Jonathan Booth's  Instablog

It has been well established that micro-cap stocks have some unique advantages over larger companies: namely relative obscurity and a lower base allowing for higher growth potential.  However, those advantages come at a cost - micro-caps are obviously considerably riskier than larger companies.  A lot of micro-caps have a great story to tell, just ask their CEOs, but I am more interested in performance and financial health.  So I have created the following checklist to assist in quickly weeding out the micro-caps that are too risky from the ones worth looking into further. 

For clarification purposes, I consider companies with a market cap below $500 million to be a micro-cap.  In the checklist, some steps call for outright dismissal of the company if it fails to meet the criteria.  I dismiss immediately because those companies on average are far too risky for their size plus there are plenty of other more promising opportunities that deserve your time.  

1.     Check to see if stockholder's equity is positive.  If it is negative, dismiss the company outright and move on.  Negative stockholder’s equity means that liabilities exceed assets, and, for a small company, that position is often untenable and can stunt and ultimately destroy the company’s growth opportunity.   If stockholder's equity is positive, then look to see if it has been increasing and, if so, if it is due to organic growth or frequent new equity offerings.  Organic growth is obviously preferable.  Frequent new equity offerings often means the company does not generate sufficient cash organically to fund operations and is likely to continue offering new equity in the future, thereby continuously diluting existing shareholders.

2.    Check to see if the current ratio is at least 1.0.  If it is below 1.0, then look at the make-up of current assets and liabilities.  If deferred revenue is present in current liabilities, then that is not representative of a future cash outlay and can be backed out.  If the remaining current ratio is still slightly below 1 after adjustments, then you will need to more carefully consider the remaining steps.  If the adjusted current ratio is significantly below 1, then this represents a serious going concern issue and the company should be dismissed outright.

3.     Check to see if revenue and gross profit have increased over the periods presented and if they have increased in tandem.  Increasing revenue paired with decreasing gross margin can either be indicative of short-term input cost pressures that have not been passed on yet or may be an indication of the company’s lack of pricing power.  If revenue has increased while gross margin declined, then you will need to more carefully consider the other steps.  Further, when analyzing the company more fully after it passes this checklist, you will need to understand why revenue and gross profit did not increase over time.

4.     Check to see if SG&A expenses outpaced revenue growth.  If they have, it might be a sign of either poor cost controls or management's interests not being aligned with shareholders.  Higher payroll costs as a percentage of revenue are of particular importance because non-shareholder friendly management often has a “pay me first” mentality.  When SG&A grows significantly faster than revenue for a few years, I am usually reluctant to continue further analysis. 

5.     Finally, check to see if FCF is positive or trending positive.  If FCF is negative, is it because the company increased working capital or because the company lost money on ongoing operations?  Increases in working capital are usually recovered or, at the very least, lead to higher cash flow generation.  Conversely, lost money on ongoing operations is generally not recovered.  Therefore, an increase in working capital causing negative FCF might still be acceptable.  The alternative is not. 

Those are my five steps for quickly analyzing a small company to determine if it is worth further analysis.  The above list may cause me to miss out on some great companies, but far more often than not, it will prevent me from wasting time on what will ultimately be a poor investment.    

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

If you read my latest article on Collective Brands, then you know that I fell in love with their management. The attention to detail they demonstrated, their success in reigniting old brands they purchased, their highly efficient global supply chain operations, and the CEO's expressed number one priority of "developing talent."  Then they did something that would seem to fly in the face of my opinion of management.  The CEO abruptly resigned...giving no reason for the resign...and with no succession plan in place.  

Obviously, the CEO does not resign for no reason.  It would appear that the Board was not happy with the speed of progress or the disappointing Q1 results and decided the company would be better served under a different CEO.  As outside investors, we rarely truly understand the inner dynamics between a CEO and the Board, so I cannot say with any accuracy all of the reasons the CEO resigned.  Regardless, I expected a company with this caliber of management to have a succession plan in place.  To be clear, I mean an internal succession plan, such as having the next CEO identified and groomed within the company.  Having a CEO leave without having the next one ready is like quitting your current job before getting a new job.  It is usually not very logical.  This is purely conjecture, but these circumstances lead me to believe that there was something else at play than pure performance, such as a strong personality clash. 

The General Counsel, who does appear to have a good bit of operational experience, is stepping in as interim CEO with the stated intention of not being the permanent CEO. The board is currently searching for a new permanent CEO and will likely hire someone outside of Collective Brands for the position.  Having read such incredible books as Built to Last and Good to Great by Jim Collins, I understand that the best companies routinely groom management internally and promote from within.    This policy allows the corporate culture to be nurtured and promulgated to the next generation, thereby preserving the core values that made the company successful to begin with.  It is for this reason that I was highly encouraged by the now former CEO’s statement that his primary job is developing talent.  

Clearly, external hires directly into the CEO position can and do work out well, so not promoting from within does not mean that the company will all of a sudden be a terrible investment.  Further, we do not believe that any success achieved by PSS was fully attributable to the former CEO.  One man does not a company make, after all.  There is still, in our view, plenty of capable managers at PSS.  In addition, we still really like PSS’s business model and prospects in both the near-term and especially in the long-term.  However, we understood the vision of the former CEO and felt confident enough in that vision to invest in the company.  The questions regarding who the next CEO will be and what his or her vision will be provides enough uncertainty for us to trim our position.  Therefore, we reduced our position in PSS by 1/3.   

One segment of society that I think is misunderstood is the unbanked and underbanked community.  Specifically, there seems to exist the perception that anyone offering any kind of financing to this community is somehow taking advantage of it.  While that may be true in some instances, that is certainly not the case for the publicly traded companies I have analyzed that provide valuable services to this community at reasonable prices.

The unbanked are individuals who do not use banks or credit unions for their financial transactions.  The underbanked have either a checking or savings account but also rely on alternative financial services.  People find themselves in one of these two categories for a variety of reasons, including poor credit history, outstanding issues from a prior banking relationship, negative experiences with banks creating mistrust, low-income forcing the consumer to live paycheck to paycheck, and/or simply lack of relevant education. 

This group of people still needs to make major purchases, such as buying a car or household appliances.  Obviously, they will not be able to come up with the cash to buy the products out right so will need some sort of financing.  Many of them are in situations where they work in one country and have to send cash to their home country to feed their families. 

Unfortunately, because of the poor reputation of places such as pawn shops and pay day loans, most people simply assume that anyone providing financial-related services to this community is in some way taking advantage of them.  For certain companies, nothing could be further from the truth.  In fact, it is actually counterproductive for businesses to take advantage of these consumers because the businesses will lose those consumers when they go bankrupt or simply default.  We look for companies that understand this type of consumer and, therefore, charge only the rates or fees appropriate for the risk, focus on strong relationships, and provide a necessity (such as a car) instead of a luxury (such as a 52-inch TV). 

The size of this community will probably surprise you as it did me.  According to a survey conducted by the FDIC in 2009, an estimated 30 million households in the United States fall into one of those two categories, which is 25% of all U.S. households.  That is an astounding number of households that generally cannot get certain financial-related services through normal channels.  The largest concentration of this community is in the southeast part of the U.S. 

America’s Car Mart

One company in particular that does everything right is America’s Car Mart (CRMT).  CRMT is in the “Buy Here, Pay Here” niche of the used car dealership industry.  The company focuses on unbanked and underbanked consumers with credit scores generally too low to get financing for cars through normal channels.  The “Buy Here, Pay Here” market is exactly what it sounds like.  Consumers buy the cars from the dealership and then physically go back to the dealership every week, two weeks, or a month (depending on how often they get paid) to make their car payments.   CRMT finances the purchases itself and keeps all loans in-house.  The company does not bundle and sell-off any of its loans, thereby creating greater incentive to minimize default rates.  Further, each dealership’s general manager is responsible for 100% of the decisions made at the dealership, including all financing decisions.  Those general managers are also partially compensated on how affective those decisions are, particularly the financing decisions. 

CRMT has over 100 dealerships across the Southeast, targeting small towns of less than 50,000 people.  The company has a great management training and development program, well thought out processes, a strong focus on customer relationships, and a solid back office that the mom-and-pop competitors simply cannot compete with.  Most telling is the inventory turnover per dealership that is over twice that of the industry average as well as the ~21% default rate versus the industry average of ~30%.  Further, 30% of their total business is repeat business – 50% at their more mature operations.  The average interest rate on its loan receivables is 13%, which is reasonable given the risk implied by the high default rates.

CRMT’s growth opportunity lies in the fact that there are plenty of untapped markets in its target region.  The company plans to increase the number of dealerships approximately 10% annually, and the new dealerships generally reach a ROIC of 15% within a year or two thanks to the meticulous processes and business model CRMT has honed over the past 30 years.

We think CRMT has roughly 100% upside at the current price, partly due to Wall Street’s misunderstanding of the business and the community it serves.  The industry also faces potential additional regulation as a result of the Frank-Dodd act.  However, we believe any material regulatory changes to be unlikely because the industry provides such a valuable service and its largest competitor and de facto face of the industry, CRMT, provides a very good example of how fairly the unbanked and underbanked community is treated.  Besides, any regulatory changes would only benefit CRMT by negatively affecting its competitors since CRMT is better equipped financially and staff-wise to deal with those changes.

Disclosure: I am long CRMT.