It’s Time to Change Your Perception of Microcaps

Sean Iddings Blog, Educational, Intelligent Fanatics 8 Comments

What truly is a microcap? The common answer would be a small public company with a market capitalization of less than $300 million. But does the label tell us anything about microcap businesses or help us become better microcap investors? No, thinking purely in labels turns us into Oscar Wilde’s definition of a cynic – “A man who knows the price of everything and the value of nothing.”

The term “microcap” has a negative perception or label perpetuated by most financial pundits, regulators, and even investors. Most look at the 11,000+ microcaps in North America and judge them as being sleazy, slimy, and insignificant. This label couldn’t be further from the truth. Many of the best investors ever, including Warren Buffett and Peter Lynch started their careers investing in microcaps. Some of the best performing companies ever, including Berkshire Hathaway, Wal-Mart, Apple, started as small microcap companies. Today, North American microcap companies employ over 2.8 million jobs. More jobs than Google, IBM, Home Depot, Berkshire Hathaway, AT&T, Pfizer, Cisco, Microsoft, Boeing, General Electric, and GM combined. All Great Companies Started As Small Companies, and it’s time people changed their perception of this unloved equity class. Our long-term mission at MicroCapClub is to bring credibility and respect back to the microcap space [Presentation].

Labeling always reminds me of Richard Feynman’s little story about knowing the name of something. In it he described a story growing up as a child, recounted below:

The next day, Monday, we were playing in the fields and this boy said to me, “See that bird standing on the stump over there? What’s the name of it?”

I said, “I haven’t got the slightest idea.”

He said, “It’s a brown-throated thrush. Your father doesn’t teach you much about science.”

I smiled to myself, because my father had already taught me that [the name] doesn’t tell me anything about the bird. He taught me “See that bird? That’s a brown-throated thrush, but in German it’s called a halsenflugel, and in Chinese they call it a chung ling and even if you know all those names for it, you still know nothing about the bird-you only know something about people; what they call that bird.

Small companies are everywhere; they, like birds, have different labels given and used by different people:

  • In the public markets they are called microcaps
  • In the private local markets they are called small businesses
  • In Silicon Valley they are called technology startups

Each term conjures different images in our minds. Microcaps, often referred to by the derogatory term “penny stocks”, have a negative stigma even though over 120 microcap companies have gone up 1,000% or more over the last five years. Small businesses have a good perception. They are the mom and pop shops that can be found throughout the U.S. and other countries: the neighborhood plumber, construction company or antique shop. Technology startups, particularly those found in Silicon Valley, have great perceptions mostly due to Peter Thiel, Marc Andreessen, Ben Horowitz, and other famous venture capitalists endorsing the space. When the public thinks of technology startups they think of gutsy founders, opportunity, and unicorns (those that have reached $1 billion valuations). Even though Berkshire Hathaway, Wal-Mart, Netflix, and many other companies started as small microcap companies, we have no well-respected opinion leaders blazing the public opinion path for microcaps. While there are plenty of truths in the public’s perception and the associated stereotypes, taking a wider view uncovers that microcaps, small businesses, and technology startups are all quite similar.

Microcaps, small businesses, and technology startups are all emerging businesses mostly run by founders with an entrepreneurial spirit. Investing in such companies is a bet on the jockey (founder) even more so than the horse (product/service). More than 90% of new businesses fail. The founding entrepreneur and their team (combined with a little luck) are the only things that separate the average, who are likely to fail, from the highly successful.

“A strong team is the most important element of a company’s ability to achieve success.” – Vinod Khosla

As microcap investors, we can learn a lot from successful venture capitalists on how they evaluate founders and management teams. They are looking for intelligent fanatics just like we are. The successful venture capitalist understands the importance of a founder and their team. They spend a great amount of time vetting founders and their teams. Great founders attract top talent, while the B and C founders attract lower quality talent. The idea is to weed out the great entrepreneurs with large long-term visions from the other entrepreneurs with different goals.

Below is a great Q&A session with Marc Andreessen of Andreessen Horowitz and Ron Conway of SV Angel. Ron Conway is an angel investor so he normally invests at an earlier stage than most venture capital firms. In fact many of Andreessen Horowitz’s investments were first invested in by Ron Conway of SV Angel. Ron Conway and SV Angel have invested in over 750 companies over the last twenty years. Conway mentions they have invested in 1 out of every 30 companies-founders they interview which means they’ve looked at 20,000+ businesses and founders.

Here are the following types of entrepreneurs (some borrowed from Steve Blank):

  • Lifestyle entrepreneur – do enough work to live their passion. Think of the musician who wants to play music all day and night. They teach just enough music classes to pay the bills and supplement by playing out at night. They don’t need to make a profit.
  • Small business entrepreneur – happy to be self-employed by operating a known small business model. They have no ambition to take over the world. Think of the plumber, website designer, or carpenter. They just need to make a small profit to keep afloat.
  • Intelligent fanatic entrepreneur – these founders either have +$1 billion visions from the first day or they are pulled into much larger visions after achieving initial success. In either case, they are seeking scalable, repeatable business models that can lead to domination. They are intensely competitive so they are never satisfied dominating small niches. Visions of world domination will come. These are the leaders who, if they are aligned financially with shareholders, have the inner alignment as well.

Microcap investors, who want outsized long-term returns, should understand that lifestyle and small business entrepreneurs are abundant and aren’t the best partners to achieve large long-term returns. These entrepreneurs, even while owning significant pieces of their business, are just as happy collecting their $250K salary while not upsetting the apple cart too much. Investors should focus mainly on partnering with the intelligent fanatic entrepreneur and holding on as the they, and their highly talented team, execute on a scalable, repeatable business model. The returns possible under such partnership is where true wealth is created.

Ian Cassel and I are working on the Intelligent Fanatics Project (www.intelligentfanatics.com) that outlines the similar qualities, cultures and strategies that intelligent fanatics possess to enable scalable, repeatable business execution over the long-term. I’ll use a short example of a company that has gone from nothing to mega billion corporation under its founder.

Intelligent fanatic Larry Ellison bootstrapped a $2,000 investment in Software Development Laboratories in 1976 and turned it into the $160 billion Oracle that we know today. Larry Ellison generated significant shareholder value creation over his tenure of roughly 25% compounded annually since Oracle became public.

orcl

Oracle was slightly larger than a microcap, $500 million valuation in today’s dollars, when they had their initial public offering in 1986. This same year the company had $55 million in revenues which quickly ballooned to $584 million by 1989. Larry Ellison continued to sustain enormous business growth and execution right up until he stepped down as CEO in 2014.

In 1981, Kathryn Gould was Oracle employee #10, and she would later become a successful venture capital investor. She believed, as do many others, that Larry Ellison possessed potent leadership skills and characteristics that made him a winner. Ellison was the yardstick that Gould would use to evaluate every other founder she came across. The full write up can be found [HERE], but Kathryn Gould’s DNA of a great leader is summarized below:

  • Have a clear mission and inspire everyone to live it every day
  • Are the best salesman in the company
  • Hire the smartest people
  • Have a technological vision and the ability to convince others that it’s the right thing
  • Know it’s about winning customers and don’t spend money on things that aren’t mission-critical
  • Are relentless in pursuit of their goals and never take NO for an answer
  • Know humor is powerful — and fun!

Conclusion

It’s time many investors change their perception of the microcap space. There have been many great companies that have come out of the public microcap arena. Microcaps are small businesses led by entrepreneurs with different motivations. Similar to venture capital investors, microcap investors should put significant thought and due diligence into which entrepreneur they partner alongside. Steer clear of the lifestyle and small business entrepreneurs and focus on the intelligent fanatics who have the vision, leadership skills and characteristics to build a scalable, repeatable business model. Intelligent fanatics do not come around often but when they do, they are observable running smaller enterprises. If you work hard, you’ll be lucky enough to find a few of them over your lifetime, and then the goal will be to develop the conviction to hold them to reap the rewards.

I’ll leave on this quote from Phillip Fisher:

“Those companies which decade by decade have consistently shown spectacular growth might be divided into two groups. For lack of better terms I will call one group those that happen to be both ‘fortunate and able’ and the other group those that are ‘fortunate because they are able.’ No company grows for a long period of years just because they are lucky. It must have and continue to keep a high order of business skill.”

MicroCapClub is an exclusive forum for experienced microcap investors focused on microcap companies (sub $300m market cap) trading on United States and Canadian markets. MicroCapClub was created to be a platform for experienced microcap investors to share and discuss stock ideas. MicroCapClub’s mission is to foster the highest quality microcap investor Community, produce Educational content for investors, and promote better Leadership in the microcap arena. If you are a passionate microcap investor, Join Us.

Comments 8

  1. Two fascinating topics: microcaps versus investing in larger companies, and identifying intelligent fanatics. I mentioned to Ian that I wanted to focus on investment research and set aside commenting on investment philosophy for a couple of months, but feel compelled to try to make a contribution here given that I’ve taken positions in WFCF and BIOYF in the last few days. The work of many MicrocapClub investors has made my research into these companies much easier.

    There are probably lots of reasons to favor microcaps, but I’m only aware of two. (1) you get more value for your investment dollar, (2) great management and or great products have more of an impact in a small company, and therefor produce higher long term investment returns. In terms of value, I’m not convinced the advantage is huge, but am working on a research study that may provide some insight. I’m studying the 200 fastest growing companies over the last two years in terms of earnings, revenues, gross profit, operating income, book value and free cash flow, and then comparing the price per share versus the earnings and free cash flow per share. More in a week or two.

    And yes, great management and great products do have more potential in percentage terms in small companies than large. Obviously. But on the other hand small companies are at a distinct disadvantage when it comes to attracting talent. As business and technology evolve at ever greater rates, the ability of a company to attract talent becomes increasingly important to investment returns.

    So I’m comparing CEO salary to gross profit. For instance, the CEO of WFCF earned $259,327 last year versus TTM gross profit of $5,099,000, or 5.1% of gross profit. The CEO of REGN received total compensation of $47,462,526 last year, but that represented only 1.2% of gross profit. Which company is better able to attract top talent? Which has greater economies of scale? I’m actually doing this analysis to compare similar sized companies, as one measure of shareholder friendliness, but nevertheless small companies have clear advantages in some important areas, but also disadvantages in others.

    On the issue of intelligent fanatics, I very much look forward to your study. Although most commentaries on the subject are presented in broad statements, the subject is full of contradictions an nuances. I’ve known some intelligent fanatics over the years, and observed their widely-different paths to success and personalities. Think Buffett versus Soros. Soros had investment returns that averaged over 100% a year in the 1970s and 1980s, with only one losing year if memory serves. Buffett averaged somewhere around 25% in that time, with I think three losing years. But my real point is the interaction between energy, judgment and risk tolerance differed greatly between the two men, but both achieved phenomenal results. A similar set of criteria can be applied to a study of the military generals — Patton versus Eisenhower versus Montgomery.

    As an investor, I’ve operated on the assumption that I’m not smart enough to be a Steve Jobs, but I’m smart enough to identify a Steve Jobs. After having tried for a few years, I still believe that but with less confidence. Compare Steve Jobs to Bill Gates for example. Both brought incredible intelligence and judgment to their work, but one was much more risk adverse than the other, one much more creative, but what made the difference was the interaction of judgement, energy and risk tolerance. (There are a couple of fascinating interviews of the two men on YouTube — interviews that really illustrate their differences in personality).

    Another criteria, as Ian has pointed out, is reaction to failure. Every great investor, manager, CEO, military general, has experienced failure, and generally lots of it. The difference between the great ones and the mediocre ones is how it affects their risk assessment going forward and their energy level. The Steve Jobs keep creating, experimenting, making investments that entail risk. The mediocre retreat. Gates seemed much more focused on risk aversion and building a recurring revenue stream.

    Having watched intelligent fanatics age, I’ve noticed that most, not all, but most become risk adverse with success. Tendencies they had to disrupt their competition and industry often get replaced with long vacations at beach houses in Hawaii. They tend to want to enjoy their success rather than risk having to start over again.

    So you’ve taken on a complicated, crucial study and the results will be interesting.

    1. Rod,

      Thanks for your thoughts. I look forward to your research study. If I recall MikeDDKing shared one small case study on a few 100 baggers that focused more on the financial metrics of revenue/earnings growth. I wonder if you have seen it yet (http://www.tsanalysis.com/wp-content/uploads/2011/03/100-baggers.pdf).

      I don’t subscribe to the belief that all microcaps are at a disadvantage in terms of attracting talent versus larger companies. There a pros and cons to both differently sized companies, but microcaps can utilize many non-financial benefits to attract talent and retain them. And there should be a line drawn between attracting talent and retaining talent.

      Generally, what I have observed is that large, bureaucratic organizations tend to focus on salary and their current “brand” power to attract talent, while microcaps, and quality entrepreneurial driven organizations regardless of size, will explicitly pay less salary and make up for the lower salary in a myriad of other ways. The obvious first way is a financial ownership mentality. The long-term upside can be significantly better at a microcap vs. a large company. Such compensation packages acquire entrepreneurial-minded employees. This can be a good motivator to attract many applicants, but from the sounds of it, retaining top talent is more difficult and more important in the long-term health of any company.

      Retention seems to revolve around culture and internal employee motivations. These are things all microcaps can provide as they don’t cost any money. Microcaps can provide plenty of opportunities for employees to grow substantially within the organization over the long-term. Large, bureaucratic companies, on the other hand, often prefer to hire “professionals” from the outside and do not provide many opportunities for individuals to advance within the organization. This type of culture significantly hurts employee morale and loyalty.

      Microcap companies can also do other things to promote an ownership mentality amongst employees at relatively little cost. Just provide employees on the front line plenty of autonomy to do their jobs. Give an employee control and they feel like an owner. Tie their pay to their performance and they are an owner.

      These are just a few ideas, but there are significantly more in-tangible benefits that a microcap can utilize.

  2. re: “all microcaps are at a disadvantage in terms of attracting talent versus larger companies”

    There are very few statements along the lines of all small companies or all big companies are this or that that have any validity. If I implied that, I didn’t write well or clearly. My point is that blanket statements that small companies (or big companies for that matter) are better investments for the following reason ignores the nuances that ultimately determine investment returns. Black and white statements about investing rarely have validity.

    Having said that, I’ll now tread dangerously close to the line. The enemy of innovative organizations, big or small, is the tendency to avoid risk in order to preserve the status quo. The constant tendency of most people is to avoid work, to look forward to 5pm. About 90% of all innovation is contributed by 1% of the working population, and in the future is likely to be more skewed, as that tendency has been gaining momentum since we were cavemen. The more sophisticated our tools, the fewer of us are competent using them.

    And about 90% of everything worthwhile created by humans is done by about 30% of the working population. Most people are some combination of lazy, incompetent and/or dishonest. Most people hang around, suck in air and practice their social skills.

    One can make this observation about men; they are ungrateful, fickle, liars, and deceivers, they shun danger and are greedy for profit. While you treat them well they are yours.
    – Machiavelli

    The jury is out on Apple, but Jobs constantly pushed those around him to abandon yesterday and embrace tomorrow. Now that he’s gone, I wonder who there is willing to force the company to constantly change and re-envision the future. Tim Cook is a brilliant administrator, and the ideal partner for someone like Jobs, but I don’t think he could have created Apple. Perhaps no one other than Jobs could have created Apple. But my real point is big or small, abandoning yesterday to create tomorrow takes a lot of guts and persistence. And a willingness to fire those who obstruct, and in general be a son of a bitch.

    Career soldiers often resist innovations, because innovations tend to make their special competence obsolete and to sharpen competition.
    – Machiavelli

    And lots and lots of small companies are resistant to innovation. There are lots and lots of small companies that are private fiefdoms of aging management who spend the winter in Florida and the summer on the golf course. Extinct volcanoes. And big companies too. It isn’t a matter of size.

    But luring highly talented executives to a small company with stock options means removing future wealth from current shareholders to recently hired executives. For that to work, the new talent needs to make the pie bigger, generally a lot bigger. Most new hires share the existing pie. People who actually make the pie bigger are rare.

    When I see big new option plans for new hires, as a shareholder, I get nervous. On its own, I don’t rule those companies out, but I don’t need much else to abandon ship. When a big company hires the guy who graduated at the top of his class in computer engineering at Stanford, the risk is proportionately smaller. That was the point I was trying to make.

  3. I’m about 80% of my way through my study. Here are the market caps of the five fastest growing companies so far:

    BLUSF – BELLUS Health Inc $80,577,000
    DPLO – Diplomat Pharmacy Inc $1,972,060,000
    MBLY – Mobileye NV $7,987,930,000
    SEDG – SolarEdge Technologies Inc $787,330,000
    ELXMF – Ellex Medical Lasers Ltd $65,130,000

    I’m not advocating investing in any of these yet. There is much, much more to it than just growth. Like receivables for instance — growth companies with receivables growing faster than sales are highly risky. And going concern net value based on earnings and free cash flow in relation to current stock price range from 25% to 2323%.

    I’m just saying that the view that small companies grow faster than big companies, while on average may be true, or may not (I suspect not) but the statement attempts to make a complicated situation simple, and thus ignores crucial considerations that have a major impact on investment success.

  4. Interesting post, Sean. My perspective (former small-cap institutional investor) is that a good place to start with re-imagining micro-cap companies is with Tier 1 media. For better or worse, WSJ, Bloomberg, CNBC, et al. still are largely responsible for highly respected financial content. Intelligence and sophistication notwithstanding though, it’s unrebuttable that respected financial reporters have very little experience with small public companies, and, to your point, when they do it’s rarely for a positive reason. Accordingly, when there is reporting in this regard, it’s mostly pejorative (i.e., “highly manipulated penny stock…”). As someone who writes and speaks extensively around the world about the need to treat the governance of small public companies differently than the governance of large public companies, I run up against this issue daily. Some examples:

    – 80% of public companies have market caps below $500m, and they, to your point, are responsible for an enormous number of jobs, not to mention innovation. Moreover, these companies raise > $30B of growth capital annually. In many years, the “PIPE” market is larger than the IPO market. Why do we incessantly hear about the IPO market, but never hear (literally never hear) about the PIPE market?

    – When Warren Buffett and Oprah Winfrey invested in Goldman Sachs and Weight Watchers, those direct investments were PIPEs… full stop. But the WSJ doesn’t refer to them that way, because… it’s Warren Buffett and Oprah Winfrey. Instead, they prefer to refer to PIPEs as “last gasp financings for shady penny stocks.” Memo to the WSJ: a PIPE is a PIPE.

    It all comes down to perspective and education. There are already some constructive advocates out there (e.g., David Weild, among others), but more is required. It’s incumbent upon all constituents of the micro- and small-cap community to respectfully educate Tier 1 media not to turn their collective noses up at small public companies. After all, the computers they are writing exclusively about large public companies on ironically wouldn’t exist without the garage-born small public companies that invented them.

  5. Rod,
    “Having said that, I’ll now tread dangerously close to the line. The enemy of innovative organizations, big or small, is the tendency to avoid risk in order to preserve the status quo.”

    ^I do agree this is very important. Leaner companies will eat a bureaucratic, risk avoiding organization’s lunch almost every time. Companies have to fight vigorously the tendency to become bureaucratic as they grow. A strong culture is the first defense.

  6. Adam,
    Thanks for your insights. It all does come down to perspective and education. I vote for Ian to go on Tier 1 media 🙂

  7. Rod MacIver,
    I just took a quick glance at your list of the five fastest growing companies
    Here is my opinion on them:

    DPLO – Lakewood Capital’s Anthony Bozza short (he could already covered it, should be checked)
    MBLY – Citron research short / obvious stock bubble
    ELXMF – illiquid/totally uninvestable stock in the US / however, good looking chart on the ASX
    SEDG – no idea.
    BLUSF – that’s an interesting one for the further dd.

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