A BigCapMicro at an Inflection Point

It’s not often that you see a stock growing its sales and earnings, selling at a P/E of 3x, right under its book value per share, where cash makes up the majority of its book value. I’m looking at one right now that could more than triple to trade at a P/E of around 10x and still be cheap. More on this in a second.

I’m not a big fan of labeling stocks as growth or value stocks. Even Warren Buffett mocks such classifications, saying:, 

“Growth is part of the value equation.” Investors should pay somewhat more for faster growing businesses, though the premium is often more than we can justify. But when the market underprices growth, buying faster growing businesses is value investing. They’re not two different categories and I just cringe when I hear people talk about now it’s time to move from growth stocks to value stocks or something like that because it just doesn’t make any sense.”

His assertion, “It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price,” prompts me to ask the question – why can’t we just find companies that are about to experience some nice growth, trading at ridiculously low valuations?

So, when it comes to labeling a stock, my intrigue lies in the concept of ‘Deep Value.’ 

A literal definition of Deep Value is a strategy which selects the cheapest stocks in a universe of stocks based on their valuation multiples. My tweak on this is to find stocks selling at cheap multiples that are also going to grow or realize some catalyst to lift valuation multiples.

Despite its merits, the Deep Value strategy faces challenges as markets evolve and become more efficient. 

We need to ask ourselves why the market is missing something that we’re not seeing to justify a company’s low valuation. There could be a reason a stock is selling at a low valuation – does it have a lot of debt on the balance sheet, or maybe a lot of customer concentration? Maybe the company has no growth plan. 

Revisions to valuation multiples occur when growth outlooks improve and/or a company becomes perceived as less risky.

The allure of investing in smaller cap stocks is that sometimes one can find a deep value opportunity simply because there’s less people investing in microcaps.

This leads me to the world of ‘BigcapMicrocaps” – Companies with substantial revenue trading as microcaps.

Some of these entities are trading at very low valuations due to prolonged periods of stagnant growth or less-than-shareholder-friendly management.

However, the low valuations in the microcap space are leading to investor activists getting more aggressive on putting pressure on “old school” management teams that have not been maximizing shareholder value. So, we’re starting to see some of these boring companies be more proactive about finding ways to grow before activists get involved.

Throughout my investing career, I’ve been constantly on the lookout for these boring companies, these diamonds in the rough that are about to be more attractive and possibly experience a ridiculous upward revision in their depressed valuation multiples. 

My team and I are looking into one of these companies right now. The stock is a typical Bigcap Micro with over $200 million in revenue, but is trading as a microcap and a crazy low price to earnings multiple of 3x!

It’s a company I’ve followed for over 20 years, but never really got excited about because management seemed disinterested in affecting positive change, even though the company was highly profitable.

Revenues have historically fallen within a relatively stable range, with earnings per share (EPS) being volatile on a quarterly basis.

However, because I’ve followed the company for so many years, I was able to detect some very subtle changes management is making, not only in the direction they have taken the company, but also in the manner in which the company is communicating with investors. 

The changes are evident by: 

• A reduction of debt by eliminating pension liability.
• Focusing on faster-growing markets.
• The unnoticed material expansion of the company’s manufacturing facility.

This has all culminated in the company setting sales records over the last five quarters and finally getting through the upper end of the revenue range it has been stuck in.

Earnings per share growth has also accelerated. So, what we have here is a company that is less risky due to a reduction in its debt AND may be entering a new growth phase.

So far, investors have ignored the company’s progress. My next job is to reach out to management to see if the last 5 quarters are setting the stage for the new norm or if the stock is a value trap that will revert to being an unpredictable company that deserves to trade at a low valuation multiple. 

However, my thirty years of investing experience has me thinking there is a good chance that we may be able to avoid a value trap. Furthermore, the high cash per share provides some downside protection.

One other thing I love about this stock is that investors are so pessimistic about the company’s turnaround story. This is what one investor I pitched the stock to had to say as he passed on the idea:. 

“A large issue is capital allocation. They should be returning cash to shareholders but it almost all gets plowed back into this low-return business.”

My whole point is asking: “What would happen if this historical pattern is no longer the case!!”