Being Right First – Inflection Investing

Great Investing Is About Being Right First

To be clear, it’s not essential to be “first” to be a winner in the investment game. You don’t have to front run every zig and zag in the market.

Not only would that be exhausting and likely lead you astray more often than on-point, it would come at an opportunity cost of missing many more obvious turns the market for a particular stock or sector are going to take.

With that being said, being the first to recognize an impending shift for a particular company or sector offers an investor an opportunity for maximally leveraged gains with the smallest amount of downside exposure.

And, after all, that’s what creates the best opportunities — maximizing reward versus risk (tempered by the frequency of all possible payouts).

Often the clues pointing to a shift in profitability of a company or companies in a sector are signaled slightly ahead of time and go under the radar of many investors. This is especially true among microcap investments as there are few analysts researching the mechanical levers influencing their top and bottom lines.

We don’t have a blueprint for these sorts of Inflection Points, but we can look at some specific and more general examples to get a sense of the key points an investor might look for in order to grasp that an inflection point is emerging much earlier than other market participants.

Inflection Points

From an investment perspective, Investopedia calls an inflection point “an event that results in a significant change in the progress of a company, industry, sector, economy, or geopolitical situation and can be considered a turning point after which a dramatic change, with either positive or negative results, is expected to result.”

Take for example what happened with microcap company Gateway Industries in early February 2011. At the time, the company was trading at a mere penny per share, but on February 8^th media entrepreneur Robert F.X. Sillerman announced that he was acquiring the company. 

Boom! The share price immediately spiked to almost US$3.00 per share—up 25,000%—based solely on Sillerman’s reputation.

Now that was one hell of an inflection point and, yes, we wish we had owned some shares in that company.    

But how does one consider inflection points when there are multiple events and numerous moments of subsequent change? What, for example, was the inflection point for the 2008 financial crisis?

It’s not always clear or even predictable when an inflection point is impending, but there can be some precursory clues.

Inflection Point Precursor More Important 

Now that we’ve got you thinking about inflection points, you’re probably realizing that their importance as a potential investing tool is limited because they tend to only become apparent in hindsight. However, by knowing that inflection points are likely to arise in the future, you can seek out inflection point precursors. Or perhaps we should just call them “impending inflection points.”

We believe that the more you look for impending inflection points, the more you will find. This tends to be especially true with younger companies like the small cap and microcap ones we follow. 

What you are looking for—and how we define impending inflection points—are any company initiatives, practices, or external influences that might suggest a near- or longer-term increase to its bottom line. Preferably a substantial increase.

Impending Inflection Points Hiding in the Operating Expenses  

In many young microcaps, especially software and tech companies, impending inflection points are often hidden by operating costs. Many such companies tend to pony up tremendous development costs and lose money until they start to gain serious market traction. During this time, revenues tend to increase in a sub-linear fashion to the operating expenses. The impending inflection point may become apparent, though, when the company’s client acquisition and revenues start creeping up. As such revenues continue to grow and become more recurring, tech companies can often scale quickly without having to significantly increase operating expenses. 

Thus, increasing revenues and client acquisition combined with readily apparent market demand may be highly suggestive of an impending inflection point. If you get in before an actual inflection point hits—say a huge jump in quarterly earnings—then you’ll likely realize some healthy gains. 

Such sub-linear increases in revenues that are initially subsumed by operating expenses do not just happen with tech companies. Consider the case of CNS Inc., which ended up making a fortune by essentially patenting a tape that helps open the nasal passages. The maker of Breathe Right™ Nasal Strips did not look very attractive to investors in 2000 when the company lost US$18 million largely due to spending almost 65% of revenues on advertising. 

Advertising is often a slow burn and can take years, if ever, to build a brand and customer base. Savvy investors noticed what we’d call an impending inflection point when advertising spending held steady while revenues kept climbing. Many such investors probably tried out the product themselves to see if such revenues might represent recurring ones based on repeat customer demand. 

Meanwhile, CNS was essentially ignored by Wall Street investors. In 2003, after the company turned its first year of positive operating income, it was trading at about $6, or nine times the previous year’s operating income. Valued at about US$85 million and sitting on about US$40 million in cash, the advertising operating expenses obscured the inherent value of the company’s business model. By 2005, revenues had almost doubled from 2000 and operating income was up by almost 244%. GlaxoSmithKline PLC (NYSE: GSK) swooped in the next year and picked up CNS for US$37.50 per share in cash. 

Be Aware of Externally Influenced Impending Inflection Points

Impending inflection points are not always generated by company activity and may result from external influences. Take for example, lithium mining. The element was in high demand during the cold war due to its use in the production of nuclear fusion weapons. However, this demand waned in the 1990s with the end of the nuclear arms race and lithium prices plummeted when the U.S. Department of Energy released its stockpiles to the open market. 

This happened at about the same time researchers had perfected the lithium battery, which had been originally invented in the 1970s. By the turn of the century, lithium batteries were starting to be adopted for a wide range of uses. Anyone paying attention then could have surmised that this would increase demand for the element. Had you picked up on this impending inflection point in early 2002 by investing US$50,000 in the three biggest Lithium mining companies, you would now be a millionaire. To showcase just one of these companies, consider that FMC Corp (NYSE: FMC), which currently trades at about US$108.00 per share, was on sale for bargain-basement prices below US$3.00 per share in February 2002. 

External Impending Inflection Points in Our Featured Picks 

We have featured  a few companies in part because of external impending inflection points. We believed that Greenlane Renewables (TSE: GRN) was poised to benefit from the external demand for its green technology. The company’s operating expenses had been outpacing revenues, but those revenues were rapidly rising along with worldwide demand for carbon-free renewable natural gas (RNG). Due in large part to government mandates, that RNG demand will continue to soar. GRN operating expenses have built a business model and infrastructure that is ready to scale with this rising demand and we have little doubt that company revenues will soon be outpacing expenses. 

Delic Holdings (CSSX: DELC) is also sitting on an externally influenced inflection point created by the recent emergence of psychedelics as a business sector on par with the rise of the marijuana sector last decade. Delic’s management foresaw this emergence and have positioned the company to become the most recognized brand name in psycheDELICs and to capture future revenues as psychedelics become legal and gain mainstream acceptance. The company is already established as an inbound marketing platform and is now scaling operations to generate revenues from psychedelics wellness centres. 

This scaling will continue with other initiatives as psychedelics gain more acceptance. Meanwhile, the external inflection point will play a greater role in the company’s success with this growing acceptance. Case in point is the state of California’s consideration of legislation that would decriminalize personal use of psychedelics. Passage of the bill, and similar legislation in other states, boosts the power of the impending inflection point, which at some point will shift into an inflection point and no longer be “impending.” 

Of course, once that inflection point is recognized as such, its impact on Delic’s business will be seen in hindsight with any share price increase already factored in.