Averaging down is a skill. Done well it can be your greatest asset. Done poorly it can mean disaster.
All Great Companies Started As Small Companies
What truly is a microcap? The common answer would be a small public company with a market capitalization of less than $300 million. But does the label tell us anything about microcap businesses or help us become better microcap investors? No, thinking purely in labels turns us into Oscar Wilde’s definition of a cynic – “A man who knows the price of everything and the value of nothing.”
The term “microcap” has a negative perception or label perpetuated by most financial pundits, regulators, and even investors. Most look at the 11,000+ microcaps in North America and judge them as being sleazy, slimy, and insignificant. This label couldn’t be further from the truth. Many of the best investors ever, including Warren Buffett and Peter Lynch started their careers investing in microcaps. Some of the best performing companies ever, including Berkshire Hathaway, Wal-Mart, Apple, started as small microcap companies. Today, North American microcap companies employ over 2.8 million jobs. More jobs than Google, IBM, Home Depot, Berkshire Hathaway, AT&T, Pfizer, Cisco, Microsoft, Boeing, General Electric, and GM combined. All Great Companies Started As Small Companies, and it’s time people changed their perception of this unloved equity class. Our long-term mission at MicroCapClub is to bring credibility and respect back to the microcap space [Presentation].
Labeling always reminds me of Richard Feynman’s little story about knowing the name of something. In it he described a story growing up as a child, recounted below:
The next day, Monday, we were playing in the fields and this boy said to me, “See that bird standing on the stump over there? What’s the name of it?”
I said, “I haven’t got the slightest idea.”
He said, “It’s a brown-throated thrush. Your father doesn’t teach you much about science.”
I smiled to myself, because my father had already taught me that [the name] doesn’t tell me anything about the bird. He taught me “See that bird? That’s a brown-throated thrush, but in German it’s called a halsenflugel, and in Chinese they call it a chung ling and even if you know all those names for it, you still know nothing about the bird-you only know something about people; what they call that bird.
Small companies are everywhere; they, like birds, have different labels given and used by different people:
Each term conjures different images in our minds. Microcaps, often referred to by the derogatory term “penny stocks”, have a negative stigma even though over 120 microcap companies have gone up 1,000% or more over the last five years. Small businesses have a good perception. They are the mom and pop shops that can be found throughout the U.S. and other countries: the neighborhood plumber, construction company or antique shop. Technology startups, particularly those found in Silicon Valley, have great perceptions mostly due to Peter Thiel, Marc Andreessen, Ben Horowitz, and other famous venture capitalists endorsing the space. When the public thinks of technology startups they think of gutsy founders, opportunity, and unicorns (those that have reached $1 billion valuations). Even though Berkshire Hathaway, Wal-Mart, Netflix, and many other companies started as small microcap companies, we have no well-respected opinion leaders blazing the public opinion path for microcaps. While there are plenty of truths in the public’s perception and the associated stereotypes, taking a wider view uncovers that microcaps, small businesses, and technology startups are all quite similar.
Microcaps, small businesses, and technology startups are all emerging businesses mostly run by founders with an entrepreneurial spirit. Investing in such companies is a bet on the jockey (founder) even more so than the horse (product/service). More than 90% of new businesses fail. The founding entrepreneur and their team (combined with a little luck) are the only things that separate the average, who are likely to fail, from the highly successful.
“A strong team is the most important element of a company’s ability to achieve success.” – Vinod Khosla
As microcap investors, we can learn a lot from successful venture capitalists on how they evaluate founders and management teams. They are looking for intelligent fanatics just like we are. The successful venture capitalist understands the importance of a founder and their team. They spend a great amount of time vetting founders and their teams. Great founders attract top talent, while the B and C founders attract lower quality talent. The idea is to weed out the great entrepreneurs with large long-term visions from the other entrepreneurs with different goals.
Below is a great Q&A session with Marc Andreessen of Andreessen Horowitz and Ron Conway of SV Angel. Ron Conway is an angel investor so he normally invests at an earlier stage than most venture capital firms. In fact many of Andreessen Horowitz’s investments were first invested in by Ron Conway of SV Angel. Ron Conway and SV Angel have invested in over 750 companies over the last twenty years. Conway mentions they have invested in 1 out of every 30 companies-founders they interview which means they’ve looked at 20,000+ businesses and founders.
Here are the following types of entrepreneurs (some borrowed from Steve Blank):
Microcap investors, who want outsized long-term returns, should understand that lifestyle and small business entrepreneurs are abundant and aren’t the best partners to achieve large long-term returns. These entrepreneurs, even while owning significant pieces of their business, are just as happy collecting their $250K salary while not upsetting the apple cart too much. Investors should focus mainly on partnering with the intelligent fanatic entrepreneur and holding on as the they, and their highly talented team, execute on a scalable, repeatable business model. The returns possible under such partnership is where true wealth is created.
Ian Cassel and I are working on the Intelligent Fanatics Project (www.intelligentfanatics.com) that outlines the similar qualities, cultures and strategies that intelligent fanatics possess to enable scalable, repeatable business execution over the long-term. I’ll use a short example of a company that has gone from nothing to mega billion corporation under its founder.
Intelligent fanatic Larry Ellison bootstrapped a $2,000 investment in Software Development Laboratories in 1976 and turned it into the $160 billion Oracle that we know today. Larry Ellison generated significant shareholder value creation over his tenure of roughly 25% compounded annually since Oracle became public.
Oracle was slightly larger than a microcap, $500 million valuation in today’s dollars, when they had their initial public offering in 1986. This same year the company had $55 million in revenues which quickly ballooned to $584 million by 1989. Larry Ellison continued to sustain enormous business growth and execution right up until he stepped down as CEO in 2014.
In 1981, Kathryn Gould was Oracle employee #10, and she would later become a successful venture capital investor. She believed, as do many others, that Larry Ellison possessed potent leadership skills and characteristics that made him a winner. Ellison was the yardstick that Gould would use to evaluate every other founder she came across. The full write up can be found [HERE], but Kathryn Gould’s DNA of a great leader is summarized below:
It’s time many investors change their perception of the microcap space. There have been many great companies that have come out of the public microcap arena. Microcaps are small businesses led by entrepreneurs with different motivations. Similar to venture capital investors, microcap investors should put significant thought and due diligence into which entrepreneur they partner alongside. Steer clear of the lifestyle and small business entrepreneurs and focus on the intelligent fanatics who have the vision, leadership skills and characteristics to build a scalable, repeatable business model. Intelligent fanatics do not come around often but when they do, they are observable running smaller enterprises. If you work hard, you’ll be lucky enough to find a few of them over your lifetime, and then the goal will be to develop the conviction to hold them to reap the rewards.
I’ll leave on this quote from Phillip Fisher:
“Those companies which decade by decade have consistently shown spectacular growth might be divided into two groups. For lack of better terms I will call one group those that happen to be both ‘fortunate and able’ and the other group those that are ‘fortunate because they are able.’ No company grows for a long period of years just because they are lucky. It must have and continue to keep a high order of business skill.”
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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.