Join Now
Education

An Essay on Investing in Small Stocks

There are a bunch of small stocks that will 10x over the next five years that are waiting to be found. Institutions can’t buy them. Only you can.

There are a bunch of small stocks that will 10x over the next five years that are waiting to be found. Institutions can’t buy them. Only you can. The opportunity in small stocks (microcaps) exists because institutions can’t own them until they go up. It is the small retail investor’s duty to find them and collect the reward for doing so. 

When you find a winner, people will say you are wrong. When you hold a winner, people will say you are stupid. When you get rich from a winner, people will say you got lucky. You tell them you love being wrong, stupid, and lucky. 

“You don’t have to invest like a big bureaucratic institution. If you choose to invest like one, then you’re doomed to perform like one.”

Peter Lynch

If you consider yourself stock picker – At some point in your life you are going to have to do the work others aren’t willing to do and bet big on something you believe in. But it takes work and conviction. YOU must do the work and YOU must form the conviction. You will make mistakes. You will buy stocks you shouldn’t. You will sell winners too soon. You will hold losers too long. But whatever you do don’t blame others. When you blame others for your investing mistakes it proves you didn’t do enough of your own work. Own your mistakes so you learn from them.  

The idea of investing in small stocks sounds reckless. It isn’t. The greatest advantage a microcap investor has is the rest of the financial world thinks you’re an idiot for investing in small stocks aka “penny stocks” and that you don’t think deeply about your investing process. Prove them wrong. Alpha is generated by being just a little bit different in a disciplined and thoughtful way. 

My investment philosophy is quite simple. I study great stocks, great businesses, and great leaders – hundreds of them. I put in the reps to develop pattern recognition and then go find them when they are small. I want to invest in undervalued companies that will get overvalued. Great companies always trade at a premium because there is a scarcity of them. All great companies started as small companies and it’s my mission to find them. This isn’t easy. I’ve been doing this for 20 years and I’m still wrong quite often. Perfection is not the goal. If you aren’t taking some small losses from time to time you aren’t taking enough risk.

“Nothing in the world is worth having or worth doing unless it means effort, pain, difficulty… I have never in my life envied a human being who led an easy life. I have envied a great many people who led difficult lives and led them well.” 

Theodore Roosevelt

I’m a growth investor at heart. The two most important frameworks or mental models I try to apply is combining tailwinds (top-down) and scarcity (bottom-up). When these two are combined they become powerful drivers of returns.

A tailwind is a wind that blows in the direction you are going. When I think of tailwinds, I picture the jet stream pushing a commercial jetliner. In the United States there is a westerly jet stream above 30,000 feet. The winds can reach 100+ mph. Commercial jetliners will use the jet stream when flying west to east. A 6-hour flight can be made in 4.5 hours. The aircraft doesn’t work as hard, burns less fuel, and still gets to the destination quicker because the jet stream naturally pushes the aircraft in that direction.

Another way to think about tailwinds is what venture capitalist Josh Wolfe of Luxe Capital calls undeniable directional arrows of progress. Simply put – investing in an area where technology is headed in a direction that is hard to stop. For example, we went from horses to horse drawn carriages, to cars, to electric cars, and soon to be autonomous cars. We’re not going back to horses unless you are Amish and never stopped using them. Another example Wolfe uses is mainframe computers, to personal computers, to laptop computers, to computers you hold in your hand, on your wrist, and perhaps in the future linked to your brain. It is hard to deny the future is headed in this direction.

When you zoom out you can find these directional arrows of progress everywhere. They might be geopolitical tailwinds or industry focused tailwinds or technological tailwinds or a combination of them. When you find a tailwind that is hard to stop, and you combine this with best of breed business, idea, or technology then you find an investment that is hard to stop. Don’t make investing harder than it needs to be. Invest where there is a tailwind. You will get to your destination quicker with less effort.  

Scarcity is a powerful driver of price. Scarcity is when demand outstrips supply and prices go up and up and up. The most extreme examples involve a tidal wave of consumer demand hitting a single product category like tickle me Elmo dolls, or the Beanie Baby bubble, or even some of the meme type stocks of today. You see the effects of scarcity when demand is focused on one product, company, stock. We don’t want to try to guess at the next superficial bubble, but scarcity also applies to quality businesses. 

We want to invest in businesses that are unique – not businesses where there are 1000 others doing the same thing, selling a similar product or service. We want to invest in special businesses. Just like a Picasso, investors are willing to pay up for high quality that is scarce. Scarcity can be found in different forms throughout a business and stock. Illiquidity is the scarcity of shares. Illiquidity is very powerful when it’s combined with a great business. Why? Investors are forced to pay up to own shares.  

My primary hurdles for new investments: 

  1. A business that can grow through a recession. 
  2. A balance sheet that can weather a storm and act with occasional boldness. 
  3. A leadership team and organization that show signs of intelligent fanaticism ie Find management teams that deserve to be running much larger companies.
  4. A valuation that can conservatively double in three years. 

These hurdles focus on quality and survival as much as upside. The best companies have all three. I used to invest in shorter term, lesser quality situations that could 2-3-5x quickly, but they couldn’t sustain those moves. Their stories, promises and momentum pushed their stocks to prices where their fundamentals couldn’t keep them. They fell right back down. You will cut out 90% of the pain of investing in small stocks by focusing on profitable businesses.  

I can’t predict the short-term, so I do my best to underwrite the next 3 years. I talk to management and industry experts to form my expectations and to determine what the KPI’s/variables are to track progress. I track quarterly progress against this 3-year objective. 

Why 3 years? 

First, if you ask management about 1-year goals, it’s guidance. If you ask management about 3-year goals, it’s strategy. Management will be more open in talking about strategy. 

Second, you’ll be one step ahead of most investors if you can simply look beyond “the next quarter”. Most other investors are focused on the next 20% move in the stock. You need to stay focused on the next 100%+ move. Trying get a multi-bagger by focusing on the next quarter is like trying to find an elephant with a magnifying glass. Zoom out. Track quarterly results against a 3-year thesis.

Third, anything can happen, good or bad, in a quarter or two. These are small business. A big order/contract win pulled in or pushed out of a quarter can distort reality. Give the next quarter or two some wiggle room. Hold your positions like a tube of toothpaste. Don’t hold them too tight. No company is perfect. Give them enough room to disappoint you a little.

Fourth, the best companies are investing for the long-term in ways shareholders don’t fully grasp or appreciate. It sometimes shows up as short-term underperformance as they invest in the future or go above and beyond for a customer.

80% of the time winners will exceed your expectations. I would implore you to not be so valuation centered. If a small company with a unique business and exceptional management team is attacking a big problem with a great strategy, then let them. If they are executing, the business is probably worth more than you think is reasonable. The goal is to find undervalued companies that can get overvalued. Let them get overvalued.  

All my winners had one thing in common, I was always averaging up. Most of my losers had one thing in common, I was always averaging down. The best investments are the ones where the fundamentals accelerate, and the stock is a better risk reward higher than it was lower. Don’t be afraid to average up. Often times the best place for new capital is buying more of the companies that make it look easy. 

Holding losers is easier than holding winners. Why? Because losers always look cheap. Holding winners is not easy. You will have to hold while the stock doubles in a year. You will have to hold as the stock pulls back 50% from its highs. You will have to hold as the stock goes nowhere for months, quarters, maybe years, as fundamentals backfill into a higher stock price. You will have to hold as expectations get too high or management goes through growing pains. You will have to hold as the stock is cheap and expensive. You will have to hold while the stock is loved and hated by other investors. Holding winners is hard. The key is focusing on the business, not the stock. 

I was listening to Patrick O’Shaughnessy’s podcast with John Harris, managing partner of Ruane, Cunniff & Goldfarb. The firm’s flagship Sequoia Fund has outperformed for 50 years in a highly concentrated equity portfolio. In the interview Harris mentioned that 10 big winners made up the bulk of their outperformance over 50 years. It was a good reminder that it only takes a few great decisions. 

Harris also talked about his deepest regrets in investing. He mentioned his single biggest loss. He was short Volkswagen which means he was betting that the stock would go down. The stock did the opposite going up 10x in one week. He lost 30% of the fund. The interesting part was this massive loss didn’t even make his top five biggest regrets. Harris said all his biggest regrets were passing on investments that would become big winners. 

It’s fascinating to think that over a career you will pass on more winners than you will let into the portfolio. This is okay. Successful investing is a game of subtraction – looking at thousands of opportunities/companies and filtering the list down to a select few that have characteristics that you can believe in and invest through the volatility. But it doesn’t make passing on winners any less painful. 

When I reflect on my 20 years of investing experience, I can connect with what Harris was saying. I never think about the losers. All my biggest regrets were selling winners too soon. The ones I sold for a 100% gain only to watch them go up another 1,000%. Those are the mistakes that haunt me. Nothing screws with your head more than watching something you used to own outperform the things you own. Losers aren’t as painful because you can only lose what you invested. When you sell winners too soon you can miss out on making multiples of your invested capital. 

In 2015, JP Morgan did an analysis of the Russell 3000 Index. The Russell 3000 is a good proxy for the US Stock market. The study found that 2/3 of all stocks included in the Index underperformed the entire Russell 3000 Index as a whole. In March 2021, a further analysis of the index concluded: “The winners generate enormous excess returns, but the median stock ends up underperforming the Russell 3000 Index.”

The JP Morgan study found that the “mega winners”, stocks that produced 500%+ cumulative price returns vs Russell 3000 Index, drove the returns of the entire index. These mega winners made up for the 44% of companies included in the index that suffered “catastrophic stock price loss”, defined as a 70% decline in price from peak levels and never recovered. This phenomenon is known as a positively skewed distribution. This is a fancy way of saying the most a stock can lose is 100%, but potential returns can be multiples more than 100%. In other words, one big winner can make up for a lot of losers and drive outperformance. Not selling your winners is crucial. 

In May, I had the pleasure of speaking with Ho Nam, co-founder of Altos Ventures. Altos is one of the most successful, yet unknown, venture capital firms in the country. They manage $10+ billion across several funds. They differentiate themselves from other VC’s by investing in capital efficient businesses. They don’t follow the normal “growth at all costs” VC mantra, where other VC firms invest for high growth in spite of high losses. Altos focuses on companies that can get to profitability quickly. Why? It protects their downside. If the worst-case scenario is they own a piece of profitable business that didn’t get as big as they thought they can still find a buyer for it. 

Ho Nam and I had a great conversation about holding winners, averaging up, and structuring the firm to be able to facilitate this. Altos is most famous for their investment in Roblox (RBLX). They were one of the first outside investors in 2008. After this initial $1.5 million investment, they invested $400 million more into the company in subsequent funding rounds. When Roblox went public last year, Altos owned 21% of the company. They’ve since sold some, but their position is still worth several billion today. I can’t imagine the pressures they had internally (from themselves) and externally (from their investors/LP’s) to sell. 10% of successful stock picking is picking great stocks. The other 90% is not selling them. 

It is easy to think of the Roblox example and think winners are these long linear stairways to heaven. But as many of us know, the biggest winners also have the biggest drawdowns. We study famous investors like Nicholas Sleep and Qais Zakaria from the now closed Nomad Investment Partnership and think to ourselves, “I’d be famous too if I just held Amazon and Costco the last 15 years”. But you didn’t and it wasn’t easy. They bought Amazon aggressively in 2005 around $30 per share. The stock went to $80, and then fell back into the $40’s during the 2008-2009 financial crisis. I’m sure they would tell you being up 150% in 2 years to being up 50% in four years in a position isn’t fun or easy. They bought Costco in 2002 around $25 per share. It would rise to $70 by mid 2008, and then fall back to $42 in 2009. Going from being up 200% in 6 years to being up 80% in 7 years isn’t fun or easy. Nomad’s extreme outperformance was on the other side of average performance. Amazon would go on to 100x and Costco 10x.  

At multiple points in time, with every winner, gaps will form between your expectations and reality. The question is whether you will fill those gaps with worry or trust. A friend of mine said “We are all looking for that one company that will change our lives. Most investors will find that company, but most will also let it go.” I do believe that in most cases it’s our own expectations that cause us to sell our biggest winners. We fall into our own bullish echo chambers and allow our expectations to get far too high. When management doesn’t meet these expectations, we blame them even though it’s our own fault. Find situations that are so good that even low expectations will yield big returns. The investor that holds their winners the longest, wins. 

Friend and fund manager Josh Tarasoff recently wrote a brilliant paper on his investment philosophy. He talks about his goal of owning a self-driving portfolio – investing in companies which have a certain set of characteristics that allow you to simply invest for the long-term and not feel pressured to sell them. Producing a self-driving portfolio in microcap is extremely hard.

Microcap businesses are generally small and, in many cases, lower quality and more impressionable because they are small. Our intention with every purchase is to hold for years, but few ultimately earn that right. The select few that do will work their way to the top of the portfolio. 

At IFCM, we own 11 businesses. The top three represent 50%+ of the portfolio. I would characterize these three as the self-driving portion of the portfolio. They have exemplary management teams, businesses, strategies, and opportunities that are so strong we will never sell them because they become “overvalued”. I’m a firm believer your largest positions should be the ones whose management you trust the most – not necessarily the ones you believe to have the most immediate upside. History has proven I’m awful at timing what will move next, so I stopped playing that game. Stocks rarely perform in the time frames we predict, and it’s why the market only works for investors that have more patience than they thought they would ever need. 

===> Interact and learn with 250+ of the best microcap investors on the planet. [Join Us]

MicroCapClub is an exclusive forum for experienced microcap investors focused on microcap companies (sub $500m market cap) trading on United States, Canadian, European, and Australian markets. MicroCapClub was created to be a platform for experienced microcap investors to share and discuss stock ideas. Since 2011, our members have profiled 1000+ microcap companies. Investors can join our community by applying to become a member or subscribing to gain instant view only access. 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. For more information, visit http://microcapclub.com and https://microcapclub.com/summit/

Share
Sign up for more like this.

Get Alerted to our Next Educational Blog Post

Related posts
Turnarounds
Education
Featured

Turnarounds

You make the most money by having a 1–3-year variant view on a business and buying the stock before the business turns up, inflects, or accelerates.

5 min read
The Ultimate Edge in Investing

The Ultimate Edge in Investing

Work every day to make your name, your word, your handshake, your counsel, worth more than the day before. Reputation means influence.

4 min read
You Have Time

You Have Time

Being “first’ to something isn’t as important as being right.

3 min read