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7 factors to look for in microcap investing

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By Mark Tobin

With well over 2000 stocks outside the ASX 200, how does anyone go about systemically filtering down to a group of microcap stocks worthy of further due diligence and research? Here we look at 7 ways to screen the field.

1. Market cap below $300mil

Most people consider under $300mil to be a microcap stock but different funds use different benchmarks or cutoff points. Some may take $500mil as the cutoff or for others, it’s any stock outside the ASX 200 or ASX 300. However, if we take the $300mil for now that leaves you with circa 950 stocks with which to look at, a circa 50% reduction already on the 2000.

One thing to consider here, especially with new listings under $300mil, is should this company be coming to the boards now or at all? Is the business mature/developed enough for public markets? Or would they be better off being funded through private equity or venture capital at this stage of their development? Just because a business can list doesn’t mean it should. Or this is the correct phase in its evolution to list.

2. Management and board

Unlike the big end of town, microcap management is critical. However, assessing management and the board is a highly subjective process. Some possible key questions investors need to ask themselves are:

  • Can this team execute on the strategy?
  • The business idea might be great on paper but can they translate this into viable, successful business?
  • Can the CEO take the company forward from the private space to the listed space for example?
  • Can the CEO actually manage a business double or triple the current size?

An entrepreneurial CEO might be great in the early days getting the business off the ground but can they run a larger more established business which requires systems and procedures in order for it to run smoothly. Ideally, you are looking for what Ian Cassel from Microcap Club would describe as “intelligent fanatics”. Some Australian examples of CEO’s I would suggest that you could classify as intelligent fanatics are Rene Sugo of MNF Group or Jamie Pherous of Corporate Travel Management.

Also look at the board. Do you think they will hold the CEO to account? What skills/networks/experience are they bringing to assist the CEO in executing the company’s strategy? Is the board just stacked with friends of the CEO? If the CEO is also the Chair and largest shareholder how is board independence maintained and minority interests protected? A good quality board can be a huge asset to both shareholders and the CEO. 

3. Capital structure

How are the management and board aligned with shareholders? What is the incentive structure for them to execute on the strategy? In microcaps, a large majority of the CEO’s are perhaps founders or large shareholders which is great for alignment of interests with outside shareholders. However, one must be careful how these large shareholders treat small/minority shareholders. You need to be careful of the CEO/Founder or large shareholders treating the company as “a private company that just happens to be listed” as the old saying goes. This is where they disregard the interests of minority or independent shareholders.

It is also wise to be careful when a reverse/backdoor listing takes place, as legacy shareholders who previously invested in the company use the new listing as an escape route out of the old vehicle. This can weigh on the share price until all the old shareholders have exited and the shareholder register normalizes again.

4. Revenue in the front door

The next thing to look at is: are these companies generating any revenues at all? Typical companies that don't are junior resource companies, some tech stocks, drug developers, biotech and medical device stocks. I am not saying money can’t be made in pre-revenue stocks but the risks are higher and I would rather stick to a company with something coming through the front door on a monthly basis. I want to avoid “business idea risk”. This links back to point 1 and perhaps these types of companies are better aligned to venture capital and private equity investors.

5. Making a buck

Next, are they generating a profit? Here it can be demonstrating positive operating cashflow or having a positive EBITDA. Ideally, I would like the stock to be showing a solid NPAT and a track record of delivering consistent NPAT. I, do, however, give a little leeway here if it is clear the company will achieve profitability in the next 12 months. To me at least that’s an acceptable timeframe. However, there must be a clear line of sight to this point via a combination of strong business growth, and the company’s financials.

Given a lot of microcaps report quarterly via Appendix 4D announcements you can track cash flows relatively well and make some reasonable projections about the future based on the cashflow run rate. A lot of companies also provide a supplementary information on business growth and strategy execution. It is important to make sure business growth and the strategy remains on track. Even small hiccups can have big impacts. Appendix 4D’s are some of the most crucial announcements to look out for from microcap companies as their businesses are generally growing much faster than larger companies. Thus, cash inflows and outflows can be changing rapidly.

6. Cash is king

In a perfect world, I want to see no debt on the balance sheet. If there is debt on the balance sheet I generally avoid companies where net debt to equity is greater than 50%. High debt and microcaps are never a good mix. Having a well-funded balance sheet allows the company to deploy cash to grow the company via organic or acquisitive growth. It also allows them the chance to raise debt at a later date if required since they are not currently burdened by it. Cash on the balance sheet also avoids the need to raise equity unnecessarily and possibly at a deeply discounted price. 

7. Relight the Fire

A stock can look on the cusp of taking off for years but if there is nothing that is going to make the general market sit up and take notice then it’s worth a rethink. Or if the company has no sustainable competitive advantage, larger players can simply compete them out of the market or new entrants can easily replicate their offering, the company will never experience sustained growth and profitability and will forever remain small. In other words, more of the same won’t do. A catalyst to change the perceived market view can come in many guises, a new CEO revitalizing the business, expansions into new markets or new products and services, acquisitions, even turning profitable after many years of losses can all be a spark to set a fire under the share price potentially.

Obviously, this is only meant to narrow the field. You then need to study the form of each of runners still left a lot more closely. However, this should leave you with a decent collection of quality microcaps upon which you can conduct some further due diligence and hopefully lead to some new stocks in your portfolio.

Published: Friday, September 22, 2017


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