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How Warren Buffett Thinks About Micro Cap Stocks

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Geoff Gannon
Jan 15, 2011
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The key to understanding why a stock picker like Warren Buffett made his best returns when he was investing in micro caps is understanding that a neglected stock is more likely to offer a mispriced bet.

The idea that there’s a trade-off between risk and return only makes sense if people are paying attention to a stock and correctly pricing it. In other words, the more people are correctly handicapping the situation, the more there is a trade-off between risk and return. The less people are correctly handicapping the situation, the less there is a trade-off between risk and return. This trade-off is not inherent to the situation itself. A fast horse and a slow horse – a good company and a bad company – only become equal in risk adjusted terms when the necessary and correct bets are placed to move the odds to the point that equalizes the expected payoff.

The trade-off between risk and return comes from price. And the price comes from the betting public placing their bets correctly so that favorites pay less and long shots pay more. If the public bets wrong, there is no trade-off between risk and return.

As Ben Graham said:

“…the influence of what we call analytical factors over the market price is both partial and indirect – partial, because it frequently competes with purely speculative factors which influence the price in the opposite direction; and indirect, because it acts through the intermediary of people’s sentiments and decisions.”

In other words, objectively observed prices are the outputs of subjective analysis. Obviously, both the inputs and the black box – the human minds – into which the data is being input will together determine the market price.

People set prices using their minds.

And here’s the thing about minds. They work from experience. And they only experience what they pay attention to.

Here’s William James:

“…one sees how false a notion of experience that is which would make it tantamount to the mere presence to the senses of an outward order. Millions of items of the outward order are present to my senses which never properly enter into my experience. Why? Because they have nointerestfor me.My experience is what I agree to attend to. Only those items which Inoticeshape my mind - without selective interest, experience is an utter chaos.”

So prices depend on attention.

The mere presence of data means nothing. People have to read 10-Ks. And they have to care about them. If nobody pays attention to a 10-K, that 10-K doesn’t enter into a stock price. Because the data in a 10-K only moves stock prices through people’s minds.

If you want to think about it like advertising you can. Some stocks are advertised by analysts and newspaper reporters and their own well-known consumer brands and products. Other stocks are unknown because they’re headquartered in the wrong state or wrong country, because they make stuff you’ve never heard of, and because you just aren’t paying attention to them.

Of course, even advertising is useless unless you pay attention to it. A lot of ads are forgotten immediately. And very few ads accomplish anything when shown just once. You might only pay attention to an ad the fifth time it crosses your path. Same thing with stocks. Unless you’re looking for them. Which works for ads too. If you can put an ad in front of someone who’s actively looking for that product, that ad has a good chance of being really effective. Most investors aren’t looking for micro cap stocks. So, it’s really hard to “advertise” micro caps and actually get someone’s attention.

Information about micro cap stocks just doesn’t percolate through the public quite the same way it does in big caps.

The best returns for Warren Buffett, Ben Graham – and yes – even me, come from investments where the public is not paying attention to the stock. It’s neglected. It’s under advertised. Information is being ignored. Maybe the stock is weirdly distributed by happenstance – as in a spin-off or a regionally owned stock.

Who knows?

What I do know is that the amount of attention a stock gets is going to skew who’s handicapping it.

With neglected stocks, most of the people setting the odds – through their bids and asks – are amateurs instead of professionals.

It’s easier to compete against grannies than hedgies.

So, instead of a correct trade-off between risk and return and fairly equal results for buyers and sellers – you end up with professionals, insiders, and people who spend hours hunting for these things winning a lot of money at the expense of amateurs who often know little and care little about the shares they’re selling.

I owned shares in a profitable company that continually bought back stock from its own shareholders at a price less than its net cash per share. There is no equality of risk and return in that situation. There is just the inequality of uninformed and unmotivated amateur investors losing more and more money in round after round of bad bets made against the company, insiders, professionals, and bargain hunters who read SEC reports.

In many cases, the sellers do not actually believe they are selling out at a fair price. They are not rational. They are demoralized.

Since I blog about micro caps, I’ve actually had the pleasure of talking to folks who I realized – after the fact – were on the other side of trades I made. We realized one of us was buying and the other selling during the same week. Essentially, we were sitting around the same poker table, or betting the same race, or whatever gambling analogy you want to use.

Where I was a buyer and they were a seller of a micro cap, I’ve never had the other guy tell me he thought he was getting fair value. I’ve never had someone tell me they thought the rest of the stock market was cheaper than what they sold.

Here’s Warren Buffett :

“In ‘74 you could have bought the Washington Post when the whole company was valued at $80 million. Now at that time the company was debt free, it owned the Washington Post newspaper, it owned Newsweek, it owned the CBS stations in Washington D.C. and Jacksonville, Florida, the ABC station in Miami, the CBS station in Hartford/New Haven, a half interest in 800,000 acres of timberland in Canada, plus a 200,000-ton-a-year mill up there, a third of the International Herald Tribune, and probably some other things I forgot. If you asked any one of thousands of investment analysts or media specialists about how much those properties were worth, they would have said, if they added them up, they would have come up with $400, $500, $600 million….That is not a complicated story. We bought in 1974, from not more than 10 sellers, what was then 9% of the Washington Post Company, based on that valuation. And they were people like Scudder Stevens, and bank trust departments. And if you asked any of the people selling us the stock what the business was worth, they would have come up with an answer of $400 million.”

Buffett’s point is that people could appraise the company correctly. They just couldn’t think clearly about the stock. The stock price was set by all these crazy fears swirling around their heads. Intellectually, they knew the collection of properties the Washington Post owned could be sold for close to $400 million. But emotionally they didn’t want to hold the stock when it priced the company at just $80 million.

I see the same thing when people sell micro caps they know are good values. The seller never quite says the stock is overvalued. Or even fairly valued.

What they almost always say is how disgusted they are with the stock. How beaten down and mistreated and just kind of vaguely hopeless they’ve become.

They know the stock is cheap, but they don’t see a way out. They can’t visualize success.

I think this success visualization thing is actually a big part of why some neglected stocks offer such good returns. I don’t want to delve into people’s brains and dredge up some wild theories, but I can’t help but notice that most investors are obsessed with visualizing the exact scenario under which they win.

That’s whacky.

I’ve said before that about 1 in 5 of the stocks I buy ends up getting taken private or bought up by another company. Usually, I don’t plan this outcome ahead of time. I have done it a few times, and my record of buying into situations where a buyout seems likely is pretty mixed. Just buying stocks that are so cheap the buyout would happen at a 50% or 100% premium – that tends to work best whether or not the buyout ever comes.

People really do try to visualize success. They want to know the exact winning scenario.

It doesn’t work that way.

Whenever I’m tempted to visualize my success, I try to snap out of the daydream. I can’t control outcomes. I can only control process.

Visualizing success is a mental crutch. It biases you to seek out situations where the exit is clear instead of situations where the difference between value and price is greatest.

Visualizing owning the stock makes more sense. How will I feel when it’s down 20% next month. Will I buy more? What if they stop buying back stock? What if they suddenly dip into the red for a quarter, a year, or 3 years? What if they go cash flow negative? What if they actually issue more shares?

I visualize the things that I know will scare me the most. I try to avoid stocks where this bad stuff will happen. Not just because I think these are bad, bad things –but because I know I’m a wimp when it comes to these particular reversals.

I want to make sure I’m willing to hold a stock forever if need be.

I’ve tried to condition myself to work in a very specific way. I’ve tried to not focus on visualizing possible outcomes or thinking about catalysts and stuff like that. I have done that at times in stocks like Barnes & Noble (BKS, Financial) and look how well that worked out.

Instead I try to only think about owning the stock. I never think about my next move after that. I don’t have a game plan. I don’t have a strategy.

I have a principle. The principle is to always be in the best position. Always own the cheapest, highest quality businesses you can. If you can improve your position by selling one and buying another, do it.

But don’t think you’ve got the future figured out. Because I know I never do.

I’ve taken this approach to an absurd extreme lately.

I now appraise all my stocks apart from their current market value and prepare an actual account summary in non-market terms. Instead of just looking at the daily updated portfolio in terms of the market quote, I also list the net current assets and the 10-year average free cash flow for each stock and then multiply that by the number of shares I own of each stock and total it all up.

Sometimes it helps to see just how much cash, receivables, and inventory I own.

And how big a stream of look through free cash flow my portfolio should produce in a “normal” year.

It sounds silly. And it is. But we have to play these silly head games – or at least I do – or I might end up misthinking a stock in such a way that I do something stupid.

I take thinking about my own thinking very seriously. And I take micro caps very seriously.

Most investors don’t.

It’s understandable that professionals ignore micro caps. They can’t put enough money to work there. But why do individual investors seem to buy and sell micro caps so glibly?

I don’t know.

I know from talking to some folks that the lack of press and analyst coverage is part of it. Often the same negatives like related party transactions, takeover defenses, and cash hoarding that occurs in lots of companies both big and small suddenly makes them very worried when it’s a micro cap. When analysts or the press write about these issues, they become less scary. I guess it’s fear of the unknown.

Actually, I don’t think so.

I’ve come to believe it’s just the lack of confirmation. When I write about a micro cap stock someone owns, they feel differently – better somehow – than when they find the micro cap themselves and never hear its name mentioned by another soul.

None of us like to feel alone. We start to question our sanity.

Personally, I’ve started to lean a bit the other way. When I read another value blogger – even one I respect tremendously – write about a micro cap I own, I start to question whether maybe we’re both fooling ourselves. I know how strong the urge is to welcome a familiar face to our little neglected stock owners support group. You have to find a way to offset that. A stock can’t rationally be any more attractive just because a blogger I like is buying it.

But emotionally it feels that way.

I think that’s the trade-off in neglected stocks. It’s not a trade-off between risk and return. It’s a trade-off between mental comfort and discomfort. Most people don’t feel good owning neglected stocks. They don’t feel comfortable.

When you’re alone in a room trying to think something through there’s often this mental tension, like your brain is going to snap, and the tendency is to quickly choose something – anything – just to make the tension go away.

Experts, analysts, friends, reporters – maybe even a simple product review – give us a convenient excuse to break that tension. We go: “Oh, good, they love the Nook. Now I can buy Barnes & Noble.”

With a neglected stock, there’s nothing outside your own mind that you can use to break the mental tension. You’re the only person reading about it. It’s just you and EDGAR. Your doubts can only be cleared up by your own thinking.

Prices are observed objectively but made subjectively.

Stock prices are determined not by the objective landscape but by the overlapping subjective mindscapes of the buyers and sellers.

People don’t just face a trade-off between risk and reward when they buy a stock. People also face a trade-off between brain pain and brain pleasure when they think about a stock.

There’s even a trade-off between using your scarce mental resources to pay attention to a stock or doing something else.

The best investments Warren Buffett and Ben Graham made were where they turned their attention – and allocated their scarce mental resources – to a stock nobody else was attending to.

Ben Graham’s investment in Northern Pipeline is a great example:

“One day I was looking through an annual report of the Interstate Commerce Commission to obtain certain detailed data regarding railroad companies. At the end of the volume I came across some statistics of the pipeline companies, which the tables said were ‘taken from their annual report to the Commission.’ It occurred to me that such reports might contain information not sent to stockholders…The next day I took the train to Washington…and asked to see the annual report of all eight pipeline companies…To my amazement I discovered that all of the companies owned huge amounts of the finest railroad bonds…Here was Northern Pipeline, selling at only $65 a share, paying a $6 dividend while holding some $95 in cash assets for each share…Talk about a bargain security!”

Nobody is saying neglected stocks are a free lunch.

I’m just saying folks are worried about the wrong trade-off. They’re imaging there’s this especially potent trade-off between risk and return in micro caps. Quite the opposite, the trade-off between risk and return is found most in big caps. The less risky they are, the less reward they offer. It’s amazing how well people handicap some of the blue chips.

The trade-off you need to worry about in neglected stocks like micro caps is different. It’s the trade-off Warren Buffett and Ben Graham made. They applied oodles of brain power to stocks nobody else was looking at. They bought things that didn’t offer any psychological solace in the form of acceptance by their peers or the ability to visualize future success. They turned their attention to things other people ignored.

Simply put, they behaved bizarrely.

They stood out from the crowd and risked looking foolish.

The trade-off these men accepted was that they could get market beating returns by taking on mental burdens. They either had to endure the brain pain or condition themselves not to feel it.

My advice to those who want to follow in the footsteps of Ben Graham and Warren Buffett is to condition yourself to buy the stocks everybody else is neglecting.

Don’t accept the trade-off between risk and return. Instead, choose to make the trade-off between feeling good and investing well.

Ben Graham took a train to Washington. Warren Buffett took out a newspaper ad to buy an illiquid stock.

These guys didn’t just pick different stocks. They thought differently about stocks.

They turned their attention to things nobody else was looking at.

You can to.

Just focus on neglected stocks.

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