I often am asked how I find the microcap stocks that I invest in and trade. A few times I’ve answered that question vaguely like when your grandmother described the ingredients of the family favorite recipe as a dash of this and a dash of that. Everybody loves that favorite food but nobody knows how to make it other than grandmother because she has never written down the recipe. Well, I finally got out the index card and started writing.
Before I go into what is on that index card, I’m going to talk briefly about the taste of my secret recipe because you might be questioning how good the food is especially if you have never tasted it. Over the years I’ve refined the process that I use and am able to select winners roughly 73% of the time based upon positions closed between 1/1/2010 and 9/27/2012 in my personal accounts. According to one article, stock traders tend to “win” around 55-60% of the time so my track record is significantly above average. Additionally, my aggregate profits have significantly exceeded my losses. My success has enabled me to trade and invest full-time for a living in the microcap space for six years.
While I have found a recipe that gives me a high percentage of winners, I’ll also be quick to point out that there are many ways to make money and my way isn’t the only way just as there are many fabulous recipes for food. Furthermore, multiple methodologies may be deployed by an individual trader and investor to make a portfolio just like several recipes are used to make a tasty meal. While I do use different methods I’ll focus on my favorite recipe that I use for the vast majority of my investments and trades. While this article attempts to reduce my recipe to a formula it is important to understand that while there is a large part of my methodology that I can quantify, there also is a fair amount of what I do that falls more in the category of art and can’t be quantified. In some cases there is a pinch of salt and other cases there isn’t and I can’t describe all those cases.
My recipe essentially is to find rapidly growing profitable microcaps that are at very cheap prices relative to present or future earnings. I’m looking to find the microcap equivalent of something like LULU only at insanely low valuations. I will go into more detail below.
On the front side of the index card I will write the ingredients for the meat of my favorite stew. For my recipe to work you have to have all of these ingredient and there is no substitution. Hence, these are essential ingredients. The essential ingredients are:
- Profitability – Almost every company I own is generating a GAAP profit. Those stocks I purchase that don’t follow this rule are almost always on the cusp of profitability. The reason that profitability is important is that company valuation is to a great degree a function of the discount value of future earnings. Not all companies have the discipline or business model to be profitable. When you pick companies that are already profitable that implies a certain degree of success. I also find that valuation of a profitable company is usually much easier than one that is not profitable.
- Sustainable Growth – I virtually always invest in companies that are growing both revenue and earnings. There are rare occasions when a drop in revenue is acceptable (e.g. cutting business that isn’t profitable). Growing earnings, on the other hand, is non-negotiable. Sometimes I invest in companies that have already produced growth but I also look for opportunities where I have reasons to believe that revenue and earnings will grow in the future. Sometimes, this is a function of new contracts, increased backlog, a new product, or some macro factor as discussed here. No mater what the reason for the growth, I strongly prefer companies that have sustainable growth (e.g. not one quarter wonders).
- Compelling valuation – I am looking for stocks that trade at a steep discount to future earnings and preferably also to present earnings. I strongly prefer companies that I think will at least double as that usually gives me a big margin of safety. I’m not going to get into the specifics of valuation as that is a larger and complex subject that can’t be addressed within this article.
Stew has to have more in it than just meat. So, on the back side of that index card I’ll describe the possible ingredients that gives the stew it’s fine taste. I’m calling them possible ingredients because you can make the stew differently as not all ingredients are required. You just need enough of them to make the food taste exquisite. Here are the possible secondary ingredients:
- High gross margin business – I really like high gross margin (GM) businesses as revenue growth drops rapidly to the bottom line. Also, raw product cost increases or other cost increases tend to have less impact on the bottom line for high GM businesses. Therefore, with a high GM business I have found that one is less likely to be blindsided by changes in cost. On the other hand, very low GM businesses can swing from a profit to a loss just because of raw product price increases. If I had to put numbers on it, I’d say that a high GM business is one with a GM greater than 50% and a very low GM business is one that is less than 20%. One other thing to consider is that sometimes businesses can grow their GM as they increase revenue so sometimes the current GM is not representative of the potential.
- Strong balance sheet – I prefer companies with stronger balance sheets but will invest in those that don’t have a strong balance sheet. If the balance sheet is weak, I’m going to need a more steeply discounted stock price.
- Attractive share structure – Some share structures are better than others. The primary thing I look at in the share structure is potentially dilutive securities such as stock options, warrants, convertible debt, and convertible preferred stock. Any potential dilution needs to be factored into my valuation analysis.
- Insider buying – I really like management teams that are buying their stock as that often is a strong signal that the stock is undervalued.
- Sexy story/sector – A good story is also beneficial as that will generate interest in the stock. Expanding product lines, products in the sweet spot of a macro trend, and products that fulfill a new need are examples of the types of things that can make for a good story. Also, certain sectors are in vogue at certain times and there are some where the businesses have almost no economic sensitivity. For example, I like growing medical companies because you generally don’t have to worry about how the economy is going to impact them.
Beyond the tangible ingredients there are also some other things that I consider but these areas are more intangible and not easily quantifiable. Management quality and experience, the company’s prior track record and history, chances of fraud, and earnings quality are items that I consider. Again, a portion of this falls more into art than the science of trading and investing.
That ends the first installment. In the second installment I’ll talk a bit about how I go shopping and then we will enter the kitchen and cook a sample.
My Secret Recipe Series:
Part 2: Shopping and a Taste Test
Part 3: Inspecting the Ingredients
Part 4: The Bargain Rack
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