None of the following is investment advice.

For years I have known there exist inefficiencies in micro cap investments, but not until recently did I grasp why. Despite the entire CFA and CFP curricula, the discovery came only through a mosaic approach in addition to lots of daily experience, trial and error. And I’m still so ignorant.

As I type this, I have Sotheby’s May 12th auction on my second screen. The parallels begin our micro cap discourse, which, I come to understand, is more an art form than cognitive activity. I see this as fact – those that excel in micro caps are brilliant artists comparable to Caravaggio, Hildegard, J.S. Bach, Chuck Berry…

However, you will not find successful investors who haven’t profited in big ways from micro caps, and normally at the beginning of their careers. A rite of manhood. They’ve all done it. Fact: because every risk is higher, micro cap investing is theoretically the easiest way to make the most money (without leverage).

Little difference exists between growing micro cap stocks and private equity stocks, where at any time, one can be overpriced relative to another. In the last 7 months, I have taken a rather large position in a microcap company and have volumes of notes about each day of trading; I am becoming more obsessed with every passing day, as normally happens when you bet big. Investing is being right with high probability. Gambling is being right with low probability.

The stock market, by definition, is an auction – where you have a room full of people putting up little signs to bet against each other. At times, you feel how greedy the buyers are – how the only reason needed to buy at increasingly higher prices is to store value. Buying for capital appreciation alone is storing value; buyers expect purchases to climb in value and/or impress others. The value derived from owning it is virtually nothing, which for art would be personal enjoyment in the art itself, and for stocks would be the cash on cash return.

I alluded to this when I wrote about speculating in April – don’t fall in love with businesses, because when they drop, you probably won’t love them. Of course, there’s a part of you that can love them, but there is a very DISPROPORTIONAL benefit between enjoying being on that ride and whether you make money/impress others with your status. Said differently, I contend that if you are wrapped up in the emotional element and don’t consider the immense gravity of the investment element, the correlation of your enjoyment of the asset and the price increases. Said differently, don’t buy businesses as stores of value alone – they are not made for that.

As Warren Buffett says, “My wife ran off with my best friend and I sure do miss him”. At first, you’d think Buffett meant plainly that the wife is the business and the best friend is the capital invested. Closer review indicates Buffett was going deeper – that you can’t fall in love with a business that’s no good, or you will lose your money. The two components – emotional investing and intelligent investing are on display.

Buffett also gives advice to young investors – you have a punch card and only 20 punches for your lifetime; each investment you make is a punch. Tremendously wise. Jump over the 1 foot hurdles, not the 10 foot hurdles. For the life of me, I haven’t found better advice anywhere. You’ll see a reference to the painting above I completed last year above.

General Market perspectives –

Buying and selling shares of microcaps is logically the hardest part, given that the auction for such stocks is much, much smaller than larger cap stocks. Generally, the available shares will not be available at auction if the stock is undervalued. To locate shares takes months if not years. Buffett would famously take many years developing a stake, putting in limit orders each and every day while also contacting existing shareholders personally to negotiate buying their shares. You will also note Buffett’s purchase of Berkshire Hathaway Textiles for these exact reasons, his self-professed greatest mistake. Needless to say, the many micro cap transactions have high explicit costs (i.e. broker commissions) juxtaposed with existing shareholders negotiating from a powerful position.

This is insufficient, since as the company is publicly listed, the quote you see every day is a complete farce. You will rarely get that price on meaningful purchases and/or sales if you decide to auction over a short period of time. Since existing shareholders owning the bulk of shares realize the stock is undervalued, the price fluctuations are demonstrative only of very small orders. To the untrained investor, this is anathema. The very reason you want to buy but also the most gut-wrenching. A 100 share order at market for a stock that trades 100 shares a day can mean a 5% drop in the auction price. Or a 5% gain.

Buy at that point where you know the stock is undervalued.

Illiquidity premium is discussed everywhere, but it means nothing without experience. It occurs when all outstanding positions are buy-and-holds. Because of this, there is no de facto liquidity.

For my investment, 30% swings were relatively common in a given consecutive 5 day period. Volumes were less than 100,000 shares, representing less than 1% of float. On days when the stock was down 30% from where I called it undervalued, I bought heavily. To give an example, one Monday the stock traded at $20. By Friday it was at $13. I increased my already large stake by 65% at an average price of $14. Was I concerned? I was not, just as a professional art collector is unconcerned that a Picasso painting has dropped an equivalent percentage.

I monitored the position daily, which might seem overly dramatic, but it was necessary. For growth stocks and for micro caps, information can be announced that completely derails your original thesis. When this happens, an undervalued stock can become overvalued instantly and all those buy-and-hold investors head for the exit. For growth micro cap stocks, the drop in price is more pronounced – you must know everything happening.

Micro Cap investing takes more work than almost every other organized market-based investment, I think. The volatility is ferocious, clearly due to a higher Beta (the amount the stock moves in relation to the general market). Nobody wins by yielding to beta – you can only maintain. Buffett hates beta, and I do too.

Many days, I postulate that undervalued micro cap stakes are far superior to private equity stakes, not only because of the higher liquidity, but for reporting reasons too – micro caps are audited with business results available at least quarterly. As I explain below, fraud is always a risk, but a good auditor mitigates the risk.

However, because volume is so low (i.e. low commissions), no analyst will cover* micro caps. The analysts that do cover them will not be from major banks. There are rarely conference calls. Obvious, yet critical to micro cap investing. For my investment, I was able to develop rapport with the CEO and the COO, speaking with the CEO multiple times. Those calls gave me strength to buy on market price weaknesses.

*Additionally, brokers will not allow for general leverage of microcap stocks. As a major source of profit for brokers and returns for investors, no general leverage will always lead to lower volume in a controlled environment.

When (and NOT if) 30% drops happen, the causes are obscured. In growing micro caps, the biggest risk is a sale of shares by the company. For a private company, this risk can be negotiated away if you add anti-dilution clauses to your purchase agreements. This is scarcely possible in the public market.

The risk isn’t the sale itself, which will result in a massive dilution and market price weakness, but the risk that the proceeds will be used in a way that isn’t as valuable as holding onto that stock. If the proceeds are relatively squandered, the price weakness will continue, but if the proceeds are intelligently used, the company is a better investment than before, becoming even more undervalued.

By the time you learn about the use of proceeds, you may have permanently lost 30% of the original investment! I refer to this as “information lag”, whereby the company’s plans for the sale proceeds takes weeks or months to manifest. You must prepare for this by understanding the strategy, the catalysts, and, most importantly, the governance of the business.

At this point, we pivot to fundamental analysis.

Catalysts for a higher share price are wide-ranging, but the best catalyst must be a turnaround. The micro cap space is full of companies belonging to mature, fragmented industries that may look undervalued, but are more likely in decline. If the company has new intelligent, hardworking, ethical management with strong alignment with stakeholders, a deeper dive is warranted.

I have said in the past that founder-led organizations are the best, but that hasn’t been true in the micro cap space. Truly, founder-led micro caps stagnate because of the founder, due to lack of vision or comfortability. In that vein, private equity has the advantage, since a strong founder understands the deleterious effect of selling shares in an IPO too early. Sufficed to say, founder-led public organizations are only appropriate at a market cap over $1 Billion generally.

Among governance issues is the expansion strategy, which involves financing options (i.e. raising money). The company could sell assets, issue bonds, or sell stock to buy cash.

From there, the expansion could be organic (generating higher revenue through the business itself), inorganic (generating revenue through purchases of other businesses), or a combination of the two. In the former case, the business must have strong economics and be nascent. This is rare. Inorganic strategies, however, have two risks to investors

  1. Overpaying – You don’t want the proceeds of a stock sale, for instance, going to buy a bad company at a high price. This is precocious behavior.
  2. Macro Risks – equities probably do have duration risk, or the risk of the price changing with changes in interest rates. As interest rates go higher, financing expansion becomes more expensive and any acquisition targets are relatively more expensive.

Looking closer involves collecting data on client reception – how clients grasp the product. Is the marketing/branding clear and consistent? Is the product easy to understand and obviously in high demand? Another way to resolve these questions is yet again by looking at average wages. A higher average and median wage derives from a high price for the company’s services. For my investment, over 500 employees, the average wage was $200,000 and the median wasn’t too far behind that.

Even so, fraud plays a larger role in micro caps relative to larger companies, especially those outside of the United States, where auditing standards can be more lax. Candidly, fraud scares the heck out of me, and it should. Making the right decision and losing anyway is absolutely a nightmare, and nearly the opposite of winning the lottery. Yes, it’s that bad.

The work isn’t worth it to determine fraud. Jump the 1 foot hurdles and not the 10 foot hurdles. If you really believe the management is aligned, if the expansion strategy checks out, and the product is in high demand, there’s probably little else you need.

Finally, my favorite metric – SEC Form 13F filings. This is where the real conviction happens. Where you can see day by day whether the C Suite and institutions are eating the cooking. You obviously want only purchases from insiders, and large stakes coming in from institutions, especially reputable institutions found in the Micro Space such as Dimensional Fund Advisors, Renaissance Technologies, D.E. Shaw… For my investment, there have been 0 sales by insiders since the turnaround started 2 years ago, and every insider was granted a rather large stock option package.

Sounds easy right?

Well, it isn’t. I am humbled daily by my own apprehension just holding micro caps. It’s human nature to measure and learn from mistakes, so while this memo lays out some of what I’ve learned, I’m not even close. The greatest gift of these investments isn’t the payoff, but the passion you derive from making mistakes and learning about yourself as you make them. The American Dream lives, shame on you Gatsby.

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