Navigating Through Microcaps with a Critical Eye

Stephen Kann |

Navigating Through Microcaps with a Critical EyeNavigating through the microcap space in the financial markets can be dangerous for a novice investor. The promises of overnight riches can often lure investors walking blindly into pitfalls in the pursuit of fool's gold. In addition to nerves of steel and discipline of iron, investors also need a guide of sorts. Someone that knows the lay of the land and can cut through the embellishments and right to the essentials.

With over 25 years of experience in corporate finance in the microcap space, Stephen Kann certainly qualifies as an expert. His experience includes more than $300 million in transactions, including private placements, PIPEs, reverse mergers, IPOs and M&A. He has been an equity research analyst on both the buy and sell side.

Equities.com spoke with Stephen to pick his brain on how he approaches the microcap space and what can learn from his experience.

EQ: Can you start off by discussing your experience in the finance industry, and your expertise in microcap and small cap companies?

Kann: I originally entered the business in 1987 as a retail stockbroker--about five minutes before the crash of 1987. The firm I was with at the time was a specialty underwriter in microcap IPOs, so we would do $5 million to $7 million IPOs back at a time when there were a fair number of companies going after that market. We were one of the biggest that did microcap IPOs, and I was one of the top producers there for about four years.

EQ: How does your understanding of the investment banking side of this market allow you to gain an edge when trying to discover unique growth and value companies?

Kann: Part of my background, beyond the transactional experience as an investment banker, includes co-founding several companies. I've been a direct investor myself as an angel in several companies, and as an advisor to companies. So I come at it with not just a purely theoretical or academic approach. I have a different sense for it because I've been in the trenches, I've asked for money, I've tried to get support or awareness for my publicly traded stock, and I just have a much more well-rounded view of anything I look at. That, I think, serves me very well when I dive into a particular stock. I'm not looking at it purely from a standpoint of, "I went to school and got my CFA, and just look at the numbers, and that's all I know."

EQ: You were also the founder and editor of the Bull Market MicroCap Review. Can you tell us what your focus and approach for that newsletter was?

Kann: My style is light analysis, and by that I mean digestible by the layman, the everyday individual investor. So my writing style is very light in that way but informative. It focuses on the most important things, and that's how Bull Market Microcap Review was styled. I profiled nine stocks that I picked. Two of them ended up not performing, but the other seven performed so well that my average return on that portfolio was almost 100 percent annualized from the time coverage was initiated in my newsletter at the time. Several of the companies that I picked got acquired in the end, and rightfully so. I thought I found them at a time when they were substantially undervalued and had something to offer to a potential acquirer.

EQ: Tell us about your work for Think 20/20.

Kann: It was almost identical in that it was really very straight forward. There are 9,000 some-odd publicly traded stocks, and 4,500 of them are considered microcap. Of those, 4,000 don't even have a single analyst covering them. So the amount of information and the spotlight shown on these companies is zero. So in that is tremendous inefficiency, and in inefficiency, you find opportunity. I used the exact same methodology at Think 20/20. The style of the writing was a little more formal because it was meant for the institutional audience, but the methodology, research, and things I keyed on remained the same, and the performance remained the same. I initiated coverage for three stocks for Think 20/20, and the average return was 145 percent on an annualized basis.

EQ: Fair or unfair, microcaps are viewed as an especially high risk and high reward space. What are some of your key criteria when analyzing small companies with sound growth potential?

Kann: I don't buy story stocks and I don't recommend story stocks. The microcap world is riddled with companies that have an idea and they have two guys in their garage--at the risk of oversimplifying--but they have not yet proven anything along the lines of their products, demand, or if anyone will pay for their products. I don't pick those.

The only stocks I pick are the ones that have real fundamentals in terms of revenue, growing revenue, attractive cost structure, attractive balance sheets, and are in an industry that has a macro picture I like. One of the things I like is when you're in front of a giant wave, you just need to be competent. You don't even need to be great necessarily because you're going to be able to do very well and have improving fundamentals. I look for companies that have inflection points where they have some some large fixed overhead that revenue has now overtaken, and now every dollar of revenue has a higher contribution to the bottom line. I love when operational leverage is about to be realized or are just being realized. Also, companies that are in obvious growth industries or are sort of contrarian plays in an industry turning around. I try to find really high quality companies and I’ve been fortunate to have done so on a regular basis.

EQ: In addition to sound fundamentals, are there any other catalysts or factors that you like to look for?

Kann: At Think 20/20, one of my areas of focus was Consumer Discretionary. This was at a time in 2009 when we were at the absolute dearth of consumer spending and consumer confidence. There was one company that I found that was extremely high quality and generating great cash flow. My analysis was that this could be a company that would lead when Consumer Discretionary turned around. So it would get a bump from that as well as from their improving operations. On top of that, the company would get another bump from higher awareness because they were reaching a market cap threshold where they would be on the radar screen of institutions that can't buy under a certain market cap. I like to look for companies that are just under $50 million or $100 million in market cap, because once a company passes over that market cap, they will show up on the screen of institutional investors way bigger than I am because most larger institutions have rules that won't allow them to buy a stock under a certain market cap.

EQ: Can you provide us with some of your best highlights and calls?

Kann: One of my favorite calls was from my Think 20/20 days two years ago. I found this company called Hypercom (traded NYSE:HYC), which is the company I was discussing before. HyperCom was the third-largest credit card processing equipment company in the world behind Verifone (PAY) and Ingenico in Europe. It was a microcap, and it really didn't have a lot of volume. So although it was the third-largest company in the space at the time, it would get no love at all. The company made some very shrewd strategic moves to enter the European market in very smart ways. As I mentioned, I also loved that consumer spending was down at the time, which also reduces the amount of transactions being processed through the equipment of a company like Hypercom. So in spite of that, they were seeing a very strong level of growth, and I saw an opportunity for that boost. I recommended that stock at $1.35 with a $4 price target, meaning I thought it worth $4 the second I recommended it. I wasn't even valuing any growth, I was just saying that based on its trend and fundamentals at the time, when you look at it as a comparable to Verifone or to Ingenico, this stock has to trade $4. Well, it got bought out at $11 in 18 months by Verifone. I actually made a sell call at $9, so I left a little money on the table. But in my opinion, I thought it was fully valued, and only to a strategic investor like Verifone would it have been worth more.

But this is exactly how it happens. You could not look at Hypercom with a critical eye, and factoring the macro picture at the time, and some of the strategic moves they made, and say this stock should trade at anything less than $4. I got on the phone, I talked to the CFO and CEO of the company and got comfortable with the level of their confidence in their business, which confirmed my analysis, and off to the races we were.

EQ: Why does the microcap space appeal to you more than other areas of investing?

Kann: Personally, I just have a tremendous passion for entrepreneurship and small growth companies. It absolutely gets me up in the morning when I'm really active in the space to find these gems, and they're all over the place. At any given time, there's a half a dozen companies that I either am prepared to talk about in terms of coverage, or have on a radar screen that I am going to track to see if certain things or improvements happen before I make the trade. It's just incredible to see that. The story about Hypercom is great, but there are tons of them.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer

Companies

Symbol Name Price Change % Volume
PAY Verifone Systems Inc. 15.74 -0.03 -0.19 1,884,232

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