I am happy to present the promised interview with Dan Schum, an investor and blogger who focuses almost exclusively on stocks below $50 million market cap with a significant amount of his portfolio consisting of stocks below $5 million in market cap. This obviously makes him a frequent OTC investor. His portfolio has so far produced great returns and his picks can provide an interesting look into the OTC world. I hope you will enjoy the below discussion as much as I did.
As per usual to open the discussion, how did you find yourself analyzing stocks and investing?
I was working for a startup company in LA when the money ran out in January 2013. One day we came into work to an all staff meeting, the CEO said sorry the money has run out and you're all on permanent furlough. Luckily I had seen the writing on the wall and already interviewed, so we moved down to San Diego a few weeks later for a new job. That experience really hammered home how dependent my family is on my income and I decided it was time to see what else I can do financially to become more secure. I was 33 at the time.
I am an engineer without any formal financial training other than one Economics class in college. I come from an upper middle-class background and got a good job out of college. I had never worried much about money and my Catholic upbringing sort of laid shame to all things money and greed. So prior to this I had no knowledge of the stock market though I did own some mutual funds through a 401k and IRA.
I started reading in January 2013. My wife had got me a streaming audio books subscription for Christmas and I started with the only financial thing I had heard of: Rich Dad Poor Dad. HA! I had heard some ad for it on the radio. I didn't know what I wanted other than for my family to be less dependent on my salary. Rich Dad is a total scam and I went through about 4 books but it did pound home the idea of being financially literate and continuing your financial education throughout your life (with the help of Rich Dad seminars and books of course...). Rich Dad talked a lot about starting your own business but I knew that was not for me.
I moved on to the next financial thing I had heard of, Jim Cramer! I really know how to pick 'em. Cramer is all over the place but he's the first one who explained to me what a P/E ratio is and how the stock market works so it was valuable. This was the first time I heard the terms "common stock", "preferred", "book value", "equity", you name it. I went through a few books and came to the conclusion that maybe the financial diversity I was seeking could be in the stock market. But definitely, I could not follow Cramer's style because as near as I could tell it was completely dependent on listening to Cramer specifically. Naturally. He's a salesman.
Next on the list was google this name Buffett I'd heard of and I came to Mary Buffett's books. I went through a few of those and finally felt like someone explained how to analyze a stock. Cramer's approach seems to be that he has this lifetime of knowledge built up in his head and you should just listen to him. Mary Buffett actually explained the thinking behind some purchases and it made sense to me. The problem I had with Buffet was the complete lack of discussion on when to sell. Buffett's whole focus was on when to buy. He has the famous quote about how his favorite holding period is forever...what BS! I'm here to make money, not buy stocks then die. I am an engineer and think like one. I need something concrete (so Cramer and Rich Dad are out). I need something quantifiable on both the buy and sell approach (so Buffet is out).
At this point, I had been reading for a few months and figured I learned enough to buy a stock. I didn't yet have an idea of when to sell but figured I need to get my feet wet. I started with about 5% of my retirement money and bought a handful of stocks. The first group was straight out of Buffett's book: huge companies with history, cheap from a value perspective and likely to still be around in a decade. Apple, Wells Fargo, BRK.B, Disney, UNP. This was April 2013.
Eventually, I stumbled onto oldschoolvalue.com where there was a recommended book list and I found 'F Wall Street'. I read that and it was like my brain opened up. It was all so clear. The definition on when to buy AND when to sell. Concrete numbers. Equations. For those who haven't read this one, it talks about using a DCF: you buy with a margin of safety then sell at fair value. This is one of the few books in my life I've read twice. I immediately sold all the Buffett stocks and started over.
From here on out I was a value investor through and through with the basis coming from oldschoolvalue.com and F Wall Street. I found many different value blogs online. Over the next couple years, I read close to a book per month. I've read all of Buffett's letters, Klarman, Graham, Greenblatt, you name it. I've read financial statement analysis books. Anything I could get my hands on that was recommended by someone reputable. After a couple years I slowed down a lot on the book reading and spent more of my investing time reading filings. Lately, I've been ready charting books.
Now investing is my passion. Buffett has said you can't really teach value investing, it's more something they are either born with or not. I feel I was born with it. It makes sense. Gradually over time, I took over more and more of my retirement money and now I manage about 95% of it in the nanocap/microcap space. I also invest some of our after tax savings.
I still work as an engineer full time. I invest, read, and blog in my spare time.
Why did you end up focusing on micro-caps and the OTC space?
As mentioned, my first purchases were mega cap companies that everyone knows: Apple, Wells Fargo, etc. I started with the big companies because I was comfortable with them. I just felt uneasy with a company I didn't know. Then one day, a few months into my stock ownership, I read an article on a microcap (INFU) on oldschoolvalue. Jae owned it and laid out some really good reasons to buy so I did. At the time I held maybe 5 stocks. Something like AAPL, MSFT, ORCL, INFU. I had my portfolio on Seeking Alpha and would check for new articles. Of course every day there were about 10 new AAPL articles on SA. Often there were articles on MSFT. My feed was just packed with info, comments, and opinions on these big companies. If a stock went up a percent or two the financial world went crazy. I remember TheStreet even live streaming AAPL earnings! It was just so much. Too much. I could not keep up and really is there a benefit to keeping up?
I read one AAPL article that was very impressive. Actually, it was about some chip maker that was a supplier of AAPL phones. It was amazing. This person had done all kinds of research and digging to find out who makes some chip and why this new tech chip would be in the new phone. It was real second level thinking and on top of that, there were a ton of commenters who knew just as much as the author! I also owned a stock IMOS which deals somehow with computer chips and there were incredible articles written by people who know more about digital memory that I could ever hope to. Here I was buying stocks based on SA articles, blog posts, or a 10-minute DCF and then you have these people spending all of their time on it. Really smart, impressive, dedicated, and motivated people were playing in this space. Eventually, I started to think who am I kidding. How can I compete with all these MBAs and PhDs.
All this time INFU was just sitting there. The stock rarely moved much and there was no news so it was easy to keep up with. Earnings would come and go without much fanfare. It was great. As I said I work full time and have a family to look after. I take the train to work so I have about an hour a day to read, plus a few minutes here and there during the day. I ended up making about 90% on INFU in 8 months. I read a number of studies and articles which all said similar things: the smaller the company the better the returns. Less liquid equals better returns. Longer holding period equals better returns. I started feeling more and more comfortable with the smaller stocks and less comfortable with the big ones. I was moving away from the competition.
I just kept going in that direction. I now hold about 30 stocks with most having a market cap below $5M. I have seven stocks between $10-$30M and my highest is $70M. I have five stocks with a market cap less than $1M. Most are reporting and some are not.
How would you describe your strategy and what are the most important factors in it?
I am a chart guided penny stock value investor. I'm a bit of a gambler. I have a very long term view, and patience. I use 10 or 20-year charts to make decisions. I don't short, index, invest in funds, or do bonds. I hold about 30 nano/microcap stocks. I try to focus on the easiest arena to invest in which means the most inefficient market with the least amount of competition. I've gone to the lowest priced and most illiquid stocks I can find. From my point of view anything bigger than a microcap is risky.
My strategy is aimed at maximum stock price movement. The movement comes from a few things: the stock has to be low priced, the perception has to change from very low to very high, and I want as few shares outstanding as possible. When I say low priced I don't mean only in the traditional value sense of margin of safety. The stock has to be priced low in relation to fair value, low in an absolute sense, and low on the chart. Stocks move a lot more the lower priced, less liquid, and lower on a chart they are. I have a stock that jumped up over 80% today and another jumped about 400% a couple weeks ago; this sort of thing happens all the time with low liquidity 10 cent stocks.
An exciting stock for me would be priced at say $0.15 with only a few million shares outstanding. A clean balance sheet with only common and no debt. Run by a long time CEO with high insider ownership. No earnings. Priced less than revenue and book. No goodwill. Chart flat and very quiet over the past few years at a low range. Exciting industry with the company working on new products.
My style of investing is also very news driven. These tiny companies can completely change in a heartbeat with one announcement. Often times they are heavily dependent on one customer and if that customer leaves the stock plummets. Likewise, imagine what one $3M contract does to a company with $1M in revenue. When the press release comes out the stock shoots up. In a news vacuum stocks drift lower because people don't like uncertainty. This is when you can pick up shares on the cheap if you have the patience to wait through the illiquidity. When the press release comes announcing good earnings or a new contract volume goes through the roof and the stock doubles in only few transactions...this is the liquidity you need to sell.
Many value investors have a major aversion to charting. Charting has its place next to fundamental value analysis. It's the study of crowd behavior and can tell you when to buy or sell. You can see the market sentiment in the chart and it's the first thing I look at when anyone mentions a stock to me. It does not always work but then again nothing does.
Regarding charting, you mentioned you look at 10/20-year charts, are you using any more short-term gauges that might influence your decision? Do you also incorporate volume traded or any other factor into your decision?
When I investigate a new stock one of the first things I do is look at the long term chart and then I'll zoom it in. I'll check the longest range I can find, then 10 year, 5 year, 3 year, 1 year, 3 month, whatever. What I'm looking for is a low range. Ideally, there is quiet stability over the past couple years. I'd rather not buy into a downtrend but if it's cheap then maybe I will.
Sometimes a stock will have a high volume spike that I sell into. It may be due to some news like a contract or earnings announcement or it may be due to absolutely nothing. Sometimes the volume will be multiples of the share count. Spikes will be anywhere from 30% to a few hundred percent increase. Depending on the news and situation I'll sell into that spike then buy back once it falls back down. I try to use a short term chart to decide when to sell. You see the same things in a 1-day chart that you do in a 10-year chart, it's just more amplified and changes faster.
When I talk about looking at a chart I mean both price and volume. A breakout means nothing if there's no volume behind it.
And I do not get very in depth with the charts. I mean I basically just look for support, resistance, and trends. I'm not looking at any fancy shaped formations.
Another factor might be time and news. Meaning as time goes by without news all stocks drop. Investors do not like uncertainty and generally people don't have patience. Let's say there's a stock I like that rose up 50% on some good news like a new contract. This company doesn't normally put out much communication because they're a tiny nanocap that does not do conference calls or anything and have no investor relations department. The stock is very illiquid so every single seller's decision affects the stock price. I will watch this stock and maybe put in a lower limit buy order. If there's no further news for a few months the stock will drift down and someone will get sick of waiting.
Do you have any precise rules regarding concentration?
I hold about 30 stocks. It was 20 a year or two ago and I bet it keeps slowly climbing. My ideal portfolio would be equally weighted between all of those but that's just not possible because I'm buying stocks at different times when I have different amounts of cash available. Plus a lot of my stocks are so low volume that I just cannot get as many shares as I want. For example, I have two open buy orders now that have been sitting there for months waiting for stock, I have some shares and want more. But generally, I have a target of making all my positions about the same size.
That being said, I am hugely overweight one stock right now so take what I say with a grain of salt. HEMA makes up about half my portfolio. Most stocks I look at end up being about equal in my eyes so I give them equal weighting, but there are exceptions. Every once in awhile a stock looks so good I will buy a bigger position.
SIMA was like that but it was so illiquid that I just gave up trying to get shares after almost a year. HEMA was like that and there were shares available so I just kept buying. Every time I had some cash I was going to spend on a stock I would look at my new ideas then compare back to HEMA and it just looked so good I kept buying. Eventually, I cut myself off when HEMA was 30% of my portfolio at about $0.45. Now the stock is over $3 and is probably over half my portfolio. I'm kind of uncomfortable with it but what can you do. I think HEMA is going in the right direction so I'm just waiting and watching.
Who influenced your investing strategy the most and what is your favorite book that left a significant 'mark' on you?
I'm going to give you a few answers on this one.
My favorite super-investor is Walter Schloss. I just love his laid-back style and feel it's very similar to my own. He worked 9-4. He had no college degree. Just buy what is cheap based on the numbers then wait. The average holding time of about 4 years. No fancy spreadsheets, no in-depth market analysis reports. Look at the balance sheet and make the call.
Early on I learned so, so much from Jae Jun at oldschoolvalue. Jae is great and he has put together a ton of educational material. The book that most influenced me at the beginning was F Wall Street. It just really laid out the basics and made me believe I can do this. In eye opener.
My favorite book over the past couple years is "How to Make the Stock Market Make Money for You" by Ted Warren. It's an old book that I haven't seen mentioned much. A friend gave it to me. When I finished reading it I immediately flipped back to page one and started over. So good. Ted did all his investing based on charts and never researched a company. He used very long range 10 or 20-year charts. What I do is apply some of his ideas to low liquidity, value, penny stocks.
The person I have learned the most from, and continue to learn the most from, is my friend and mentor. Shortly after I started my blog I got an email from a guy who liked one of my posts. He's a stockbroker that has been focused on nano and micro caps for 40 years. He owned a stock I had wrote about and thought I did a nice job so he figured I might be into more of his stocks. He sent me a list of stocks to check out. It was clear he really knew his stuff and had a very distinct strategy, which is now my strategy. I asked question after question and luckily I have not bothered him away yet. We are always chatting about stocks and I still ask him questions all the time. Ian Cassel wrote a blog post at MicroCapClub some time back about how important it is to get a mentor and I have to agree. I consider myself exceedingly lucky to have found one and it was all by chance of him finding my blog. It was him who pushed me to take charting seriously, focus on low share count, focus on low absolute stock price, and keep an optimistic long-term view. The market is filled with potential.
You frequently mention your discussions with the management teams in your blog posts (or your attendance at shareholder meetings), what are the main questions that you want them to answer?
I'm just looking for as much information as I can get and I want to know what the future holds. If a company announces a contract I'd be asking when revenue starts coming, how likely they are to get follow on contracts, what did they do to get this great new contract. If a company has old dying business lines I'd ask what they see themselves doing 5 years from now, what will the revenue source be. If a company is run by the person who founded it 40 years ago and owns 60% and is now 75 years old I'd try probing to get an idea of what the endgame is, when will they move on and what will they do with the company. If the company is dark and doesn't communicate I'd try to get an idea of why and when they might start talking to the public again.
A lot of these little companies don't communicate with the market at all. They file quarterly and/or annual reports and that's it. No conference calls and no press releases. Sometimes they reuse the same business description in their filings year after year so you really have no idea what's going on unless you ask.
I'll give some examples. When I first bought into ELST they had a new CEO and recently announced share repurchase program so I asked questions trying to figure out what other shareholder friendly activities this CEO might do in the future. When I found ZMTP they had shot up from $0.15 to $1 due to a single contract signing. It was a 5 year deal to use the Motorola name; I was trying to figure out what will happen after the 5 years and how they got the deal from the company that had it prior and get any information I could to figure out how this would impact revenue.
When I first found QDLC they had not communicated with the public in a couple years so I wanted to know why and when will they communicate again. I originally bought into GLGI because there was a possibility they were going to land a huge deal with Anheuser Busch so I was trying to get whatever information I could to know if that's real.
Recently I sent in questions to SOFT because they have not filed a report in months, I want to know why and when they will communicate again and how is their plan to sell off a division going and how is the new business line coming along and really do they even exist anymore.
How do you 'screen' for opportunities?
Unfortunately, I'm not going to have any golden nuggets to share with you on this front. I get all my ideas from my email inbox. My friend emails me ideas all the time then I research those companies. He spends his days reading every 10Q, 10K, and press release that comes out. Sometimes other people email me and tell me of some stocks. I follow a lot of blogs and every once in a while something interesting pops up.
One screen type activity I will get to someday is looking through all the companies that have de-registered from the SEC. Often times this causes a stock to plummet.
If I were to run a screen it would be something like this: revenue > 0, market cap < revenue, market cap < $10M, shares outstanding < 10M, stock price < $1.
What was the most peculiar SEC filing that you have ever read?
I have a couple in mind but looking back they turned out to be press releases that didn't get filed as 8k's. Oh well, I'll still go with them.
BMRA put out a press release on Apr 6, 2016 announcing "the Chairman and CEO, along with all of the board members of the Company's board of directors, together plan to purchase up to $500,000 of Biomerica common stock in the open market over the next 12 months." What a weird thing to announce. Once they would start buying they'd have to file form 4s anyhow so I don't know why they were doing this. In the end they did not follow through but rather a few of them bought a total of around $140k.
I think they did it as a public relations stunt to help drive up the stock price so they could uplist on NASDAQ (which they did so it accomplished the purpose). Of course, that is only my opinion but I don't know why anyone would announce an intention to buy stock on the open market sometime over the next year.
DPW put out a press release on June 30, 2017 with one of the more unique descriptions I've seen, "The added value to shareholders is yet to be understood. Over the coming years, this contract and relationship we believe will provide massive value to our shareholders." That's the only time I've heard management say they were going to deliver 'massive' value.
Finally, in the spirit of our previous interview and the current US president (i.e. tackling insanely complex questions via Twitter), how would you describe the OTC market in under 140 characters?
Where there is fear and boredom you may find opportunity. Why subject yourself to competition if you can avoid it.
Fitting description! Thanks a lot for the interview Dan, I thoroughly enjoyed the discussion and hope that the readers did as well. Feel free to leave any comments underneath and don't forget to follow Dan's investing adventures on his blog (nonamestocks.com).
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Editor's Note: This article covers one or more microcap stocks. Please be aware of the risks associated with these stocks.