Investing in Small/Micro Cap Stocks

[DesertCat]

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Great post DC just curious if you want to share some details at what you're looking for and at in the companies you choose to invest in.

Cheers, Kristoffer

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The ones I've shared in the past have been dogs, and I can never share my best ideas because they are so illiquid. Some trade as little as $10k per day and if I suddenly realize I made a mistake I'm not coming back here to tell everyone first, I'm dumping.

General details are I look for value. A company with good growth prospects and competive barriers. A company with lots of cash and management that intends to do something smart with that cash. Everything at a substantial discount (50% or so) from what I think it's really worth.

[maxtower]

DC,

People often ask you what your current ideas are, etc... You also give the same response each time, and I agree that not telling folks is probably the way to go. Perhaps it would be interesting though if you could run us through a former idea that paid off (and maybe one that didn't) start to finish.

How did you find the stock? screener? random chance? other sources?

What was the first thing you saw that tipped you off it could be a good one? How did you follow that up with research to know that it was undervalued? What assumptions were made? What info had to be found beyond the balance sheets and annual reports?

Finally, when did you know it was time to sell?

[DesertCat]

Well most of my better ideas are in a very specific area that I don't like to publicize because of the obvious, and illiquid bargains. But I can talk about one idea that's not typical, but it was my best investment of all time.

I found MDPA (now MDF) when a friend of mine (also a value investor) told me about it. If you have friends who are value investors, they'll often share ideas with you just to see if you can poke some holes in their thesis. Essentially prior CEO had expanded a small medical services provider in FL into a pharmacy and one other business, and destroyed it's profitability and almost the company itself. I think it was actually trading at around 20 cents not long before the new CEO started.

The new CEO shut down the money losing businesses, to focus on it's core business of providing medical services to a large HMO (Humana) in a small area of Florida. It was already on pace to earn 14 cents per share, and the balance sheet was in okay shape. I expected earnings to grow as they continued to trim expenses. The risk was their business model, essentially if they lost the contract with Humana they'd have huge turmoil. But after investigation it seemed very unlikely, both companies needed each other. It also had some geographic risk, it was a small business ($140M in revenues).

After researching it I decided that it was pretty clear that earnings were going to grow substantially over the next few years due to deleveraging of balance sheet and elimination of the old business unit's costs. At I put 25% of my portfolio into it at 73 cents, thinking it as a bargain at essentially 5x PE. Things pretty much worked out as I hoped, plus it benefited from some medicare legislation. Within a year it hit $3, which I think was close to a 15 PE. At that point I started to worry that the price wasn't giving me enough margin of safety given it was such a small company with the risks it had. Plus it's earnings were juiced because of tax loss carry-forwards that wouldn't last forever.

I sold out between $2.80 and a little over $3 one year after purchase, as soon as I could get long term capital gains treatment. The company decided to start it's own HMO in other FL counties, and that hasn't worked out so great, yet. But in the long run it might make it a much more valuable business. I moved on to easier ideas.

Note: This is such a bad example because it's really difficult to screen for companies in turnaround and find the ones where the turnaround is already happening successfully, but the market doesn't recognize it. I just got lucky my friend found it somehow. Plus I got a little lucky with the medicare legislation, it probably should have been a double or triple, instead of a home run. And it wasn't risk free, but I was willing to take a big loss on it due to other investments that I felt really good about.

[yellowbastard]

Do you think Kaiser would be a good arbitrage? It's currently trading at less than BV and composed mostly of cash and cash equivalents. From what I understand there has been talk by management of liquidation. When will this happen and what are the alternative routes management might take?

[DesertCat]

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Do you think Kaiser would be a good arbitrage? It's currently trading at less than BV and composed mostly of cash and cash equivalents. From what I understand there has been talk by management of liquidation. When will this happen and what are the alternative routes management might take?

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I'm convinced mgmt will either liquidate or announce an acquisition, and that either will create value. But i've been messing around with it for a long time now, and they are moving much slower than I had hoped. But what else can they do? The majority shareholder isn't reaping any benefits or creating any value for himself (actually his family) until they do one or the other.

[yellowbastard]

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As a side note, many small cap funds that do well attract lots of new money which make it increasingly difficult to maintain performace as size has several disadvantages when investing - especially in small caps.

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OK correct me if I'm wrong but I was under the impression that ETF's would avoid this phenomenon (of attracting new money which causes a drag on returns) because ETFs are closed-end and no new money can come into the actual fund and swell the NAV. Am I wrong here?

[DesertCat]

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OK correct me if I'm wrong but I was under the impression that ETF's would avoid this phenomenon (of attracting new money which causes a drag on returns) because ETFs are closed-end and no new money can come into the actual fund and swell the NAV. Am I wrong here?

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ETF's aren't actively managed, they are just another structure for (usually specialized) passive indexes. With microcaps/smallcaps you would want an active manager who can make +EV decisions. I.e. owning every microcap stock in a microcap ETF isn't likely to be as successful as a small group of microcaps carefully selected by an accomplished investment manager.

[kyleb]

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A company with lots of cash and management that intends to do something smart with that cash.

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Read this. Memorize it. Know it.

Great advice, DC.

[gull]

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I think a company called Bridgeway (?) has some funds with great track records in this space.

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Just to clarify, Bridgeway does have good small and micro funds. And even though they are tax-managed, they are still great choices for taxable. Also, they are passively managed.

[donfairplay]

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I think Kimchi is right. I almost always recommend index funds because they protect you from making big mistakes. But index funds aren't probably the best options for microcaps. You might look for a small mutual fund with a strong record in small/microcaps (i.e. it beats the small cap indexes over the last 3 years or more), and get in before it gets too large to be successful anymore. I think a company called Bridgeway (?) has some funds with great track records in this space.

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I'm an investor in Bridgeway's Ultra Small Company Market Fund. The expense ratio is very low (.65%). I've done about average with it, about +11% over the year, but that's mainly because I bought it near its top. It tracks about the same with the CRSP 10 index. Its more of a quant/model based microcap fund than a stock picking fund.

I think the real value is reading John Montgomery's fund reports. He's very upfront about mistakes he's made along with his successes. There's even a section for each fund's top 10 biggest percentage losers entitled "What didn't work".

I've been *occasionally* investing in some of the individual stocks that he picks. However, you need to be very careful if you do that. I used to work for a subprime auto lender that was a big holding of Bridgeway's. The stock dropped real fast after a profit warning, Bridgeway sold every last share after the stock dropped 40%, then the stock dropped even more (around a 65% loss in a period of 6 months). Unfortunately, I'm unsure of when Bridgeway bought into the subprime auto lender, so the 40% loss may have been a long-term holding with steady gains.