Being “first’ to something isn’t as important as being right.
In this article I lay out the major pitfalls that I have found so that you don't have to fall into them.
I’ve written much about what I look for in a microcap investment such as profitability, sustainable growth, and compelling valuation in the My Secret Recipe series of articles which include: The Index Card, Shopping and a Taste Test, Inspecting the Ingredients, and The Bargain Rack. However, I haven’t written much about what I don’t want in an investment. These pitfalls are attributes that may lead to a bad investment. In this article I lay out the major pitfalls that I have found so that you don’t have to fall into them. I’m assuming in this article that the company generally meets my criteria so you don’t have to read through attributes that you already know I avoid such as unprofitable businesses, no growth, etc.
While this guide can be helpful, it is only outlines some of the pitfalls I try to avoid. I’m sure I’m forgetting at least a few of these pitfalls. Also, when investing in microcaps you will find that most companies have some aspects of at least one of these. These negatives need to be evaluated in the context of all the attributes of a company to determine if the positives outweigh the negatives.
Poor Share Structure
Some companies have very poor share structures. The worst kind is usually when you have convertible debt which converts at a discount to the market for the stock. That can create what is known as a death spiral. Let me explain how this works. First, the holder converts some of the debt at a discount to market prices and sells it at a profit. The selling puts pressure on the stock price causing it to drop. Next, the holder converts more of the debt at a discount to the now lower stock price and in turn sells it at a profit. The cycle continues until the debt holder converts and sells all of the debt. A big problem with this arrangement is that each time the debt holder converts, he or she gets more shares for the dollar because the stock price drops. What can happen in this situation is that a company with a decent share structure can see their share quantity balloon. Convertible preferred stock can also be structured with a death spiral. I will never invest in a company with death spiral financing because it is a quick way to see your investment dollars fall into the abyss.
Just because a company doesn’t have death spiral financing doesn’t mean they have a good share structure. I always investigate the total diluted share count for each company. In addition to the outstanding common shares, one needs to examine any preferred stock (especially convertible), convertible debt, options, and warrants. With that information you have a view into what the total share count might look like in the future and can factor that into your analysis. For example, if the share count is going to double over time, the future per share earnings potential might not look as good as it seems on first glance. I also look at the company’s history of share issuance. If don’t like it when a company has a history of handing out options like candy. I much prefer a company that treats their shares like gold.
Further commentary on share structure can be found in The Importance of Share Structure.
Weak Balance Sheet
The first thing I look at on a balance sheet is the tangible book value per share. When it is negative I have to be careful. Let’s say you have a company that has a stock price of $1/share and is expected to earn $0.12/share in the next year. If the tangible book value is slightly negative, let’s say -$0.02/share, that is a cause for caution. When it is say -$1/share, that is usually a cause for great concern.
A negative tangible book value isn’t the only thing to cause caution on a balance sheet. Debt coming due soon can be a cause for concern especially if it will be difficult to refinance that debt. If a company cannot renew their debt or otherwise pay it off, there usually are some pretty negative consequences. I like to examine a company’s debt to see how big it is, the interest rate on the debt, and when the debt comes due?
Along with debt, one also needs to look at a company’s cash position. If they don’t have enough cash to operate and don’t have access to debt (e.g. a line of credit), they may have to raise money which will mean dilution of your holdings. Usually when a company raises money by selling stock it is below market prices for the stock which will cause a drop in the stock price. I much prefer to avoid companies that need financing. A MicroCap Investors Worst Enemy is Dilution is a good article which delves into a company’s future need for capital.
There is much more to analyzing a balance sheet than I have said here. Some poor balance sheets can be OK where as others are not. It is an art you have to learn.
Poor Quality of Earnings
Sometimes companies have great earnings but they are of poor quality. For example, maybe they have significant revenue but they can’t collect their bills fast enough. This will show up in a metric called DSO or Days Sales Outstanding. When I analyze a company I usually ignore the nuance of credit sales versus overall sales and just use overall sales as credit sales levels are rarely disclosed. I have found that when the DSO calculation gets above 90 days you need to look very carefully. Repeated numbers that high can indicate that the customers are of poor credit quality. I usually calculate DSO on a quarterly basis.
Sometimes recent earnings are not sustainable which also falls into poor quality of earnings. For example, maybe there was a factor that temporarily increased gross margin. Maybe there was some sort of one time gain that boosted earnings such as winning a lawsuit. Maybe the company is just about to start paying taxes whereas they haven’t in the past. Perhaps there was a large piece of revenue that came in that isn’t repeatable. Earnings could grow dramatically when the large order is fulfilled, but then sink afterwords.
Customer concentration can also fall into this category. For example, if ACME Widget is receiving 80% of their revenue from one customer, there is a huge problem if that customer goes away. Customer concentration doesn’t necessarily scare me away but it often will reduce the size of the position I’m willing to take on.
The main way to investigate the quality of earnings is to read the footnotes in filings and the details in PRs. What one has to do is to factor the quality of earnings into the valuation model for the company. Just because some earnings are not repeatable doesn’t mean the company is a bad investment. It is just a part of the entire analysis that one has to do.
Low Gross Margins
I don’t like low gross margin (GM) businesses because one small mistake or problem can often turn a profitable business into an unprofitable business. Those problems can come in a variety of ways. Some examples include increasing input costs, pricing pressure from competitors, and loss of scale from decreased revenue.
While it is hard to be precise, I’ve said before that a high GM business is one with a GM greater than 50% and a very low GM business is one that is less that 20%. Also, one thing to consider is that sometimes businesses can grow their GM as they increase scale. Thus, the current GM isn’t always indicative of what to expect going forward.
Lack of Moat
Companies lacking a moat can be a problem because they can rapidly go from producing good results to bad results as it is difficult for them to differentiate. Mostly all they can do to compete is to be a low cost producer or provide greater service. A background article on moats is The Vision To See Economic Moats.
A good shortcut for knowing if a company is in a commodity business and thus has little to no moat is if they have low gross margins. Highly differentiated businesses usually have high gross margins although that isn’t always the case.
There are three general categories for these companies that I will address including commodities, commodity product, and intellectual property risk.
I usually avoid companies in the commodity space or companies that service this space. I’m talking about companies in the oil, gas, and minerals businesses. To win in this space you have to be right about the commodity price and the business. I find that it is hard enough to be right about the business that I don’t need to add commodity price risk. In a pure commodity business, even being a low cost producer is no guarantee of profitability as we have seen recently in the oil industry. There are times where I will go out on a limb and invest in a company in the commodity space but they are becoming increasingly rare. There are people that specialize in this space that are very good but it isn’t for me.
There are companies that have products or services that are commodities. Here I’m not talking about oil and gas per se, but products that really aren’t differentiated. For example, imagine a company that sells construction nails or a company that sells cheese. Unless they have a special type of nail or a special flavor of cheese, they are unlikely to be able to have any kind of pricing power. Services sometimes fall into this category too. However, services often can be very sticky which means that there is some level of pain involved in the customer switching to another provider.
Intellectual Property Risk
Intellectual property risk is probably most drastic in pharmaceutical patents although it does come up elsewhere. A company with a great product that is about to come off patent can suddenly be up against a slew of competitors. Also, sometimes you see a company that has a great product but hasn’t done anything to protect it. Perhaps the idea isn’t patentable. Sometimes, the best way to protect a product is with trade secrets.
There can also be risks that a company is violating a competitor’s present or future patent. This is often hard to investigate but it is something to watch especially when there are similar products in the market.
A great product that isn’t protected will find itself up against competition eventually. In microcaps sometimes this is OK because it is such a niche market. However, any product of even moderate scale will soon find a competitor and that can be very damaging to margins.
Excessive Management Compensation/Lack of Alignment with Shareholders
Let’s go back to ACME Widget. Let’s say that they have annual revenue of $3M and have $300K of net income. However, the CEO has a salary of $750K and has a history of granting himself significant blocks of options. Furthermore, this CEO has never purchased shares on the open market and only owns shares that he acquired through option grants. This CEO is not someone that is likely to have shareholders’ interest in mind and appears to be treating the company as a piggy bank. I much prefer to have a CEO that owns a lot of stock and pays himself a reasonable salary of say $175K or less. A CEO that makes money when the stock goes up is more likely to focus on doing the right things and is more likely to treat shareholders fairly. For a more detailed analysis of this pitfall I suggest reading this article.
Overly Promotional Management
One of the job’s of management of a public company is to maximize the value of the stock. I’m a firm believer that the first step in that process is to produce good results. While management should be a cheerleader for the company, sometimes there are management teams where it appears they think that is their first job. If I see outlandish projections, that usually is a sign that management isn’t focusing on job one (results) and often is more focused on selling stock. If the story that management is telling sounds too good to be true, it often is. Beware of Story Stocks is a good article to read on the subject.
When you hear a story that sounds outlandish, one thing I like to do is to check past management projections. If they have a history of making their projections I’ll find them much more credible than if they miss their projections. Again, I don’t mind management telling the story because that is part of their job. It is just that if they become too promotional, that is a sign to be careful. The worst situation is when you uncover a company that is part of a pump and dump.
Business Models with Major Uncontrollable Risks
There are some businesses that have some major risk that they can’t control that just scares me away. For example, maybe the business is a pawn shop business and the government is looking to increase regulation. Sometimes businesses like this are a value trap. They look highly profitable but with one quick change their profitability decreases. Another major risk can be an industry that is declining in size. I’d rather swim with the current on a growing industry than swim against the current with a shrinking industry.
Cyclic industries also fall into this category. Some industries go through major boom/bust cycles. I will certainly invest in cyclic industries but I much prefer if the industry isn’t cyclic.
I find that reading the risk section in annual filings (see Risk Factors in the 10-K for US companies) is a good place to read to check for major risks like this that you might not see on the surface.
Proper due diligence requires that you examine both the positives and the negatives about a company. This document provides a framework to look for some of the negative items. Next time you are looking at a new investment, be sure to check the company against these pitfalls. Also, please share any other pitfalls you would like to add to this list by posting a comment below.
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