Hidden Inflection Points and Small Cap Stocks

Hidden Inflection Points and Small Cap Stocks

Hundreds of public companies are likely to find themselves in an exciting place at any given time: They are experiencing a major positive inflection point in their businesses. While the past may have been one of stagnation or operating losses, the future for these companies looks bright. Whatever the scenario, a positive inflection point produces a hockey-stick improvement in operating performance, creating a potentially rewarding situation for investors.

Unfortunately, the market is pretty good at anticipating inflection points, and valuations reflect this fact. Disciplined investors resist the impulse to invest when everyone else anticipates an inflection point. The challenge is to uncover situations that remain underappreciated or misunderstood. Naturally, these kinds of situations are most often found in the arena of small public companies.

The rewards are substantial, but how do we find such opportunities? We may be able to uncover hidden inflection points by scouring the small cap landscape for companies with two or more businesses, one of which is typically a large, declining legacy business. If the other business is a profitable growth business, we may have found a gold mine. The reason is that, at a company level, operating performance appears lacklustre. As most investors find small underfollowed companies via quantitative stock screens, a company that at the corporate level shows stagnant revenue growth and poor earnings will fail the test, often resulting in a low market value (actually I did this last year with some of my small cap stock ideas). But by reading the earning releases and regulatory filings of small companies, we put ourselves in a position to find stocks that look like duds but actually hide a valuable growth engine. If we are lucky, the market will price the entire company less than our estimate of the value of the most promising business segment alone.

And of course, dissecting companies with multiple business segments isn't the only way to uncover hidden inflection points. Occasionally, simply reading the public filings of a small-cap company can yield surprising insights.

Resources

The Manual of Ideas, The Proven Framework for Finding the Best Value investments

John Mihaljevic