"The best decade was the 1950s; I was earning 50% plus returns with small amounts of capital. I could do the same thing today with smaller amounts. It would perhaps even be easier to make that much money in today's environment because information is easier to access."-----"You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map." Warren Buffett on investing in tiny companies
Generally when Warren Buffett speaks most people pay attention, that does not appear to be the case in regard to microcap investing. It seems that most investors are uncomfortable investing in tiny companies which rarely scroll across the bottom of CNBC. They are perceived as risky and highly speculative, frequently labeled with the pejorative connotation "penny stocks"; conjuring images of the old Vancouver Exchange where invested money disappeared with the same frequency as coins deposited into a slot machine.
Risk and Volatility are Different Concepts
In reality, small companies are not riskier investments than their larger brethren per se, as long as they possess a margin of safety. However in many cases, they are more volatile. Volatility was unfairly categorized as risk by efficient market theory, a misconception which is nearly impossible to debunk. The average investor who does not understand the concept of margin of safety will always equate stocks which display large swings in price per share as risky propositions. Most serious value investors understand that risk and volatility are completely different concepts. To paraphrase James Montier, I never met a long investor who gave a damn about upward volatility, its downside volatility that they do not care for.
Potential Hazards in Microcap Investing
It is not all wine and roses when it comes to investing in microcap stocks; they offer some drawbacks which must be addressed. Most tiny companies experience very little volume, particularly if they only have only a few million shares outstanding, therefore if one is forced to sell it is difficult to move shares without dropping the market price. As my old broker friend used to say, "this stock trades by appointment only". In such cases margin calls can be disastrous, therefore microcap investors should never employ leverage.
Secondly, since tiny companies are obscure in nature, sometimes they can languish for years without being recognized. If they happen to pay a dividend the long wait is not so emotional taxing, however very few investors exhibit the patience to wait for an unknown company to get discovered, particularly if the general market is rising. Therefore, extreme patience and resolve is necessary if an investor wishes to record a capital gain rather than a loss when purchasing microcap stocks.
The use of trailing stops as "protection" can be lethal when purchasing small companies with low daily volume. Frequently, tiny companies frustrate investors who employ this tactic after they repeatedly lose their shares only to watch them quickly recover after their shares have been plucked.
Anyone who recognizes the value of the stock can merely buy the few shares that separate a trailing stop from the current price and plunk the shares as easily as picking a ripe strawberry. If you lack the conviction to withstand downside volatility and regularly use trailing stops, I suggest that you refrain from buying low volume microcap stocks.
The Explosive Power of a Catalyst
Many small companies have extremely small floats in addition to a small amount of outstanding shares. The combination of those two factors can super-charge an upward movement in the price per share when a positive catalyst presents itself.
The float of a stock refers to the total shares outstanding minus the restricted shares, shares held by insiders and shares held by other owners holding at least 5% of the outstanding shares. For example imagine a company has one million shares of stock outstanding, if management owns 25% of a company, and five institutions own 5% each, the total float of the company would be 500 thousand shares.
Companies with extremely low float can experience quick and extreme upward volatility if good news is announced or some other positive development occurs. Furthermore, momentum traders who watch the top daily gainers list tend to flock into microcap stocks when they spot an upward price per share surge. The process exacerbates the volatility of smaller stocks and can result in rapid gains or losses (if negative news is announced) as opposed to larger companies.
A catalyst can be defined as set of circumstances that triggers the upward movement of a stock in a short period of time. Many value investors, particularly ones who lack patience and do not demand long term capital gains, require a perceived catalyst before they will invest in a stock. Examples would include positive earnings announcements, news of a spin off, a sector rotation, the emergence of a business cycle or any other key development which is perceived by investors to be positive.
Now it is time for a bedtime story. Back in the early 2000s I owned shares of Lakes Gaming, symbol LACO. The name has since been changed to Lakes Entertainment. LACO was an asset play with a tangible book value of about 15 dollars per share much of which was Las Vegas land near the strip. Their operational business was involved in setting up Native American casinos and managing the properties until the owners were able to take over; they received in return, a percentage of the profits. The business was languishing but the real estate holdings provided a substantial margin of safety since the company was trading in the low six dollar per share range. Mario Gabelli owned a substantial position in the company. Subsequently, some of their accounting practices were called into question from prior years in regard to accrual earnings. I deemed that the accounting news was not consequential to the underlying value of the real estate nor the current earnings. As I recall, non-cash earnings were the subject of the inquiry. The market did not agree, the stock dropped and I purchased more shares in the low four dollar range.
Lyle Berman, an avid poker player, was the CEO of Lakes Gaming and he had conceived of a novel idea. His idea was to put a camera at table level which revealed the two hidden hole cards during competitive Texas Holdem tournaments. For those of you who do not know, Texas Holdem is the game played at the main event of the World Series of Poker. Watching the game without knowing the players hidden cards is deadly boring. Anyway, Berman was able to parlay the idea into the World Poker Tour after receiving a television contract from The Travel Channel. Almost overnight, LACO had a new line of business and the era of the Texas Holdem craze had begun.
The new concept of showing the hole cards to viewers provided wonderful entertainment and the subsequent television contract provided a powerful catalyst, sending LACO stock soaring upward. The low float, (Berman owed a large percentage of the stock) and the new fascination with poker, super-charged the gains. I sold out my position at around tangible book value which was about 15, believing that Texas Holdem was merely a passing fad, possessing no real earnings power. Of course the stock quickly roared up to about 30. As Paul Harvey used to say "now you know the rest of the story".
Conclusion
1) Microcap stocks are no more risky than larger stocks as long as they contain a satisfactory margin of safety. Frequently their increased volatility is confused with risk.
2) Added volatility in tiny companies is fueled by low share counts, low stock floats and momentum investors.
3) Investors in low volume microcap stocks must exercise patience, avoid margin and never, I repeat never, employ the use of trailing stops.
4) A positive catalyst can super-charge the upward movement of microcap companies. Try to spot positive catalysts in advance if you are not willing to hold the company for an extended period of time.
This is the first edition of a series on microcap investing. The next article will focus on intelligent speculation.
Generally when Warren Buffett speaks most people pay attention, that does not appear to be the case in regard to microcap investing. It seems that most investors are uncomfortable investing in tiny companies which rarely scroll across the bottom of CNBC. They are perceived as risky and highly speculative, frequently labeled with the pejorative connotation "penny stocks"; conjuring images of the old Vancouver Exchange where invested money disappeared with the same frequency as coins deposited into a slot machine.
Risk and Volatility are Different Concepts
In reality, small companies are not riskier investments than their larger brethren per se, as long as they possess a margin of safety. However in many cases, they are more volatile. Volatility was unfairly categorized as risk by efficient market theory, a misconception which is nearly impossible to debunk. The average investor who does not understand the concept of margin of safety will always equate stocks which display large swings in price per share as risky propositions. Most serious value investors understand that risk and volatility are completely different concepts. To paraphrase James Montier, I never met a long investor who gave a damn about upward volatility, its downside volatility that they do not care for.
Potential Hazards in Microcap Investing
It is not all wine and roses when it comes to investing in microcap stocks; they offer some drawbacks which must be addressed. Most tiny companies experience very little volume, particularly if they only have only a few million shares outstanding, therefore if one is forced to sell it is difficult to move shares without dropping the market price. As my old broker friend used to say, "this stock trades by appointment only". In such cases margin calls can be disastrous, therefore microcap investors should never employ leverage.
Secondly, since tiny companies are obscure in nature, sometimes they can languish for years without being recognized. If they happen to pay a dividend the long wait is not so emotional taxing, however very few investors exhibit the patience to wait for an unknown company to get discovered, particularly if the general market is rising. Therefore, extreme patience and resolve is necessary if an investor wishes to record a capital gain rather than a loss when purchasing microcap stocks.
The use of trailing stops as "protection" can be lethal when purchasing small companies with low daily volume. Frequently, tiny companies frustrate investors who employ this tactic after they repeatedly lose their shares only to watch them quickly recover after their shares have been plucked.
Anyone who recognizes the value of the stock can merely buy the few shares that separate a trailing stop from the current price and plunk the shares as easily as picking a ripe strawberry. If you lack the conviction to withstand downside volatility and regularly use trailing stops, I suggest that you refrain from buying low volume microcap stocks.
The Explosive Power of a Catalyst
Many small companies have extremely small floats in addition to a small amount of outstanding shares. The combination of those two factors can super-charge an upward movement in the price per share when a positive catalyst presents itself.
The float of a stock refers to the total shares outstanding minus the restricted shares, shares held by insiders and shares held by other owners holding at least 5% of the outstanding shares. For example imagine a company has one million shares of stock outstanding, if management owns 25% of a company, and five institutions own 5% each, the total float of the company would be 500 thousand shares.
Companies with extremely low float can experience quick and extreme upward volatility if good news is announced or some other positive development occurs. Furthermore, momentum traders who watch the top daily gainers list tend to flock into microcap stocks when they spot an upward price per share surge. The process exacerbates the volatility of smaller stocks and can result in rapid gains or losses (if negative news is announced) as opposed to larger companies.
A catalyst can be defined as set of circumstances that triggers the upward movement of a stock in a short period of time. Many value investors, particularly ones who lack patience and do not demand long term capital gains, require a perceived catalyst before they will invest in a stock. Examples would include positive earnings announcements, news of a spin off, a sector rotation, the emergence of a business cycle or any other key development which is perceived by investors to be positive.
Now it is time for a bedtime story. Back in the early 2000s I owned shares of Lakes Gaming, symbol LACO. The name has since been changed to Lakes Entertainment. LACO was an asset play with a tangible book value of about 15 dollars per share much of which was Las Vegas land near the strip. Their operational business was involved in setting up Native American casinos and managing the properties until the owners were able to take over; they received in return, a percentage of the profits. The business was languishing but the real estate holdings provided a substantial margin of safety since the company was trading in the low six dollar per share range. Mario Gabelli owned a substantial position in the company. Subsequently, some of their accounting practices were called into question from prior years in regard to accrual earnings. I deemed that the accounting news was not consequential to the underlying value of the real estate nor the current earnings. As I recall, non-cash earnings were the subject of the inquiry. The market did not agree, the stock dropped and I purchased more shares in the low four dollar range.
Lyle Berman, an avid poker player, was the CEO of Lakes Gaming and he had conceived of a novel idea. His idea was to put a camera at table level which revealed the two hidden hole cards during competitive Texas Holdem tournaments. For those of you who do not know, Texas Holdem is the game played at the main event of the World Series of Poker. Watching the game without knowing the players hidden cards is deadly boring. Anyway, Berman was able to parlay the idea into the World Poker Tour after receiving a television contract from The Travel Channel. Almost overnight, LACO had a new line of business and the era of the Texas Holdem craze had begun.
The new concept of showing the hole cards to viewers provided wonderful entertainment and the subsequent television contract provided a powerful catalyst, sending LACO stock soaring upward. The low float, (Berman owed a large percentage of the stock) and the new fascination with poker, super-charged the gains. I sold out my position at around tangible book value which was about 15, believing that Texas Holdem was merely a passing fad, possessing no real earnings power. Of course the stock quickly roared up to about 30. As Paul Harvey used to say "now you know the rest of the story".
Conclusion
1) Microcap stocks are no more risky than larger stocks as long as they contain a satisfactory margin of safety. Frequently their increased volatility is confused with risk.
2) Added volatility in tiny companies is fueled by low share counts, low stock floats and momentum investors.
3) Investors in low volume microcap stocks must exercise patience, avoid margin and never, I repeat never, employ the use of trailing stops.
4) A positive catalyst can super-charge the upward movement of microcap companies. Try to spot positive catalysts in advance if you are not willing to hold the company for an extended period of time.
This is the first edition of a series on microcap investing. The next article will focus on intelligent speculation.
