Join Now
Education

Beware of Story Stocks

Most story stocks don't have happy endings.

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.

===> 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
We Are All Fighting The Same Battles

We Are All Fighting The Same Battles

A good rule of thumb is to be quieter than you want to be. Don't give people a reason to root against you. It's an asset when people can't tell whether you are winning or losing.

3 min read
Survival

Survival

Survival is the ultimate performance measure of a business.

7 min read