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Small Stocks: Should Value Investors Only Buy Microcap Stocks? - 4 Stocks People Ignore: BCIS, SODI, BDMS, RSKIA

October 06, 2010 | About:
Geoff Gannon

Geoff Gannon

409 followers
Greg Speicher has posted twice now on a great discussion over at the Corner of Berkshire and Fairfax message board.

Question: Should value investors stick to small cap stocks when investing their own money?

My Answer: Every value investor should try small cap stocks. Most don’t.

I get a lot of emails saying something like this:

I’m getting out of college this year and I just recently got interested in value investing by reading Warren Buffett and Benjamin Graham – what should I do?

I give a lot of responses like this:

You should focus on the smallest stocks out there. Nobody else is. You’ll have to do real work every day. You’ll only be able to work with primary sources: the 10-Ks and 10-Qs. You’ll learn more working with small cap stocks. And you’ll have to decide for yourself. Benjamin Graham’s Mr. Market metaphor is obvious in tiny stocks. In big stocks: even value investors get lazy and listen to the market instead of taking advantage of it.

Microcaps are the best place to learn investing. But are they the only place to make money?

No.

You can make money buying stocks people hate or you can make money buying stocks people ignore.

Here are 4 microcap stocks people ignore – and the reason why:

  1. Bancinsurance (BCIS): Unusual Combined Ratio
  2. Solitron Devices (SODI): Past Bankruptcy; Can’t Pay Dividend
  3. Birner Dental (BDMS): Cash Earnings Not Reported as Income
  4. George Risk (RSKIA): Combines Investments With a Business
Here’s where I agree with some folks who say microcap investing is harder today than it was when Buffett started. It is harder. There are mechanical screens. Most of the good bargains you find depend on something you can’t screen for.

A microcap bargain is often the result of an accounting quirk or a one of a kind business.

If Bancinsurance had a combined ratio of 100, it might’ve been worth 2/3 of book value. Lots of insurers write at a combined ratio of 100. And lots of insurers trade below book. But Bancinsurance had a very long history – 29 years - of writing at very low combined ratios. If Bancinsurance was a big cap stock, everyone would know that. Nobody thinks Progressive (PGR) is worth book value. Everybody knows a dollar of Torchmark (TMK) book value is worth at least as much as a dollar of MetLife (MET) book value, because everybody knows MetLife – blimps and all – can’t write at a lower combined ratio than Torchmark.

Since Bancinsurance was a microcap – delisted in fact – it’s incredible underwriting history was ignored. Even after the CEO offered $6 a share, I could get some shares at $6 and under. Try doing that in Torchmark or Progressive. In years that don’t end in ’29 and ’08 – it just doesn’t happen.

Let’s look at the 4 examples of microcap bargains I threw out off the top of my head. There’s a madness to the market's method in each case. Basically: the market is getting each of these stocks half right.

Solitron has a weird bankruptcy in its past. It can’t pay a dividend – yet. Buying stocks like Solitron was a favorite tactic of both Warren Buffett and Benjamin Graham. Buffett says – in one of his partnership letters – that a bank he was buying in a big way couldn’t pay a dividend despite strong earnings. And Graham was sure Northern Pipeline was being valued by its dividend alone. People ignore cash that can’t be paid out when the cash is in a microcap stock. If Solitron was a big cap stock, everybody would know the exact date Solitron could start paying that cash out.

I’ve mentioned Birner Dental before. Because corporations can’t own dentist offices, Birner acquires dentist office management contracts instead of the offices themselves. Birner amortizes the acquisition over 25 years. This hides a ton of cash earnings for a long time. Investors in big cap stocks read analyst reports that tell them about big differences between the cash flow statement and the income statement. Investors in microcaps have to look at the statements themselves. They don’t.

George Risk is the simplest explanation of all. The market sometimes values the stock right as an investment portfolio and sometimes values the stock right as an operating business. But it almost never values it right as both.

Why not?

There are no analysts – though there are a few bloggers – writing sum of the parts analysis on George Risk. If George Risk was a big cap stock everyone would know exactly how much cash it had. Think about Microsoft (MSFT) and Apple (AAPL). Proportionally, they don’t have more surplus cash than George Risk. But no analyst is going to tell you that. You have to read the SEC reports yourself.

George Risk has a huge number of small shareholders. On average: they own a little over 1,000 shares. Most big companies have fewer shareholders of record than George Risk. The shares are ridiculously spread out. You’ve got a strange group of people trading that stock. And they don’t trade it often. In that case: it's easy to see what Benjamin Graham meant by Mr. Market.

Are all 4 of these stocks winners?

No.

Bancinsurance was a clear winner at $6 a share. It isn’t at $8.50. The board wants to sell it to the CEO at that price. He’s lucky. A big cap stock’s shareholders would reject $8.50.

So – yes – sometimes even buyout prices are too low for small cap stocks. Sometimes the ignorance discount never goes completely away – but getting 90% of fair value is enough to make big bucks when the stock is sometimes priced at 50% off.

Warren Buffett and Benjamin Graham were security analysts first. The place to do security analysis is in microcaps.That's why microcaps are the best place to learn value investing.

One huge warning: I’ve noticed - over the years - that most value investors think differently about big caps and microcaps. They choose their big cap stocks as investments and their small cap stocks as speculations. Don’t do that. It's a self-fulfilling prophecy.

There are so many times more small stocks than big stocks that it’s plenty easy to find quality small cap stocks as long as you’re willing to sift through 10 or 100 times as many candidates. That’s all it takes. Work.

Searching for microcaps is like doing research. Everybody assumes the best work in the field is the paper people already cite the most. Maybe. But you can’t know that until you dig through the archives and read stuff that’s 90% garbage.

Usually you find something just as good that nobody’s heard of.

Talk to Geoff about Microcap Stocks

About the author:

Geoff Gannon
Geoff Gannon


Rating: 4.6/5 (12 votes)

Comments

Sivaram
Sivaram - 3 years ago


How about poor corporate governance? Based on your experience, would you say it's hard to price the risk of poor corporate governance?
Geoff Gannon
Geoff Gannon - 3 years ago
Sivaram,

Great question. Yes. It's very hard to price the risk of poor corporate governance. But in my experience: people also generalize way too much about big caps having good corporate governance and microcaps having bad corporate governance. Big caps get more attention from outsiders. But they can still have bad corporate governance. In general: the issue is just that fewer people are paying attention and looking out for you in microcaps. You aren't going to have analysts, reporters, fund managers, and activists - until things get really ugly - looking out for you and saying bad things about management in microcaps. You will have that in big caps that do wrong by investors.

One huge warning: There are microcap frauds. I would say - and this is just my own experience talking - they tend to be in more speculative and young companies rather than purely small companies. A lot of small companies are also young so people get the two confused. Old microcaps are often like old big caps and young microcaps are often like young big caps.

So a microcap that is an old, family controlled company with tons of retained earnings in some mundane business is often just that. If it's hoarding cash or something - It's usually doing it for reasons no different than a big cap company that does that. It usually means management has few options in the existing business and doesn't know much about putting money to work elsewhere.

I would read the SEC reports carefully. Some people come to different conclusions. So for me all the George Risk related party transactions - and there are a ton of them - aren't real nefarious, because if you look at the actual dollar amounts they aren't real generous. The family doesn't pay themselves as much as it could get away with, it doesn't pay the board at all, and the other transactions aren't egregiously favorable. Then look at a bigger stock I'm in - Barnes & Noble (BKS). The Riggio related party transactions are egregious. Len's brother stayed on as Vice Chairman even after they got a new CEO. The interest rate Riggio got on the college booksellers deal is high. There are lots of examples.

So it depends. Corporate governance is a huge issue. But investors tend to think being naive is a worse crime than passing up an opportunity because you assume the worst in people. There is good and bad corporate governance at all market cap levels. It usually depends on the history of the culture, the way the company was and is controlled, and the ethics of the people involved. Not just size.

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