Be a cockroach in the
Small-Cap (Mid-Cap) World
The problem with investing is often too much to choose from.
Eliminate the huge dinosaurs where all the institutional money goes and be a
cockroach investor who seeks out the market inefficiencies in the small cap
world. To eliminate some of the risk in this part of the investing market, insist on buying theses companies on the cheap but don't buy into value traps or companies with dying assets.
To avoid value traps I like to see revenue growth over the last few years and a strong
balance sheet to help assure me that the company will be able to navigate
periods where credit may be hard to obtain. I also like to see some free cash flow (I use the cash return
metric to track this) and finally a strong
motivated management team that holds a significant stock ownership in the company.
A proven track record of capital
allocation is also preferred...In addition, I also check out the
price to sales ratio of the likely candidates, if it is below say 1.5 times, it
is a confirming indicator of value (margin of safety) and thus makes the
qualifying stocks all the more valuable.
Once you have found a small cap with that satisfies the
above criteria, the key phrase to focus on is…an accelerating rate of positive change…that might be a management change (which would have a
more of an impact on a smaller cap stock), it might be a strategic acquisition that might harm earnings in the near
term (hurting the stock price) but might also be accretive to cash flows and
earnings in the longer term. (that would also indicate that the present
management team isn’t afraid to build the business for the future benefit
of the shareholders…a good thing)…it might be an investment in the business itself (growth capex, research and development,
marketing etc…)
When one or more of the changes above occurs within the
framework of a small or mid-cap company it can accentuate the profit potential
of the investment. Couple this with the fact that smaller firms are easier to
understand and have fewer product lines to cloud your analysis and suddenly small cap investing starts making a lot more sense...This is comforting stuff to a cockroach.
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