Small Stocks are Roller Coasters

The roller coaster has a long and surprising history that stretches back several centuries. Its origins trace to 17th-century Russia, where “Russian Mountains” were popular winter attractions. These early rides were massive wooden slides covered in ice, reaching heights of 70 feet and speeds up to 50 miles per hour. Riders would climb stairs and descend on sleds made of wood or ice. Catherine the Great was reportedly a fan, and even had one built on her estate.

In the early 1800s, the concept spread to France, where it evolved into wheeled carts on tracks. One of the first was the "Les Montagnes Russes à Belleville" in Paris. These rides used guided rails to keep the carts on track—setting the stage for modern roller coaster design.

The roller coaster took a major leap forward in the United States. In 1884, LaMarcus Thompson opened the first successful gravity-powered coaster in Coney Island, New York. Called the “Switchback Railway,” it ran on a wooden track and carried riders at 6 miles per hour. It was a major success and helped spark a golden age of coaster building across America.

I was recently at Hershey Park, and I went on the Comet which is the oldest roller coaster in the park. It was built in 1946 and made of wood. It’s a rather tame roller coaster by today’s standards. 

The Comet starts in a slow ascend up the 96-foot main camelback hill. Anticipation builds as the rollercoaster slowly climbs the hill.  At the top, the rollercoaster feels like it almost stops. Then momentum shifts forward, and you plunge into the descent hitting 55 mph at the bottom and that momentum takes you through the remainder of the 3,300-foot ride.  

Small stocks aren’t smooth train rides through the countryside. The path isn’t carved through the landscape and tunneled through mountains.

Small stocks are old roller coasters. They are fast and violent. They go up and down, and sometimes upside down. You must hold on to your lap bar and anchor yourself to the business, so you don’t get tossed out. 

The best time to buy great microcaps is before discovery.

Get on the ride before the first big hill. When you buy before the initial discovery move it’s just you and few others that are still living in their parent’s basement. The others probably don’t even understand what they own.

The first big discovery move in a microcap is always the easiest. Why? No one owns it to sell it. There is the least amount of friction. Just a few people with low expectations.

The catalyst could be a large contract win or series of small wins, legislation change, competitor leaving the market, or any number of reasons that create a quick 20-100% growth spurt in the business over 2-6 quarters. 

The first breakout quarter is like a siren going off to the thousands of retail and small institutions looking for such things. 

The revenue growth flows through the income statement with relative ease producing operating leverage on the bottom line.

The crowd gets excited. The stock moves up 100-500% in 12 months. The issue with discovery moves is expectations become too high. 

Everyone projects out 50% annual revenue growth and 200% net income growth for the next 10 years. Smart retail buys first, small institutions second, and finally dumb retail pay the highest price at the top. 

The stock trades for perfection. You've reached the height of the discovery move.

What most investors don’t realize is the company is over earning. Management is learning as they go and is late in making the necessary investments to support a larger enterprise.

Then management realizes they are behind the curve. They need more infrastructure and redundancies. C players must be replaced with B or A players. They must spend $3 million on a new Sales Force CRM implementation. 

At the same time growth gets harder.

Last year’s 50% growth turns into this year’s 30%.

200% earnings growth turns into flat earnings YoY due to the increased investment in labor, technology and infrastructure. 

Investors are shocked because they’ve never run a business before. 

Expectations fall. 

The stock/rollercoaster made an elegant and graceful rise over a few quarters and now it plunges 50%+ in a few days.  

This is why selling is necessary and perhaps the most important skill in microcap investing. Those that sell the first wave of discovery are correct for doing so. The base rates are low for management teams proving they are more than a one hit wonder. 

The valuation compresses. 50x forward earnings turns into 15x trailing earnings. Growth investors leave, and value investors start circling the company again.  

The second-best time to buy great microcaps is after the discovery bubble bursts. 

Investor sentiment flips like a light switch from extreme optimism to extreme pessimism. From nothing can go wrong to nothing can go right. From penthouse to outhouse. From high expectations to low expectations. 

The opportunity is doing the independent work and buying when nothing good is priced in. If the business is growing, profitable, and not diluting chances are investors will come back to it.

But now the stock is a known company. It might even have an analyst or two that picked up coverage. 

When a stock goes from $1.00 to $5.00 and back to $2.00, it will take a lot more time, volume, and fundamental progress to surpass $5.00. Unlike the initial discovery move, now you have a bunch of investors with higher cost basis waiting to sell when they get back to breakeven.

The hardest part of buying the rebound is most stocks never surpass their discovery peak. The discovery move was driven by high expectations. It’s a tall task for management because it will likely take 2-3x the earnings to surpass the old highs.

Short-term stock prices are driven by emotion, sentiment, and expectations. 

Long-term stock prices are driven by fundamentals. 

Then of course Morgan Housel brings it together brilliantly,

“The valuation of every company is simply a number from today multiplied by a story about tomorrow.”

Small stocks are roller coasters. Learn how to ride them.

_{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 1200+ 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 https://microcapclub.com/ and https://microcapclub.com/summit/}