Simple Rules For Finding Small Cap Investment Opportunities

by: Erik Kobayashi-Solomon

Originally Published September 2, 2016

Team IOI spent the last two days at the Midwest IDEAS Conference - an investment symposium shining a spotlight on small capitalization companies that's hosted by investor relations firm Three Part Advisors, LLC. Three Part's founder, Dave Mossberg, is a former analyst himself and deeply experienced in the small cap investment space. He organizes three invitation-only conferences a year, each showcasing the best small and micro-cap companies that have come across his desk by way of his network of institutional fund manager contacts.

IOI got some good ideas at the IDEAS Conference and those will come to you over the course of the next month. Here is just a sample of the companies we heard present and, in many cases, had the chance to speak with upper management:

Table

Structural Opportunities

Small cap equities have been an investment subject unto themselves over the past 15 years since historically, these stocks generate higher returns than their larger market value peers. We believe that much of this outperformance is a function of the structural issues about which we talk in the IOI 101 course on behavioral biases and structural factors.

Sell-side firms (places like Goldman Sachs and Morgan Stanley) generate revenues through trading fees. The higher the volume flowing through their desks, the more revenues they generate. Small cap stocks tend to have lower trading volumes, so sell-side trading desks are not as interested in transacting in them in the first place.

Also sell-side research analysts are, in a real sense, the marketing arm of their firms' trading desks. At the end of the day, analysts' jobs mainly consist of figuring out reasons for institutional investors with very large portfolios to (mostly) buy and (rarely) sell large cap stocks through those desks. If trading volumes and market capitalizations are small, it is a career-limiting move for an analyst to "waste" any time on small cap research.

Because analysts don't publish reports on small cap companies, many investors never come in contact with them, and because of that, trading volumes are low. It's a self-perpetuating, vicious cycle of lack of attention leading to low volumes leading to a lack of attention. This vicious cycle can be frustrating to small cap company managers, but it also often gives rise to opportunities to patient, insightful investors.

Analytical Difficulties

Underfollowed stocks can present good opportunities, but they can also present unique problems. While some small cap stocks are those of established companies with well-defined business models and strategies (e.g., Encore Wire or Macquarie Infrastructure in the list above), others are in the process of trying to create a new market into which they will sell a wholly unique product (e.g., Park City Group or NovoCure in the list above).

Companies with established business models are usually much easier to value because the demand environment is more understandable, as is how the company's profitability changes during different stages of the business cycle. But for companies that are expanding into totally new areas, it is difficult to project even rough best- and worst-case scenarios for these basic valuation drivers.

In addition, it is hard to know how long it might take before a firm like this reaches some "normalized" level of revenue growth and profitability. Small firms often have a few very important customers, and if one of these customers suddenly cancels a contract, the firm's progress can be set back years.

It's for this reason that small cap stocks' price volatility is often high, and why our valuation ranges for small cap stocks are also often wide.

Finding Attractive Ideas

There are some 9,000 or so companies listed on major U.S. markets that range in size from micro-cap (tens of millions of dollars market capitalization) to mega-cap (hundreds of billions of dollars market capitalization). How is it possible for busy professionals to sort through that many stocks to assess attractive investment ideas?

Some people rely on quantitative screens, but as we discuss in the IOI 101 course, common screens on financial ratios can often be misleading and of limited use. Other people take a more haphazard approach - getting tips from one's golfing buddy or overhearing a conversation in the Starbucks line. This approach has an obvious drawback: the person you're listening to probably has nothing but anecdotes and wishful thinking fueling his or her investment thesis.

In contrast with these methods, we like to follow three simple rules for assessing new ideas, then take a quick peek at the firm's key valuation drivers to see whether or not it looks like it is worth spending more time on to do a full valuation.

  1. The idea comes to you from a knowledgeable, trusted source. The source might be a famous investor (Buffett portfolios and our own Covered Call Corners fall into this classification) or someone who has a lot of experience in a certain industry.
  2. The idea has been vetted by that source. If a knowledgeable, trusted source has led you to an idea, there must be a reason the source liked it in the first place. What is that reason? They should be able to express their reasoning in terms of the key valuation drivers that we discuss in our IOI 102 course on valuation.
  3. The idea falls within your wheelhouse. This is a nod to Peter Lynch's dictum to invest in what you know. While Lynch's rule of thumb can lead to problems as well - specifically, people confusing anecdotes with valuations - we do believe it is a good idea to take a pass on things that you don't understand and don't want to learn about. Don't know what a reinsurance company does? Don't care? You read the statements and it's all gobbledy-gook? Do yourself a favor and take a pass.

The IDEAS Conference was a great opportunity because we already knew that the companies presenting had been reviewed and vetted by a knowledgeable, trusted source. Since it's a conference focused on small cap stocks, we also had reason to believe there might be some interesting, underfollowed companies in the list, giving us a structural edge. In an environment like this, it is just up to us to decide what falls within our wheelhouse and whether or not we want to spend time learning about a certain business.

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