Good Business Great Stock
If you find a well-run cash generative micro/smallcap, share this article with the management team. Subject: Just Do This!
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:
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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If you find a well-run cash generative micro/smallcap, share this article with the management team. Subject: Just Do This!
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