When it comes to value investing, patience isn't just a virtue; it's a necessity. This is especially true for microcaps, which is really categorized as value investing to the extreme. While large cap and blue chip stocks may be undervalued by the market at times, it is rarely to the extent of those in the microcap space.
With little-to-no media coverage or attention from the larger investment community, many of the opportunities in this arena may take long periods of time before their actual value is realized. The misconception is that microcaps is where fortunes are won and lost overnight. In reality, it can take months or even years before a small company is recognized by investors. When it does, however, the take-off can happen very quickly.
We asked microcaps expert Stephen Kann for this thoughts on the risks of market timing and how investors should approach opportunities in this space instead.
EQ: Market timing can be a dangerous strategy, but most investors do get drawn in by the "buy low, sell high" mentality. Why is this mindset especially dangerous when investing in microcaps?
Kann: I wouldn't as much call it dangerous as it is ineffective. Microcaps, at least the ones I've looked at, by definition are opportunities discovered before the crowd. So we are looking to buy into fundamentals before those fundamentals are fully valued and acted upon by investors in the market place. The danger, if you will, is one of lost opportunities. Not necessarily losing your money per se, but rather we don't know when the crowd is coming into a deal. So many people want to try to buy microcaps the minute before it's going to move and sell it the minute it gets to its high. I like to tell people that nobody rings a bell when a stock is about to move or when it hits its high.
So you have to remove that greed factor from your decision making and instead focus on the fundamentals. The mindset has to be about buying great value at a great price, before the market has fully valued the opportunity, and with the intent of being in the position when it moves whether that's a week, a month or a even year later.
EQ: Would you rather risk getting in too early and holding, or would you prefer getting in a little after the stock has moved up some but has realized some of its potential?
Kann: Absolutely early. I don't mind waiting because when I'm in a deal, I'm in it for a return of 3x, 4x, 5x, 6x or more. If I have to wait two years to get that 3x or 4x, then my annualized return is going to be outstanding. The risk with microcaps, however, is they're relatively illiquid because they're relatively unknown. If they become known in the market--perhaps through media coverage or a major investor gets involved--then all at once, these things can move 100 percent in days or even hours. At that point, you've really lost leverage because if you're looking at a stock that is trading at $1, and it moves to $2, you've lost half your leverage. That's half as many shares as you could buy. For me, I'd have rather bought it early and been content to wait until the broader market recognized the value that I already had recognized.
EQ: You've said that investors may need to wait as long as a few years for a microcap opportunity to realize its potential, assuming that the fundamentals meet their criteria. Can you talk about the patience and discipline required in doing that?
Kann: Absolutely. To give you an example, the most disappointing and tragic investing mistake I made was when I was a very young stock broker. When I started to develop my methodology and understanding of how small-cap stocks work, there was a company that I was interested in named VideoSpection, Inc. It was trading at just over $1 at the time, and looking at the fundamentals, industry, growth prospects, and basically looking at everything, my colleagues and I knew we had a winner. We bought as much of the stock as we possibly could, essentially what was the entire available float. And then it sat there and did nothing for three years. The fundamentals improved, the story improved, the inherent value continued to increase while the stock price did nothing because the crowd hadn't recognized it yet.
In fact, it actually backtracked down under 50 cents, and for three years, it was half of what we paid for it even though the underlying fundamentals hadn't changed. So in other words, if I was looking at it two and a half years into that investment, instead of already having already held it for three years, I would've seen the same great value and at an even better price. Well, unfortunately I lost patience and let that position go. Of course, in 90 days the stock went from 50 cents to $17. The crowd finally recognized it, and in this case the crowd was a Goldman Sachs broker who bought it up to $17 a share, at which point Videospection was acquired. The shares that were given to the shareholders of the original stock that we picked received shares in the acquiring company, and within one year, the return equated to over $100 a share, relatively speaking.
So this stock that we bought at about $1 per share went from 50 cents to over $100 in less than 18 months. But we lost patience and got away from our own core methodology, and that was a tragic missed opportunity.
EQ: When or how do you know to cut your losses?
Kann: When the story changes. If the stock is priced higher than the underlying value as it appears relative to growth, then it's no longer an opportunity. You have to ask yourself, as a disciplined and unemotional investor, if you're already in a stock and you wake up one day and look at it as if you were looking at it for the very first time, would you buy it again based on its fundamentals and price? If the answer is, "No", and it doesn't meet your criteria, then why not sell it? Every day that you choose to own a stock that you already own is like making the affirmative decision to buy it again that day. Your money is better invested in stocks that actually do match what you're looking for in an opportunity.
EQ: So in essence, microcap investors should stay focused on the fundamentals and intrinsic value of an opportunity so as to not get discouraged by the volatility of the stock price?
Kann: That's exactly right. If you keep your eye on the ball then, to me, volatility means an opportunity to build a position if the story hasn't changed. Of course, there are different levels of expertise to understand what the intrinsic value of a stock is, and I know I fully understand the value of the companies that I'm looking for. But for average investors, people talk about averaging down, dollar-cost averaging and doubling down, that's all well and good so long as they know that fundamentals haven't changed.
People get in trouble when they throw good money after bad, and that's the discussion about the fundamentals and not about the price. The price can increase when no value has increased, and the price can decline when no value has declined. It's important to understand that and know the difference, and not be scared off by the volatility. Keep your eye on the ball. That means focus on the underlying growth in the company, its value relative to its peers, and if that story hasn't changed or has gotten better, then I'm not worried one bit about a declining price for a month, a year, or as I mentioned, even three years.
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