Beware of Story Stocks

Neil Cataldi Blog, Educational 11 Comments

Confession. I have invested in companies based on promise and promise alone in the past. I have met CEO’s and listened to pitches on opportunities so compelling that I’ve felt the need to take action and take it quickly. And… on more occasions than I’d like to admit, I have lost money investing in such story stocks.

This is the challenge in navigating “story stocks.”

A story stock is a company who has yet to show execution fundamentally though profitability or revenue growth. The value in the equity reflects expectations and future potential. Earnings, revenue, and/or assets are typically nonexistent except for cash reserves, which are burning away. Keep in mind, story stocks do not make money. And, valuation, as a result, is much harder to assess as it is influenced much more so by expectations. That expectation barometer can swing wildly depending on management, their tendency to lean aggressive vs. conservative, and how the profile for their growth trajectory changes over time. When you invest in a story stock, you must trust management exhaustively. Their word is all you have.

Story stocks are most prevalent in the technology, biotechnology, and resource (mining and oil & gas exploration) sectors where the promise for new products and new resources can be profound. Imagine if I told you the name of a company who will cure cancer! Look at the growth companies like Apple and Netflix have realized in recent years. Our enthusiasm for Microcap opportunities is derived from asymmetric risk reward, thus the returns from bellwether disruptive companies like those mentioned validate our wild expectations. It can happen to large companies just as it happens to small companies. However, separating emotion from discipline in this business is paramount. Learning from your mistakes and understanding the reasons why you have success, or the lack thereof, is a stepping stone to achieving a stronger process in the long run. And… losing money, while counter intuitive to the greater goal, is not always a bad thing. Consider it an investment in the stream of profits you will receive in the future, or a type of tuition expense.

I’ve focused the past several years of my career solely researching sub $250 mln market cap companies. During that time, I’ve interviewed over 300 micro cap CEO’s. Most executives in this subset of the capital markets need to be salesmen, whether it’s a pitch for their business to customers or investors. If they can’t convince you they have a compelling opportunity, there is likely not a good opportunity to be had at all. The challenge therein lies with differentiating the business plan that is simply a story vs. one that is close to reality. You want to seek tangible results, traction and revenue or earnings inflection points. Channel partners, customers, industry awards are all nice, but don’t necessarily lead to long term price appreciation.

The story can appear in several different forms too. Just like the movies, we have action stories, love stories, and unfortunately some sad stories too. The traditional and most popular version is simply that of an early stage company building a pipeline which is on the verge of significant sales traction. A product is coming out or a service is ready to be launched. Just watch the revenue floodgates open! A different version focuses on an acquisition that will literally change the game going forward. Perhaps it’s a junior mining or oil & gas exploration company drilling right next door to a major. Maybe there is a management change that could be the difference maker, or perhaps it’s even a new strategic relationship. The story can exist is any number of varieties, and I haven’t even touched on the pitfalls yet.

Whatever the specifics may be, the takeaway should always be this. Results speak much louder than hype and speculation. The company in the pipeline is simply in the pipeline until it’s brought over the goal line. There is a big difference in “pipe” vs “goal” when we’re referencing “lines.” The new CEO won’t make tangible changes for quarters. The new strategic relationship likely won’t yield results anytime soon either. Events such as these provide positive spin for a story and most definitely impact expectations when announced, but when all you have are expectations, they can fade as times passes by. Taking that into consideration is very important. Understanding that meaningful appreciation should and will follow tangible results is equally as important. As mentioned prior, expectations can swing wildly and a story stock is simply a barometer of those expectations floating in the market wind. That being said, here are a number of anecdotal story scenarios to watch out for:

  1. Technology as a whole can be argued as very disruptive, and is evolving quickly. Computers, tablets, and phones are replaced every few years. The consumer no longer needs to pay for hardware because it is often subsidized or simply sold to promote the use software. iPhones and the Kindle are examples of this. With so much change, disruption can happen very fast. For that reason, I watch for and seek out new technology more so than any other industry. The profile of a company I like is one where there is a massive tail wind rising the tide for all boats, and thus the success of my investment should be predicated on what they do, but excellence aside, they should be shooting fish in a barrel either way. This scenario makes losing harder to realize. There are several keys to success in technology. Here are two. First is identifying the tail wind, whether it’s the Internet of Things, Machine to Machine communication, monetization of mobile, mobile advertising, robotics, etc. Upon identifying the tail wind, you must assess whether the demand environment exists. A market that needs education is one that can elongate a sales cycle significantly. Please avoid this. It simply adds chapters to the story. You want to finish the book after all. Secondly, technology without a barrier to entry is risky. Intellectual property helps. Your investment needs protection, especially when it comes to technology. Every company claims they have the next best thing. It’s rarely true. Venture capital and private equity have their hands in any number of emerging technologies. A competitor almost always exists. When the public market sees the best technology, it’s typically at a market cap exponentially larger than that which I would be interested in. That being said, traction is the only testament and validation for a product or service. Wait for it. Patience is key. If it truly is that disruptive, you may miss the first inning, but capturing the next 8 will be a fun ride.
  1. Big Brother relationships. Several years ago I thought the big brother relationship could be viewed as a point of validation. When a multi-billion dollar company decides to take on company risk with a sub $50 mln micro cap, that says something! Fast forward to today and I would argue that such an announcement should be viewed as a signal to sell… almost immediately. First, the strategic relationship is always a positive on the surface. Expectations fly high, only to fade over time into what can be a long cycle before fundamentals actually change. Capture the move, hopefully binary at first, and step to the sidelines. Second, and more importantly, the interim period post announcement and before revenue is recognized is typically a scenario where the balance of risk vs. reward has swung out of your favor. Be cognizant of this as execution is on the come, especially with companies exponentially larger than your baby micro cap.Assuming the stock has had a substantial rally on the announcement, you’re risk reward has likely changed and is now temporarily unfavorable.
  1. I struggle citing an acquiring company in the microcap universe that has performed well after announcing a strategic acquisition recently. The story is always much sexier afterwards. Management takes a shot of enthusiasm to the arm and can run circles around revenue increases, expanding margins, and how it may literally rain profits down on their headquarters. The hard truth is that synergies always take time, integration is challenging, and similar to the big brother relationship, expectations fly high only to fade, which means fundamentals matter most. Skepticism breeds lower valuations and acquisitions create more variables. It’s linear in that sense. I’ve learned to move interesting companies who have been acquisitive to the sidelines until signs of progress are shown… or wait and buy at a great discount. You may get your price.
  1. Municipality/Government traction. Government and Municipality opportunities are a red flag. The pipeline is never captured as planned. And, if the value proposition applies to one such opportunity, it typically applies to many. Insert township, state, etc as needed. As a result, companies can talk about very large addressable markets. However, changes to funding and budgets impact the timeline considerably. Political leadership is an additional curve ball. My suggestion is to tread carefully in this universe.

Microcap investing can be treacherous. Companies without fundamental earnings or revenue have no choice but to tell a good story. The only way they can grow when they’re not making money is to invest in growth and raise more money. Essentially, they are marketing machines. A good question to ask the CEO of a story stock is “how much stock have you purchased with your own money?” If the answer is zero, then the story may be too good to be true.

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About the Author

Neil Cataldi

Neil Cataldi has 15+ years of Wall Street experience including roles as an Options market-maker/Specialist, Derivatives Strategist, and Portfolio Manager. He launched Blueprint Capital Management in 2012 which is a Microcap equity strategy focused on the Technology and Consumer sectors. If you asked his 6 year old twin boys what he does for a living, they would say, “the stock market game.” Little do they know he takes the “game” very seriously.

Comments 11

  1. Neil, I enjoyed your insights about investing. I felt like I was back in school with a knowledge professor imparting distilled wisdom. I definitely will learn from this.

    Thanks

    Mike

  2. Thanks Neil for sharing your thoughts. Your last paragraph is key. They tell a good story because they have to. They have to keep the stock liquid and high to raise more money to fund the story. Unfortunately most people that start investing in microcaps do so by falling in love with a story stock. They lose their money and never want to invest in microcaps again. The best advice I can give new investors is stick to the 15% (1000+ companies) of microcaps that are profitable.

    1. so true. I invested in Aerogrow back in 2008/2009 before they became an OTC stock. Had a lot of promise but bad finances nearly killed them. I know you’ve written on them in the past year or so, and that’s when I remembered about them again.

      But my initial investment was definitely based on the story instead of durability of the product and brand with customers and widespread adoption (outside the cannibis market.. lol)

  3. Neil, thanks for sharing your thoughts on story stocks. One stock that comes to mind to me is ABHD. I remember late 2012 the CEO was projecting $17-20m in revenues and it was clear that goal was extremely unreachable. This was a prime story stock that over promised and under delivered…..was always in NYC raising money and now the stock is at a nickel. This is what we have to filter through in NanoCap / MicroCap land 🙂

    From a PR November 14, 2012: http://www.abtechindustries.com/#!Abtech-Holdings-Inc-Reports-Third-Quarter-and-Nine-Month-2012-Financial-Results-AbTech-Confirms-First-2-Municipalities-Intend-to-Proceed-with-P3s/c7a5/558300100cf27a6b7454cdfc

    The Company continues to expect significant sales growth in the fourth quarter of 2012 and into 2013 as new projects being pursued in storm water, industrial waste water and produced water markets begin to generate revenues. It is important to note, that although AbTech believes it is near the point of receiving long awaited orders, it is unlikely that its projection of $17 to $20 million in revenue and/or purchase orders will be met in 2012.

  4. Neil, I think that’s a great topic that you’ve brought on the table.

    Especially the analogy you’ve made between the pitfalls around falling in love with a story stock and the importance of keeping in mind that the goal is to, quote, ”finish the book after all”.

    Over time, I found that too short stories are more likely than not to become traps and turn into a lenghty book before you can see the first dollar of profit.

    I respect CEOs who have a trackrecord and who admit a change/integration will take several months, if not years, to fully materialize into long term gains.

    When I hear the opposite, it usually means to me that the speaker doesn’t realize all the unknowns lying ahead, and perhaps reveals a lack of experience.

    Thanks for sharing you thoughts,
    Seb

  5. Thanks for the comments! I loved writing on this topic as it’s a challenge I face every day. The market environment is extremely relevant as well when trading story stocks. For ex, 2013 was a great year for stocks to trade simply on expectations. 2015 is not! If you’re going to dip your toe in the water, make sure you’re doing so at a time where investors have a greater appetite for risk.

  6. Great thoughts Neil,

    This really hit home too.
    “Most executives in this subset of the capital markets need to be salesmen”
    Most people (myself included) aren’t able to interview CEO’s as deeply like yourself, so it’s really important to ignore all the stories, hype and expectations and come up with our own ideas about the business and whether the tailwinds really do exist.

  7. Another thing which Neil hit on is the infamous “large strategic acquisition”. Especially in the microcap world, companies strive to get bigger at all costs. The problem is many don’t do the right acquisitions or have the right timing (using high priced equity) to make them accretive.

    I’m reminded by this excerpt on Henry Singleton in a 1979 Forbes article:

    “American business is still gripped with a mania for bigness. Companies whose stocks sell for five times earnings will think nothing of going out and paying 10 or 15 times earnings for a nice big acquisition when they could tender for their own stock at half the price. Shrinking — à la Teledyne — still isn’t done except by a handful of shrewd entrepreneurial companies.”

    With most large acquisitions I see in the microcap space, much more shareholder value would have been created by not doing them.

  8. Great Article………

    I have also learned a good lesson with ‘story stocks’ thru my investing years……..and much prefer to wait for the company to have increasing revenues and earnings—-and not buy the story,

    I am willing to pay up when the situation is no longer a story and has been ‘de-risked’ with actual revenues and earnings.

    When i hear a story being pitched to me—–I will actually say to that person, “When I want a good story, I go to my library.

  9. Great article Neil.

    I’ve often said to focus on the sexiness of a company’s financials & not the sexiness of the business. Better yet, find a company that has both.

    My favorite “story” stocks are ones where a chart of EPS starts in the lower left and continues on to the upper right.

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