In an interview with John Train, author of The Money Masters, Carret revealed that his favourites were the over-the-counter stocks. “And yet I'm more conservative than most people,” said Carret. “Most people think that 'conservative' means General Motors, IBM, et cetera. But I've always been in offbeat stuff. They're less subject to manipulation than New York Stock Exchange companies, and are less affected by crowd psychology… I avoid fads like the plague. When I invest, I gamble with a certain amount of my capital, buying dogs."

While beginning investors or those without the time or ability to do in-depth research are better off sticking to bigger fish, for those who are not so constrained – who know what to look for - buying into undervalued small caps possibly provides one of the better chances of beating the market.

Most institutional investors and hedge funds cannot spare the time and money to research smaller stocks – it’s just not worth their while. Consequently you’re more likely to find a bargain in this relatively under-exploited area of the market. But, of course, because there is less interest and less coverage, doing your own due diligence becomes that much more important.

That said, investing in the dogs as Carret put it, comes with a few disclaimers. Unless you can read a balance sheet, income statement and cash flow statement properly, forget about it. Unless you’re able to take everything you hear and read (especially from insiders) with a grain of salt, challenge every assumption, dismiss every story (except the bad ones) and are willing to bail out at the first whiff of trouble, forget about it. And, unless you have the time and the desire to ensure, even after you've bought, that you will always know more than your average small-cap writer, forget about it.

After that, if you still think looking at small caps is worth your time and effort, a good place to start is in knowing what not to bother with.

If the company has not grown revenues consistently for some time, look no further. If the company is not growing operating earnings and cash flow, look no further. If the company is heavily in debt, look no further. If the growth potential isn’t immediately obvious, look no further. If management has failed on previous occasions, or can’t be trusted, look no further.

If revenues and/or value aren't of a sufficient size (and here you decide) it isn't worth your time.

Nor should you waste time looking at those small companies that are enjoying a lot of media attention. There’s always a good reason someone’s put out a story, but it’s seldom for your benefit or to your advantage.

Finally, don't bother looking at companies that compete in industries you don't like, don’t understand or can’t see growing at a brisk pace – why would you?

Next you want to avoid the common mistake investors make when investing in small companies: Paying too much for expected growth; applying a large company earnings multiple to a micro-cap 's earnings. Of course, if it's a small company that is growing fast and that growth is occurring at a high rate of return on capital, paying up is justified. But all too often the upside story gets more attention than the downside risk, and the risk of overpaying for earnings that may not prove sustainable is very real.

Besides, a discussion of expected profits and how they relate to market performance should always begin with the caveat that earnings and stock prices are not joined at the hip. There is virtually no historical correlation between changes in year-over-year earnings and stock prices.

“The main problem,” says William Hester at Hussman Strategic Advisors, “is that the prospect for long-term returns hinges on whether the earnings and profit margins used by investors to value stocks are normal and sustainable, or unsustainable. Unless current profit margins can be sustained indefinitely, price to earnings multiples may turn out to be very unreliable measures of value. In addition, most meaningful profit recessions have been preceded by stock market declines. Lower prices led both of the earnings declines beginning in 1991 and 2001. While the earnings slowdown in 1998 was mild, it was also preceded by a drop of almost 20 percent in the market.”

So, what should you look for when investing in small caps?

The quick answer: cash, cash, and more cash. Essentially, the ability to generate cash is king. Look primarily for companies that have demonstrated the ability to consistently generate cash, and are growing free cash flow over time. Then look to buy these companies at a low multiple of that cash flow - ideally under six or seven times. There has to be some compensation for the risk you are taking buying into a tiny, illiquid stock. It makes no sense to pay ‘fair value’ (something that’s almost impossible to determine) for this type of stock. If you’re not buying at a significant discount, it's not worth the risk. Rather stick to more liquid stocks on which more light is being shone.

The other thing to look for is cash on the balance sheet. If you can find a stock trading for 50c that has 49c a share in cash on its books and is still generating cash, it’s unlikely you’re going to lose a lot, whatever its size.

Have an entry and exit plan and stick to it.

Don’t put too much at stake. Small caps are volatile. They are inclined to move quickly, by a significant amount. Sure, buy a stock at 10c in the hope of selling at 15c, but remember that it can just as easily go down to 5c – in which case you’ve lost half your money. Do this a few times with your entire bankroll, and you’re quickly out of the game! Nor can you rely on a stop-loss to prevent it happening. The illiquidity and large spreads that are a feature of most small caps don’t allow it. Rather limit your purchases to a small fraction of what you’ve allocated to this particular game, and in turn limit that to a small percentage of your overall portfolio. Even so, most “serious” investors will tell you that’s already too much. But ignore them.
 
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