A few days ago, I received some very relevant questions from an investor about how GeoInvesting goes about researching microcap stocks and making investment decisions. I’m going to just jump right into it and hope you find the following information helpful in learning a little about how we operate at Geo. Here are the answers I gave…
How do you go about covering enough microcap stocks to make it worth your firm’s time?
There’s more than enough opportunity out there – I believe the real question is “how do you narrow down the stock selection universe from thousands of companies to ‘A Few Good Men’?” At almost any point in a market cycle, I have found that many investors express the opinion that they can’t find any value in the market. I have quite the opposite view. One problem is that sometimes too much focus is placed on what the numbers are today as opposed to what value will look like tomorrow (finding inflection points via InfoArb). Still, looking at the current numbers, if you turn over enough rocks, you will reveal more undervalued microcap opportunities than most portfolios can handle. The related mispricing opportunities may be greater in the microcap space since they are less liquid than larger caps.
Here are the steps I applied early in my career to streamline the research process and to narrow down the microcap universe:
- Tracking new highs
- Comparing press releases to CC transcripts
- Reading all earnings releases from microcap companies
- Stock Screens (But careful using screens. They have their limitations as I outline in an article, Beware of Automatic Stock Screeners).
Another great information arbitrage opportunity is reading shareholder letters, letters from the Chairman of the Board, and company annual letters to shareholders.
I vary my initial filter by what I think is working best. Right now, momentum is working like a charm in the microcap space. Then, I filter to stocks that are less than $30 per share with shares outstanding of less than 20 million (although most of the stocks I will buy are typically under $15 and 5 million outstanding shares).
Next, I separate the pack by looking at various fundamental, growth and valuation criterion such as:
- Revenue growth of at least 10 to 20 percent
- EPS Growth of at least 20 to 30 percent
- Debt to equity ratio less than 20 percent
- Positive working capital
- ROE greater than 15%
- Pre-tax margins at least 7 percent
- Trailing P/E less than 25 and/or forward P/E less than 15, although this range can vary by industry and situation).
The stocks that do not meet this criteria set are put into “Basket Two” to determine if things are going on that may eventually put them in “Basket One.” Special situations also go to “Basket Two.” Ironically, “Basket Two” is where you find some of the best opportunities and where information arbitrage sometimes yields the biggest pay off: trying to find inflection points in companies that look overvalued and messy before other investors find them. I find it funny that when I used to reference Investor’s Business Daily momentum/fundamental scores as a stock picking tool early in my career, I would look for stocks that had scores below IBD’s top criteria.
How do you determine entry and exit points in investment decisions?
Entry points depend on what type of situation I am looking at. The most straight forward opportunity that I am looking for are in stocks that meet my plain vanilla valuation criteria I eluded to above (“Basket One”). For many of my early years, my entry point was simply to buy qualifying stocks that were selling below my P/E requirements and sell them when they exceeded them. I look at several other factors than just P/E ratio, but the microcap universe is full of retail investors than don’t look past the P/E ratio, so I find it beneficial to think like a retail investor when I am initially searching for microcaps. From there, I wrap in some higher-level concepts to gain edges.
Basically, if I think a stock is undervalued, I’m going to buy it. I am a fundamental investor at heart, but at times I look at technical signals on stocks I want to buy based on fundamentals (like volume breakouts and flat line chart breakout patterns). In these cases, I will be extremely aggressive when I am buying. For more elaborate sell discipline methods I employ, you can check out this page, and an article written by one of my analysts, Siggy Eggert.
When looking at special situations, it is important to understand that you will encounter risk if you hold your position past the catalyst. Here is an article that I just wrote that includes some special situation information arbitrage strategies. Swing or day trading some stocks that go down after they complete an equity offering that will not be dilutive to EPS might be a strategy you come to like. In the right scenario, the stock will find a bottom at the offering price. The repricing here can happen in a few days to a few weeks. See our case studies on BGSF and ORBK for more examples of this.
How often do things go as planned?
When the environment is right, well over 80%. From the late 1980’s to 2008, the environment was perfect for microcaps. But from 2009 to 2016, the time it took for smaller stocks to react to positive catalysts has taken longer, thereby exposing you to more time risk and increasing chance of failure when negative company news occurs. You may have already read this article where I elaborate on and speak on this topic. The good news is that it appears President Trump has brought back the pre-2008 environment for microcaps: they are in the best shape I have seen since 2008. I think you are exploring the space at the perfect time.
It seems like a lot of work to be covering such ground; what areas do you focus on the most when pulling apart something new?
I have it down to a process where I very quickly determine which of these baskets a stock goes into:
- Growth + value without dividends
- Growth + value with dividends
- Various special situation plays (love looking for takeovers and repricing of risk via selling assets to pay down debt).
- Wait and see
- Trash can
Finally, due to specialized risks, I tend to avoid banks and exploration companies.
I think I could learn a lot from your style as these lessons on microcaps would translate to the mid & larger cap stocks also…or do you not find this to be the case?
I think you can find some of these opportunities in bigger caps, but clearly not as many. From my experience, one of the best Info arbitrage chances in larger caps can be found by comparing conference call transcripts to verbiage in related press releases.