Managing Microcap Investment Risk
Should you listen to investing advice from someone who turned $18 million into $14 billion in 13 short years? That is, advice from Peter Lynch, manager of the Magellan Fund, one of the best performing mutual funds in history.
Du-uh, of course you should. And microcap and small cap investors should definitely heed his advice to “know what you own, and know why you own it.” This is “Investing 101” type advice and one of the best means for mitigating investment risk. However, a surprising number of investors fail to follow it. Many such investors are pure speculators, perhaps chasing momentum, or riding the coattails of the latest sector boom. Such investors take little time to understand the companies they may be taking a stake in and focus more on the stock and what it is doing in the market. And sure, the market alone can move a stock price, but what the company does—or doesn’t do—will ultimately move the share price.
So again, heed the advice of Peter Lynch, and know that “behind every stock is a company. Find out what it’s doing.”
“How,” you ask?
Well, start with the company’s management. As noted in our June 10 blog—Discerning the Vision, Focus, and Commitment of Microcap Management—you want the leaders of your potential investment to be flush with vision, focus and commitment. And, as noted in our blog, fleshing out where management’s passions lie only takes a bit of sleuthing.
To find out what a company is doing you have to first understand the business the company is engaged with. Thus, you should only invest in things that you understand. If you’re considering a microcap biotech firm based on its promising immunotherapy to cure breast cancer, you should probably know—or school yourself—about cancer treatment in general and immunotherapy in particular. Additionally, you need to have a firm understanding of the Food and Drug Administration’s drug approval process and the role of clinical trials in this process. No matter how promising a company’s novel drug might appear to be, such drugs—and their companies—are made or broken during this process.
Likewise with small tech stocks. Whether an app, high-speed Internet tool, some newfangled precision laser-cutting instrument, or a ground-breaking perpetual energy machine, know the science behind it. And if you truly are considering a perpetual energy machine company, you definitely want to brush up on physics 101. Know the science and understand how the company’s tech is going to fit in with existing tech. Is whatever the company is building or promising to build a completely new concept or just a re-invention of the wheel. If the latter, such needs to truly be revolutionary and not just a new, polished chrome rendition. If the former, will it truly work and, if so, will it stimulate demand?
Along with the company itself, know its competitors. Whatever your target company may be bringing to market has to generate sales. A market already flooded with similar offerings definitely represents a barrier to such, so understand how the company plans to surmount any such barriers.
Know what the company is doing with its balance sheets. High debt loads are B-A-D bad and you should be wary of them. Earnings and cash flow are G-O-O-D good and you should fully understand how the company is generating such and have a good idea about how the company plans to ensure that this continues and increases.
If you cannot understand how a company is making money—if the balance sheets are so convoluted that for all you know the company is spinning straw to make gold—steer clear. There are plenty of microcap and small cap companies out there sitting on a foundation of hype and promise, but not much more. Plenty of fraudulent companies, too.
That all said, there are some decent microcap and small cap companies out there with real promise and the potential to bust into the big leagues. Companies with a solid management team, reasonable balance sheets, viable product or idea, and innovative business execution strategy. Some of these smaller companies trade for little more than book value and a small multiple on earnings, with investment in such representing minimal risk with plenty of potential upside.
We’ll add here that you shouldn’t just be looking for one company to invest in, but instead enhance your risk mitigation by investing in four or more, with potential risk spread out by number and allocation of each stock’s cost. Look for “big win” companies with potential to see five-fold share price gains in five years (known as 5 in 5s), and those that might even end up as shorter-term 10-baggers. Of course, nothing is certain in life or stock picking—except taxes—so you’re also looking for companies that, no matter what happens, aren’t likely to deliver you a big loss.
Thus, each stock in your portfolio should offer one of four different outcomes:
- Big win
- Small win
- Break even
- Small loss
But not the “big loss.” By managing risk in this manner with a basket of microcap or small cap stocks, you’re giving yourself the opportunity for one or more big wins—and maybe even that really big 10-bagger—knowing that should the rest of your portfolio end up with one of the other outcomes, you’re still sitting pretty and safely winning the game.
