How do institutional investors buy a micro-cap? They buy a smallcap and wait for its stock price to go down. Unfortunately, that is largely the truth. With increasing regulatory costs, fewer and fewer microcaps are coming to market via initial public offerings. Many microcaps come into existence by starting as a smallcap and losing market value. This article’s headline suggests getting excited when a microcap gets smaller. Really? Are value investors so determined to buy cheap that they are excited to buy companies with falling sales? Well no. Of course the growth investors are on to something when they look for companies that are getting bigger. You want to own companies whose sales and profits are headed to the moon. The headline is a tease, but in certain situations there’s an important truth in this headline that you want to understand.
Everyone knows that you want to own companies that are growing sales and profits. These days any good stock screener can find a bunch of fast growing micro-caps for you in micro-seconds. It can find them for every other investor too, and much of the time the stock price reflects the growth. Sorting out which of these high growth companies will continue to grow is tough work. It requires a deeper understanding of the company and its competitive position than the markets collective opinion. Investors work hard, perhaps talking to management, customers, and suppliers to get a better understanding of the company’s business and competitive moat. With a better understanding, growth investors can pick and choose among the high growth companies to find the ones to invest in profitably. Accolades to you growth guys that get it right with consistency.
But there are times when you can buy a high-growth microcap at a value price. Those opportunities frequently are found among those micro-caps that were created from small caps, that is, the long-time losers. Valuations among the failed micro-caps that have been abandoned by the institutional investors often appear silly cheap. This one trades below book value, that one trades at a fraction of sales, another trades near liquidation value. Every year in December the losers go on super sale. Most every shareholder has a loss and therefore a tax-refund incentive to sell. Few institutional investors are managing portfolios small enough to buy microcaps. Individual investors are able to invest in the smallest of the small, but most individuals are pooling their money into multi-billion dollar mutual funds. These funds then are too big to invest in microcaps. There are lots of motivated sellers of microcap losers and there’s no one to buy. Tax-loss selling will drive them down to prices that sometimes you just can’t believe. You’ll see people advocate a strategy of buying the losers in December and selling in February. Bet you could do all right with that. Still, you want to buy growth stocks with a bright long-term future, not trade junk for a quick buck. After all, you pay taxes too; but not on the stocks you buy and hold. Most of these losers are indeed losers that you do not want to own long term. But don’t some of these losers turn around and grow back into smallcaps? Of course, and a telltale sign that could happen is the microcap getting smaller first.
No board of directors wants to shrink the company they manage. No CEO wants to sell or shut down a business that they’ve worked to grow for years. What CEO relishes explaining to shareholders that the business the shareholders invested their money into with dreams of growth and profits is gone; sold to the highest bidder? It’s not normal human behavior to shrink your company. On the contrary, normal is a company getting bigger by making acquisitions. Normal is a company introducing new products to increase sales. Normal is a CEO expanding the empire and justifying a higher salary. Truth is that a micro-cap needs to get bigger. The costs of being a public company and the salaries of professional management need to be spread over a larger revenue base. Normal is for a microcap to try to grow, grow, grow. Selling a division of a micro-cap’s business to get even smaller is not normal? But you’ll see it happen from time to time? Why?
There are several reasons a company gets smaller. First and most common is that fewer and fewer people want to buy their product. This, unfortunately, is all too normal and it isn’t anything to get excited about. Probably this is the “getting smaller” you thought about as you were concluding the author of this article’s headline was off his rocker. What should peak your interest, however, is a company getting smaller by selling or shutting down a division or product line in their company. It’s not normal for a microcap to intentionally get smaller. Why would company management do this? That’s the question you should immediately ask when you see the press release announcing the sale. Why did they do it? Sometimes it’s because the company has a lot of debt and needs cash to keep operating. If that’s the reason then you just lost interest in the company. Sometimes, the division they sold has been a money-loser for years. Seems like a no-brainer to shut such a business down. But it’s not. Management doesn’t want to shrink the company, lay off employees, and admit it’s a failure. Instead you cut costs here and there and don’t invest much in the business so that it runs as close to cash-flow break even as possible. That way shareholders can still hope, and the CEO still has a job. Sometimes the business sold is healthy and profitable and the company just wants cash to invest in something else.
The key differentiator between an “exciting” sale and one that you dismiss is choice. If management really had to sell the business then the sale isn’t interesting to you. It’s normal to sell when you have to. If the management chose to shrink their microcap company, however, that’s just not normal. There must be a reason. You need to find out the reason. And, if after some investigation the reason turns out to be one fairly common reason, then you get excited. And that fairly common reason is …?
The management and board of directors really like the business that is left. It’s much easier to make the difficult decision to permanently part with a portion of your company if you can see a bright future for what is left. In fact, companies often hold on to loser divisions until they have some new business or new product with a bright future. Then they have a reason to dump the loser, and the CEO can dump it without losing his job. This idea, that a company dumping a division probably has something good left, is a very simple idea, but there is so much money in it for aware investors. Whether you invest in growth stocks, value stocks, tech stocks, natural resource companies, or whatever, when a microcap company chooses to sell a division of their business, you must understand why. And you must look at the prospects of what is left. You’ll often find that what is left is a high return-on-equity business that’s been growing nicely and that you’d like to own.
And you’ll often find that it’s cheap too. Why? Because the stock is a long-time loser with plenty of motivated tax-loss sellers, a historical stock chart that goes mostly straight down, historical financial numbers that look awful, and it’s shrunk to a microcap valuation that no institutional investor can buy. The growth investors running a screen on company financials can only see the historical garbage and not the favorable performance of what is left. Even months after the sale, the company financials will show a good quarter or two with years of bad numbers prior to that. A couple of anomalous quarters in a sea of bad years is nothing for most growth investors to get excited about. The only investors that will understand what’s going on are the ones that jump in, ask some questions, do some digging, and find the answers. That would be you.
The best place for the individual investor to look for opportunities like this is among the microcaps. The reason is that professional hedge fund managers are well aware of the opportunities in subsidiary dispositions. In fact, Joel Greenblatt, manager of the hedge fund Gotham Capital, discusses dispositions as one of his favorite special situations in his popular 1997 book “You Can Be a Stock Market Genius”. See, even the public has known about opportunities in dispositions for at least 15 years. You’ve got nothing on the hedge fund managers just because you know dispositions can be lucrative. But what you do have on the hedge fund managers is less money. They can’t touch the little micro-caps and nanocaps that you analyze. They’ve got too much money. But you, you’re poor. If you want to buy a $12 million market cap stock, you can buy all you want in a few days of trading.
A few individual investors specifically look for microcap dispositions. Many other individuals aren’t looking for them but can’t help but stumble across one from time-to-time. The lesson to take from this article is that the next time you stumble across one, have the sense to spend a few minutes figuring out what is going on. In coming articles, we’ll discuss how you find dispositions if you want specifically to look for them. Once you’ve found one or stumbled across one, we’ll discuss where to look for information on the business that is left. After all, if you just look at the historical financials, you’ll see the same garbage everyone else does. We’ll also look at some historical dispositions and the information that was available to investors at the time. Why did management sell, and what clues were there that something good was going to happen? What did happen? Finally, some current disposition situations will be discussed. If there’s a recent disposition you’re aware of, please make a comment at the end of this article identifying the company. Perhaps the coming article could include discussing what’s happening with that situation.
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Mark: Great article on a very different approach to investing in microcaps.
Very good read Mark. I’ll be looking forward to reading your articles in the future.
this is great, serious, old school deep fundamental research and is exactly how you find 10 baggers in micro caps. awesome writing really and I think my favorite part about your posts on here are the historical examples. you’ve clearly been doing this a long time and very much looking forward to your future posts!
Your experience with the 100 bagger reminds us once again that the hardest part of investing is knowing when to sell. I had a similar experience with a stock I bought a bunch of at the half dollar level and then sold (smartly) for about two bucks. Luckily my wife kept hers which is now selling about $17, down from $35.