3 Cheap Nanocaps

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Includes: CAPC, SPRS
by: Ruerd Heeg
Summary

Nanocaps can be great investments.

I rank nanocaps on a combination of multiple metrics to find even better returning nanocaps.

In this article, I share research for 3 great nanocaps found with this quantitative algorithm.

Statistical stock research suggests investing in nanocaps works well. In particular, David Vruwink and 2 others published a paper, A Modified Price - Sales Ratio: A Useful Tool For Investors in 2007. Their research suggest returns of 40% for cheap nanocaps. In his book, What Works on Wall Street, James O’Shaughnessy reports lower returns over a longer study period, but still 17%. Also Tweedy, Browne Company confirms a size effect for international companies in What Has Worked in Investing.

To get even higher returns, I rank nanocaps on several metrics. It is like giving a stock an average mark for factors like P/B, P/B, P/CFC and so on. See also my article, Use Your Extraordinary Edge With These 2 Investment Strategies, for more explanation on ranking and good factors in general.

What kind of companies are these nanocaps? To get a feeling, I discuss three of these nanocaps below. These are the best ones from my ranked list of nanocaps. On a statistical basis, they are good stock bets. Two of them trade in the US as OTC companies, the third stock trades in London.

1. Surge Components (OTCPK:SPRS)

Ticker,

Piotroski

Share

Price

Market cap

EV, in millions

EV/EBIT

EV/Revenue

P/Tan B

P/Ret Earn

SPRS

7

1.1 USD

-

5.75 USD

4.97 USD

5.5

0.16

1.21

5.25 (8-yrs)

Date

cash flow

EBIT, ttm

until mrq

Cash flow

from ops

Free cash

flow

P/FCF

2018-02-28

0.91 USD

0.77 USD

0.72 USD

8.0

May 2018: Surge Components is a wholesaler of electronic components in the US. These are commodity-like products. About half of the revenue comes from capacitors and the other half from simple active components like semiconductor rectifiers, transistors and diodes. The company sells its products to original equipment manufacturers and distributors. The company’s export sales are about 40% of the revenue. Important export countries are Canada and China. Half of its purchases come from Taiwan.

Several multi-year metrics suggest strong competitive advantages. First, 7-year average of Gross Profit/(Total Assets - cash + debt) is very high at 0.75 with a low standard deviation. This ratio has decreased from 0.76 seven years ago to 0.69 over the last reporting year, though. Such a (relatively) constant ratio suggests competitors need more assets to earn the same amount of gross profit. Second, the company generates a lot of free cash flow compared to its total assets.

Also, multi-year averages of return on assets and return on capital are very high. However, these 2 metrics might not suggest a moat because their values vary a lot over the years: over 2016, the company made a loss and the profit over 2017 was much lower than in 2015 and before.

These attractive multi-year metrics are remarkable. After all, the company does not sell anything but commodity products, partly even to distributors. If these multi-year metrics confirm anything, it must be prudent management: customer and supplier selecting and asset allocation.

See also the annual report over 2017 and the more recent quarterly report.

When taking into account the convertible C-series preference shares (10,000 shares also with $5 per share liquidation preference) and deducting 1.0 million USD of deferred tax assets, Price/Tangible Book = 1.5.

The company is conservatively financed with Total Assets/Tangible Book just above 2. The company has little debt and enough cash. The company does not have any retained earnings, which suggests lower returns on a statistical basis. However, over the last 8 years, the company earned a bit more than it paid out to shareholders. So these accumulated losses are from longer ago.

In 2016, Brian Grosso discussed the stock, at much lower levels. Among others, he mentioned the following governance issues:

  1. The company might be paying too much rent for office and warehouse space from certain officers/shareholders.

  2. Two managers and directors are also substantial shareholders. He thinks they get paid too much.

  3. The company awards managers with stock compensation. At the time, this was very dilutive for other shareholders because of the low share price.

  4. Incorporation in Nevada, with “extremely lax corporation laws”.

On October 31, 2016, two substantial shareholders started a lawsuit against the company. The 2 shareholders held 22% of the shares. Among other things, they claimed the directors had breached their fiduciary duty to shareholders. On December 22, 2016, the company settled with the 2 shareholders.

The settlement changed governance much but probably not completely. First, the company bought back 5 million shares at $1.43, so for $7.15 million. As required in the settlement, the directors did not tender their shares. As a result, these directors increased their stakes. Excluding a 2% stake from in-the-money share options, they own about 45.5% of the company. In particular, CEO, President and director Ira Levy owns 22.4% and Vice-President and director Steven Lubman owns 18.6%. See page 12 here.

The 2 activist shareholders tendered their shares and sold more shares in the open market. As a result, they are below the reporting threshold of 5%. So the 2 main shareholders control the company now more than ever. In an attempt to find some sort of a balance within the board, the settlement required reducing the number of directors to 6 and appointing a new independent director. I think this new director is Peter Levy. There are no family relationships between him and other board members, including Ira Levy.

Second, the board was not allowed to award any equity compensation for a year. This type of compensation may now be awarded again. I would not like it if I were a shareholder, because it is a form of self-dealing. However, at the current share price, it won’t be as dilutive as it was before. But it is also disappointing that bonuses and salaries of the 2 main shareholders stayed at the same high level.

Third, the company had to reincorporate from Nevada to Delaware. I think the difference is small, but I suppose this is indeed better for minority shareholders. So far, this has not happened yet.

Fourth, the company has to get rid of its staggered board. All directors have to be elected every year. I think this also will increase statistical returns. The company seems to keep this promise, see the second page here.

Fifth, it seems the rent of warehouse and office space was lowered a bit.

My take on Surge Components

From the perspective of a statistical investor, this is an excellent opportunity for the following reasons:

  1. The company bought back so many shares last year. The company did this under pressure of the 2 activist shareholders, but apparently, $1.43 was also the fair value of the shares. Since then profits have improved.

  2. Over the last 8 years, the company has positive retained earnings and this is now combined with a low EV/EBIT, a low EV/Revenue and a decent ratio of Market cap/Free cash flow.

  3. The company has an extremely low market capitalization.

  4. Several multi-year metrics suggest the company has strong competitive advantages.

There are several scenarios for unlocking value. First, the company might be able to grow earnings, which is usually followed by stock price increases. Second, the company is attractive for an acquirer. If the company were allowed to go dark (after buying out most shareholders), it could save costs. It would not need to file audited reports any more with the SEC. I suppose that would increase free cash flow and net profit by several hundreds of thousands of dollars. For example, such a buyout would make sense for the 2 main shareholders. Since they do not have a majority stake, an outsider could also try to get control by placing a new tender offer.

2. Capstone Companies (OTCQB:CAPC)

Ticker,

Piotroski

Share

Price

Market cap

EV, in millions

EV/EBIT

EV/Revenue

P/Tan B

P/Ret Earn

CAPC

7

0.24 USD

11.3 USD

7.4 USD

2.8

0.22

2.39

-

Date

cash flow

EBIT, ttm

until mrq

Cash flow

from ops

Free cash

flow

P/FCF

2018-03-31

2.6 USD

3.9 USD

3.8 USD

3.0

May 2018: Capstone Companies designs and sells LED lighting products and has them manufactured by third-party manufacturers in China. The company sells its products under licensed brands: Hoover and Duracell. The company tries to develop niche products such as wireless remote-controlled lamps and motion sensor lights. It tries to protect products with patents, also on manufacturing processes. Almost all revenue comes from Costco (NASDAQ:COST) and Sam’s Club. See also the annual report over 2017 and the more recent quarterly report.

The company is trying to diversify into other products than LED. It says it will introduce a new product line in January 2019. For the rest, the company is vague, but between the lines they do give some information. The company has increased its research and development team for this new product line. The new products will be far more expensive than their current products and will be more “software and technology based”. It is not a “me too” product either and it has an “ongoing improvement and enhancement requirement” to stay ahead of the competition.

The company says it might up-list to the NASDAQ some time when revenue increases and if the new product line is a success.

Despite this buzz, the stock declined about 60% since a year ago. Much of the decline can be attributed to the last quarter of 2017 with much lower revenue and hardly any profit. But the stock has declined before that as well.

In the beginning of 2017, the company hired a consulting firm to look for strategic alternatives. Usually this means management wants to sell the company. Shareholders anticipating such a transaction bid up the stock price. Unfortunately, it turned out there were no buyers.

On top of that, the SEC asked unpleasant questions about internal control and the impairment of a loan of $1.5 million. In 2016, this loan was given to AC Kinetics for 3.5% and options on 1,666,667 shares of Capstone at $0.15 held by again another company. What I understand of this transaction is the following: conditions for repayment and payment of interest were that a bigger company would be taking a stake in AC Kinetics and would fund a project at AC Kinetics. These conditions were not met. Despite that, the company exercised the options for a gain of almost $600k; this was a bad deal. I think the interest rate was much lower than in similar deals. In addition, the company should have demanded interest to be paid every year. Investors might have concluded the company tried to hide this when answering a question during an investors call.

Shareholders have been asking questions on the share price. The CEO commented that he is perplexed watching the ongoing decline. It is not related to the small loss the company reported last quarter, since the stock price already declined before that announcement. He still believes in this new, undisclosed product line. Without disclosing the details, he says the new product will be like a tablet. It will be complementary to the smart home environment.

Several multi-year metrics suggest durable competitive advantages. The average ratio Gross Profit/(Total Assets - cash + debt) is very high and has gone up over the last 7 years. Furthermore, multi-year averages of return on capital and return on assets are high. Also, over the last 7 years, the company generated a lot of free cash flow compared to the book value of its assets.

I think the company grows by doing very efficient and profitable research and development. In the 4 recent years, these expenses varied between $295k and $377k per year. The company’s product development is not capital intensive either: the company hardly spends anything on capex. Another thing to like is the company’s strong balance sheet with much cash, no debt and low leverage.

So far, the company has not paid out any dividend. Instead, it has used its cash to grow its balance sheet and to keep leverage low. As I wrote above, it has bought back some shares, but in a foolish transaction. In 2018, the company intends to buy back more shares. A red flag is that the company has converted loans from directors into shares. See here.

Such repurchases are also in the interest of the CEO, Stewart Wallach, with a 20% stake and in the interest of outside director, Jeffrey Postal, also with a 20% stake. The company filed a “shareholder action by written consent in lieu of a meeting of shareholders”. I do not understand this since it implies another substantial shareholder who cannot be found in the filings.

My take on Capstone Companies

Usually buzz from management about a new product line sounds like a red flag to me. New products fail much more often than that they succeed. Since for this company the ratio Gross Profit/(Total Assets - cash + debt) has increased over the year, I give it the benefit of the doubt. Even without this buzz, the company looks very cheap when ranking nanocaps on several combined metrics, among others: market cap, 8 years of accumulated retained earnings, P/E, EV/Revenue, Piotroski score, liquidity and measures for distress. All these values are even more attractive combined with the share buyback from last year.

If you own many stocks with similar metrics, your returns will be very high. For this one, there are 3 catalysts. The first one is some reversion after a declining stock price because of the questions from the SEC, lower revenues from last quarter and the failed search for “strategic alternatives”. The second catalyst is a successful introduction of the new product category. Even an announcement with more details on these new products could push the stock up. The third catalyst is less likely but still possible: that the company will see more growth with existing products.

3. Tandem Group

Ticker,

Piotroski

Share

Price

Market cap

EV, in millions

EV/EBIT

EV/Rev

P/Tan B

P/Ret Earn

NCAV / Market cap

LON:TND

6

1.43 GBP

6.8 GBP

2.9 GBP

1.2

0.08

1.2

1.14

-

Date

cash flow

EBIT,

ttm until mrq

Cash flow

from ops

Free cash

flow

P/FCF

Yield

%

2017-12-31

2.1 GBP

3.58 GBP

3.55 GBP

2.0

2.9

May 2018: Tandem Group designs and distributes sports, leisure and mobility products (bicycles and accessories and wheeled toys) in the UK. The company sells its products under its own brands and also under brands from others.

An internet search on the company name and keyword “fraud” did not reveal relevant links.

Multi-year metrics do not suggest any durable competitive advantages. In each of the last 7 years, the company paid a substantial dividend, but mostly combined with raising smaller amounts from issuing new shares. Seven years ago the company spent much on buying back shares: 1.2 million GBP on 6.1 million GBP of book value.

See the annual results over 2017 and the annual report over 2017. In 2017, the company restructured its bicycles division. The purpose of that reorganization was to make it more profitable by reducing costs. As a side effect, revenue from the bicycle business went down. Profit did indeed double compared to last year. Unfortunately, the company does not report segments. Much of the company’s purchases are in USD. Though the company says it hedges against fluctuations in the USD, I think the company should benefit from the much stronger GBP this year.

The screener reports an EBIT of 2.1 million GBP (table above). However, this number seems to include finance costs and tax. Therefore, I think the real EBIT over 2017 is 2.4 million GBP and the real ratio EV/EBIT is lower than the screener reports in the table above.

The balance sheet shows pretty much leverage with Tangible Assets/Tangible Book of almost 4. Just Total Assets/Equity is slightly more than 2. Current Assets/Current Liabilities, aka the current ratio, is 1.6. There are probably no debts or they should be included in non-current “other liabilities” of 1.6 million GBP.

There is also a non-current defined benefit pension plan deficit of 2.9 million GBP. The company already booked a one-time gain on the revaluation of this deficit. I expect the company to book more gains on this item since worldwide interest rates are increasing.

Total share count is 5,026,091. The screener (table above) does not take the 357,522 in the money employee options into account. So I suppose the screener underestimates the market cap by about 5%.

Substantial shareholders (as of April 13, 2018): Jupiter Asset Management 10.8%, Mr. S. Bragg 9.0% (increasing), Mrs. D. Waldron 6.2%, CEO Mr. S. J. Grant 5.0%, non-executive chairman Mr. M. P. J. Keene 5.0%, and finance director Mr. J. C. Shears 3.4%. Bragg and Waldron are not directors. Probably they are outsiders. I have not found any anti-takeover measures. Therefore, I think this is an easy target for an acquirer.

My take on Tandem Group

Despite there is not much attractive, this stock is the cheapest of the 3. In fact, it is the number 1 on my ranked list of over 850 nanocaps. Typically, the least attractive and less known stocks have the best returns. Based on these 2 subjective metrics, I think Tandem Group is a better stock to own. Of course, it is a gamble, but I assume the average outcome of this bet is better than for the other 2 stocks.

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 (other than from Seeking Alpha). 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.