Investors are always looking for the perfect opportunity. A good business you can buy at less than tangible book value. Why not throw in a couple long-term tailwinds and short-term catalysts. Sign me up. I’ll take two.
But in reality you won’t find too many perfect situations. Microcap investing is by an large a game of acting on imperfect information. Often times an opportunity is an opportunity because the conditions aren’t perfect yet.
As you gain experience you get better at identifying the good that can become great, understanding weaknesses that can be overcome, and identifying situations with unique optionality.
I thought I would spend some time talking about microcap portfolio construction. My thoughts on this have changed quite a bit over the years. I’m a firm believer that If your strategy or thought process hasn’t changed in 10 years you aren’t learning. You need to constantly evolve to stay in the game.
My portfolio today is made up of a diverse set of companies. There are product companies and service companies. There are deep value stocks and story stocks. There are profitable and unprofitable companies. There is even a mining company. “My goodness Ian, you have a family. Don’t you know mining is where capital goes to die.” The mix of companies I just described probably sounds chaotic.
If you were to ask a healthy person what they had to eat last week – to list the foods they ate during the entire week. I’m sure it would look like chaos. But you would quickly be able to divide the foods into groups. A well balanced diet consists of dairy, vegetables, fruits, grains, and protein. The food groups are important, but so is the portion sizing. This is how I think about portfolio construction.
My portfolio looks like chaos, but it isn’t. I divide my holdings into groups or categories. Each category serves a purpose and in the right proportions supplies a slightly different set of optionality to the portfolio.
I’m trying to invest in intelligent fanatic led businesses that are misunderstood by the market place. I’m looking for situations whose stocks can conservatively double in three years. That is the goal.
Over the years I’ve found that these misunderstood situations generally fall into three groups or categories:
- Good to Great Businesses
A business that dominates an expanding niche market and whose happy customers continuously pull them into underserved markets. Proven management that has either created their market or have taken market share away from competitors. A product or service that is needed by a diverse set of customers. They are called Good to Great Businesses because they are a good businesses that I believe can turn into a great businesses. For discussion purposes I don’t call any microcap a great business until it ascends out of the microcap arena. These companies can often go misunderstood if earnings are depressed due to reinvestment or if management is not promotional. As long as they keep growing and earning more money they will be found by institutions. This is the largest category of my portfolio.
A stagnant or declining business whose management is making strategic steps to transition to growth. This normally means cutting cuts, selling off non-core assets, and focusing on a growth vertical where they have a competitive advantage. These situations usually take more time to turn than most shareholders can stomach. The opportunity is to understand the turnaround process and to accumulate when you see the signs of it turning. Successful turnaround investments are companies you initially buy based on the balance sheet (deep value valuation) but eventually trade based on the income statement (growth valuation). This is the second largest category in my portfolio.
- Rocket Ships
A situation that offers rocket ship type returns. The issue is rocket ships rarely take off on time or even at all. A recent NASA study showed that 39% of space shuttles take off on time. NASA utilizes the best checklists in the world 30 days prior to take off and the result is still a low takeoff percentage. Half the delays are technical malfunctions, and the other half are weather related. The same can be said for rocket ship stocks. The key to rocket ship investing is finding those rare situations where you won’t lose much money if the launch is delayed or doesn’t take off at all. These are small strategic investments. You never bet the farm. Rocket ships are the smallest category in my portfolio. But if one does take off, it can take the entire portfolio with it.
I own companies in each of these categories. In all three categories I try to only invest in leadership that exudes many of these intelligent fanatic principles and values:
- Mission Driven
- Beginners Mindset
- Learning Machines
- Intrinsically Motivated – Inner Scorecard
- Capacity to Suffer – Personal Sacrifice
- Prevailed through Adversity (GRIT)
- Obsessed with Eliminating Risk
- Large ownership – Low Salary
- Lead by Example – Blue Collar Founders
- Employee First Mentality
My strategy has evolved. I try to utilize the full arsenal of investing disciplines. I think too many start investing a certain way and feel forced to continue down that path – to stay in their lane. “I’m a deep value investor.” “I’m a growth investor”. “I’m a special situations investor”. “I’m a Buffett Disciple”. You don’t need to label yourself. If you study the best investors ever they have almost opposing investment strategies. Don’t be afraid to be unique. Be afraid if you’re not. The key to investing success is thinking different and better.
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