Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Only an exceptional leader can successfully lead a company from hustle to scale.
“It’s quite interesting to think about Wal-Mart starting from a single store in Bentonville, Arkansas against Sears, Roebuck with its name, reputation, and all of its billions. How does a guy in Bentonville, Arkansas with no money blow right by Sears, Roebuck? And he does it in his own lifetime—in fact, during his own late lifetime because he was already pretty old by the time he started out with one little store….”– Charlie Munger
I love the story of Sam Walton and Wal-Mart. In 1962, at the age of 44, Sam Walton started with 1 store. In just 30 years, Wal-Mart became the #1 retailer in the United States. At the time of his death in 1992, there were 1,735 Wal-Marts, 380,000 employees and annual sales approaching $50 billion. The fact this was all accomplished in the second half of Sam Walton’s life is staggering. This wasn’t a present-day tech company that could scale effortlessly. Walton had huge tangible and logistical challenges. He was CEO up until 1988, and Chairman until his death. He was in charge. Only an exceptional leader can successfully lead a company from hustle to scale.
All great companies started as small companies. The smaller the company the more important the CEO, founder, management becomes. The smaller the company the more hats the founder is forced to wear which amplifies his or her impact on the business. Bad decisions can destroy a small company. Great decisions have a compounding effect on a small company. If you don’t believe that founders and management are important to small companies like microcaps, just wait a little longer. You will.
The MOAT of any small business is the management.
Hustles – 0 to $50 million market cap
Every small company starts the same way. The founder/co-founders do everything. They are the CEO, Bookkeeper, VP Sales, Garbage Man, Human Resources, company contact person, etc. They do everything because they have limited resources. They do everything so the work is done to their standards. They do everything so they have control. Some get used to doing everything.
Brent Beshore defines them as “hustles”. If they are at the right place at the right time, hustles can go from zero to $20 million in annual revenues with just a few capable people. But the hustle it takes to start and initially grow a business isn’t always the same skillset to scale a business. The road from 0 to $20 million in revenues is oftentimes different from $20 million to $100 million. The hustling CEO might be the floor to the business, but they also might be the ceiling. All of those hats the CEO gets used to wearing – They need to eventually pass those hats to talented people.
Microcaps are public companies with market caps less than $500 million. But there is a huge difference between a $10 million market cap and a $200 million market cap business. A $10 million market cap is a hustle. A $200 million market cap is normally a larger more robust businesses that have proven they can scale.
In my early investing career, I made a lot of money investing in $15 million market cap companies growing into a $50 million market cap companies. The beauty of hustles is it doesn’t take much fundamental progress to make this 200% move. If management can get to sustained profitability, the stock will likely make that move. In fact, it might only take a narrative or sentiment shift to the story. Most hustles can’t scale past $50 million market cap. You buy a $15 million market cap knowing they are a bit like cigar butts in that you are betting on one or two easy puffs of growth before a big question needs to be answered.
Is this the CEO, founder, management that can transition from hustle to scale? Is this company that has gone from $15 million to $50 million market cap now capable of growing to $200 million market cap?
Scale – Growing from $50 million to $200+ million market cap
A mentor once told me – “For a stock to double, other investors need to think it can triple.” For a $50 million market cap to go to $100 million market cap, most investors in the stock need to think it can go to $150 million market cap. The move from $50 million to $150 million or $200 million market cap takes serious fundamental drivers and deliberate execution.
Fundamentally speaking for a microcap to go from $50 million to $200 million market cap you are looking for a management team and business that can grow earnings from $1-3 million to $10-15 million. This isn’t easy. Few microcaps can cross this chasm.
In Lightening in a Bottle, I talk about the characteristics of companies that can cross the chasm from $50 million to $200 million market cap very quickly. They prove out that the business can scale profitably and sustainably.
How do you find these management teams, these intelligent fanatics, that can make the transition from hustle to scale? What visible qualities and characteristics do they possess? How do you find them early?
Past success isn’t invisible. Invest in management teams that deserve to be running much larger companies.
Once or twice per year my “Spidey sense” is triggered. An accomplished management team takes over a small obscure microcap company. They provide a cash infusion and implement a new strategy. When you dig into the management team, they have all “done it before” in their bios. They are Winners. What does this mean? It doesn’t mean they have Fortune 500 C-Suite experience. It means they have successfully founded, built, scaled, and sold other businesses. They look like a management team and board that could run a business 50x the current size.
I love to invest with repeat winners. Their past successes has allowed them to form key relationships in business, industry, politics, banking ie funding sources, which increases their chances of success. Their past successes allow them to move quicker the next time. Key stakeholders, core investors, partners, already trust them. Repeat winners already know the right accounting software, CRM software, HR processes, marketing systems, incentive systems to implement. The know how to form win-win partnerships, structure contracts, and get things done the right way. They’ve already made the dumb mistakes. They know how to scale.
These types of management teams also surprise you with products and partnerships that prove they are already thinking 3-steps ahead. As microcap investors we are often so short-term minded wondering if the company can grow 30% this quarter, when great management are busy laying the foundation so they can grow 20% per year five years from now.
When I find this setup, it forces me to clear the calendar and dig in. It’s a race to find out the truth before someone else finds it. I try to get on a plane to meet them as soon as possible. Why? This type of management team isn’t going to tell you the plan over the phone or zoom. They aren’t talkers. They are doers. They don’t need your money. They are funding the company themselves. These quality individuals rarely pander to Wall Street – there isn’t a need for it. The only thing they respect are investors making the effort to truly understand them.
Michael Liu and I recently traveled to meet with a sub $20 million market cap company that had this type of setup. We immediately got on a plane and met them. We met with the largest investor, the patriarch, who’s provided the funding and vision. We met with the CEO and team. We met with the controller who used to run a $500 million revenue company. The public company utilizes talent, office space, and resources that is expensed to the family office. This is what winners do – focused on making the business a success is more important than expensing $20k per month to the public company. We met with them all day. We didn’t take notes. Taking notes while someone is talking isn’t how you build a relationship. We just asked questions and listened.
If you can find this setup it increases the chances of success from 20% to 70%. It’s like getting dealt an Ace / King or Ace / Queen in poker. You can still lose but the odds move heavily in your favor. To find great companies early, you need to find great leaders early. Winning isn’t invisible.
When you think about the big winners you’ve held – you rarely had to make excuses for them. Why? They executed. The fundamentals, the numbers, proved out management’s vision and strategy. Great management teams lead and build trust with execution and transparency.
The great thing about microcap investing is you can make a lot of money on small companies that can become larger small companies. You don’t need to find the next Google. All you must do is find is a great management team that can take a business from 0 to $10+ million in earnings. These are 5-10+ Baggers. Is this easy to find? No. Is this easy to do? No. But it isn’t impossible either.
All great companies started as small companies. Let’s find them.
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Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
Nicolai Tangen is the CEO of Norges Bank Investment Management, Norway's $1.4 trillion sovereign wealth fund.
Dilution is the subtle erosion of ownership. This hidden, persistent addition of new supply of shares leaves shareholders with less and less of the company’s value. Dilution, like inflation, is a silent killer of returns.