You have to turn over a lot of rocks to find those little anomalies. You have to find the companies that are off the map - way off the map. You may find local companies that have nothing wrong with them at all. You can't do that with big blue chips.
- Warren Buffett
Showing posts with label Small Cap. Show all posts
Showing posts with label Small Cap. Show all posts
Sunday, August 30, 2009
Sunday, April 20, 2008
Tips for choosing Small Cap value stocks
1) Find the Big Fish in Small Ponds
It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and at MD we're not speculators but investors.
So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!
For an example of this, consider Winnebago (WGO). At under 500 million market cap, this is clearly a small cap stock. Motor home manufacturing is not a lucrative market with wide appeal. Because of this, few new competitors bother to enter it - only about 10 companies control the market. Winnebago is the big fish in this small pond, with over 20% share. Because of this, the company has been able to maintain (and even increase) pricing, continue to build brand equity, and reward shareholders with dividend hikes and buybacks. Winnebago has averaged well over 20% return on equity for over 10 years - a sign of a potential competitive moat.
2) Management Matters
In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).
With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.
To value management, look for founder CEOs that own a large stake in the company - preferably 10% or more. This aligns their interests with yours. Founder CEOs of small caps with strong profitability records likely have a good strategy and have been successful putting it to work. Beware of small caps with vagabond management or those that use shareholder capital to give themselves generous salaries or perks.
3) Debt is Dangerous
This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.
Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky, and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.
Ideally, you want to pick small caps with no debt whatsoever. Minimal debt can be helpful, but be wary of stocks with a debt-to-equity ratio over 30%.
4) Diversify
When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see it's business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a very focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.
Take for example an MFI stock, Select Comfort (SCSS), the maker of the Sleep Number bed. Just a year and a half ago this company looked like a great buy, driving returns on equity well over 30% and growing revenues and earnings in the 20% range (and with no debt to boot). But a number of challenges all hit the company at once. The housing market went into a deep decline, competitors like Tempur-Pedic (TPX) gained ground, and soon Select Comfort found it's only product under siege. Sales and earnings tanked, and the stock has dropped from the mid-20's into penny stock range.
For these reasons, you MUST diversify when buying small caps. Even the most attractive opportunities are not immune to stock price swan dives.
5) Never Forget the Fundamentals
The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (20-25% return on equity, 25% or higher return on invested captial), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.
Another great sign in a small cap is the payment of dividends. Dividends are a very underrated part of total stock returns. In his book The Future for Investors, Wharton professor Jeremy Siegel calculates that reinvested dividends would have accounted for the majority of S&P 500 index returns over the past 60 years. Not only this, but the payment of dividends is tangible proof of a company generating excess cash flow. Instead of blowing those extra cash flows on overpriced acquisitions, they are paid out to their rightful owners - the shareholders. Paying out this excess cash also optimizes return on capital.
Don't be Afraid of Small Caps!
Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. But as I showed in the first article of this series, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up. The MD mission is to keep you away from the former and get you into the latter.
Sourced from here
It is fundamentally difficult for small capitalization stocks to build and maintain a competitive moat. For one, these companies do not have the economies of scale that large, multi-national corporations have developed that gives them the ability to squeeze suppliers on price, spend hundreds of millions on marketing, or afford huge sums for research and development. Many small companies do indeed grab market share by being first to market with new technology or ideas, but this advantage rarely lasts. In the best case, the company is purchased at a premium by a larger competitor. At worst, the company is copied and then priced or marketed out of existence. The outcome for these companies is speculative, and at MD we're not speculators but investors.
So how do we find small caps with a reasonable competitive advantage? One way is to find companies that dominate very small, limited markets. This is known as the "Big Fish in a Small Pond" scenario. Because of the limited market opportunity, larger firms generally don't bother to compete there. This can allow a relatively small company to control the market, consistently able to raise prices and perhaps move into closely related industry. The outcome of this is high returns on capital for long periods of time. Of course, we don't want to buy these until they are cheap!
For an example of this, consider Winnebago (WGO). At under 500 million market cap, this is clearly a small cap stock. Motor home manufacturing is not a lucrative market with wide appeal. Because of this, few new competitors bother to enter it - only about 10 companies control the market. Winnebago is the big fish in this small pond, with over 20% share. Because of this, the company has been able to maintain (and even increase) pricing, continue to build brand equity, and reward shareholders with dividend hikes and buybacks. Winnebago has averaged well over 20% return on equity for over 10 years - a sign of a potential competitive moat.
2) Management Matters
In general, Wall Street overvalues management. Businessweek and Forbes paste the faces of successful CEOs all over the front page in recognition of a few quarters of beating estimates. But there is ample evidence that previously great managers have limited effectiveness when running a poor business. See Alan Mullaly at Ford (F), David Neeleman at Jetblue (JBLU), or Eddie Lampert at Sears (SHLD).
With small caps, the story is different. Here, managers often wear several hats and are responsible for strategy and implementation, making great minds even more important. A great strategy can easily fail if not well implemented. Even more evidently, great implementation of a poor strategy is a sure path to small cap failure.
To value management, look for founder CEOs that own a large stake in the company - preferably 10% or more. This aligns their interests with yours. Founder CEOs of small caps with strong profitability records likely have a good strategy and have been successful putting it to work. Beware of small caps with vagabond management or those that use shareholder capital to give themselves generous salaries or perks.
3) Debt is Dangerous
This one is obvious - excessive debt is especially dangerous when dealing with small caps. Some large companies can afford to carry large debt loads, as they are virtually assured of future cash flows and can easily survive major economic downturns. Hershey (HSY) is a good example of this.
Few small caps have the luxury of knowing that their cash flows can survive virtually any economic situation. Also, banks sometimes consider small companies more risky, and price debt at higher interest rates for them. Therefore, every dollar of debt owed requires a higher return on capital than a similar dollar of debt in a big, stable corporation. Clearly, debt is a bigger burden for small caps.
Ideally, you want to pick small caps with no debt whatsoever. Minimal debt can be helpful, but be wary of stocks with a debt-to-equity ratio over 30%.
4) Diversify
When investing in widely diversified stalwarts like Johnson and Johnson (JNJ) or GE (GE), each of whom has been around over 120 years and controls multiple product segments, there is almost no chance of losing all of your investment. With small caps, on the other hand, even the most carefully chosen pick can easily see it's business opportunities disappear. Most of these companies rely either on a single product or a small selection of products in a very focused market. The lack of product diversification is dangerous because if that one market is affected by any adverse factors (from technology changes, new competition, even changing consumer tastes), the small cap company can be dragged down with it. Thus, lack of product diversification is the single biggest risk in small cap investing.
Take for example an MFI stock, Select Comfort (SCSS), the maker of the Sleep Number bed. Just a year and a half ago this company looked like a great buy, driving returns on equity well over 30% and growing revenues and earnings in the 20% range (and with no debt to boot). But a number of challenges all hit the company at once. The housing market went into a deep decline, competitors like Tempur-Pedic (TPX) gained ground, and soon Select Comfort found it's only product under siege. Sales and earnings tanked, and the stock has dropped from the mid-20's into penny stock range.
For these reasons, you MUST diversify when buying small caps. Even the most attractive opportunities are not immune to stock price swan dives.
5) Never Forget the Fundamentals
The last rule may seem obvious, but it's a rule nonetheless - don't forget the fundamentals! Particularly, look for a reasonable history of above average returns on capital (20-25% return on equity, 25% or higher return on invested captial), and solid free cash flow margins (at least 5%). Any fad stock or technology leader can generate high returns on capital for a year or two, but only a company with a sustainable market and business model can maintain these returns for 5 years, preferably more. As always, don't be lured by earnings growth alone... if the company is making sales it won't be able to collect on, those earnings are no good. Focus on cash flow instead of earnings.
Another great sign in a small cap is the payment of dividends. Dividends are a very underrated part of total stock returns. In his book The Future for Investors, Wharton professor Jeremy Siegel calculates that reinvested dividends would have accounted for the majority of S&P 500 index returns over the past 60 years. Not only this, but the payment of dividends is tangible proof of a company generating excess cash flow. Instead of blowing those extra cash flows on overpriced acquisitions, they are paid out to their rightful owners - the shareholders. Paying out this excess cash also optimizes return on capital.
Don't be Afraid of Small Caps!
Many investors are lured away from small caps by their financial advisors. Some reasons for this are legitimate - small caps require a lot more research time and are subject to more risk. But as I showed in the first article of this series, the rewards are well worth the effort. The Magic Formula screen is filled with both quality and questionable small cap stocks. Some of these will fade into obscurity, and some will rocket back to their true value - and keep going up. The MD mission is to keep you away from the former and get you into the latter.
Sourced from here
5 Reasons to own Small Cap stock
This is the first in a series of articles examining how and why to own small cap, value based stocks. This is an important component of the Magic Formula, and most companies on the overall screen fall into this category.
1) They Outperform Every Other Class of Stock. Period.
Ibbotson Associates analyzed data from 1926 to 1997 and concluded that small cap value stocks outperformed the general market by 4.3% annually - more than any other class of stocks. Vanguard has published data that shows that, from 1927-2004, small cap value outperformed large cap value, blended, and growth portfolios. A Fama and French study shows this class outperforms all others in recessionary periods as well. Another study by Fund Evaluation Group shows that small cap value has outperformed every other group, and by a wide margin.
If we want the best returns for our portfolios, we have to invest in the best performing class of stocks.
2) The Market's Valuation of Small Cap Stocks Is Inefficient
Stock analysts overwhelmingly cover large, well known companies. Their clients prefer to be in stocks of companies they know, and the investment firms they work for are forced to purchase large cap stocks so as not to exceed statutes by owning too much of a firm. When funds are operating with billions of dollars of assets, it doesn't make sense to invest in small companies - any investment returns from these will not materially affect the fund's performance because the position is too small.
One of the best books ever written on investing, Peter Lynch's One Up On Wall Street, explains this phenomena well. Lynch earned stellar returns running Fidelity's Magellan fund by buying hundreds upon hundreds of small positions in promising small cap stocks and holding them until the market realized their value.
Small cap stocks are valued inefficiently because of the lack of research on them, leading to misunderstanding of a company's business or prospects. Add to this the general investment community's unwillingness to invest in small caps, and you have a perfectly inefficient market for them, leading to bargains.
If we want the best returns for our portfolios, we have to take advantage of inefficiencies in the system.
3) Small Caps Can Become Big Caps
This one is obvious - you're not going to find the next Microsoft or Wal-Mart by investing in Microsoft and Wal-Mart. When Microsoft started trading on the NASDAQ in 1986, it's market capitalization was about 700 million. Today, it's worth 260 billion - giving you back your initial investment 370 times over (and that's not including dividends!).
Relating to point #2, once small cap stocks grow to a certain size, institutions and mutual funds can safely invest in them without worrying about statutory regulations or problems of scale. This leads to an influx of institutional money, sending stock prices up even farther. As market cap grows, these stocks get added to various indexes, which leads to investment by index funds that track them.
Small caps by their very nature have more and larger avenues of growth than large capitalization stocks. This, plus the intricacies of the financial markets, give them several advantageous characteristics for share price appreciation.
If we want the best returns for our portfolios, we need to own the best opportunities for revenue and earnings growth.
4) Small Caps Are Attractive Buyout Bait
Large companies are always struggling to deliver growth to their shareholders. Adding meaningful growth to a company with billions of dollars in revenues and earnings is not easily done. These large companies are often bureaucratic nightmares, slow to adapt with new trends and not nimble enough to stay ahead of changing markets.
Instead of taking the time, patience, and effort to develop new businesses, these cash rich mega-corporations often turn to acquisition as a quick fix for growth. Also, private equity groups will often buy these companies to restructure and then take them public again, reaping a big windfall. Buying small companies, even at a significant premium to market price, is often a drop in the bucket that delivers new opportunities in an instant. Take a look at some recent small-cap buyouts:
* Getty Images - bought for a 48% premium to the trading price.
* PETCO - bought for a 45% premium to the trading price.
* Russell Athletic - bought for a 35% premium to the trading price.
These are just a few examples. Small caps get acquired for significant premiums very frequently. If we want the best returns for our portfolios, we have to position ourselves for big buyout profits.
5) Warren Buffett Says So
No less an authority than Warren Buffett himself has guaranteed that he could earn 50% annual returns investing sums of around 1 million. How would he do this?
"...look for small securities in your area of competence where you can understand the business"
If we want the best returns for our portfolios, we'd be wise to listen to the world's greatest investor!
Sourced from here
1) They Outperform Every Other Class of Stock. Period.
Ibbotson Associates analyzed data from 1926 to 1997 and concluded that small cap value stocks outperformed the general market by 4.3% annually - more than any other class of stocks. Vanguard has published data that shows that, from 1927-2004, small cap value outperformed large cap value, blended, and growth portfolios. A Fama and French study shows this class outperforms all others in recessionary periods as well. Another study by Fund Evaluation Group shows that small cap value has outperformed every other group, and by a wide margin.
If we want the best returns for our portfolios, we have to invest in the best performing class of stocks.
2) The Market's Valuation of Small Cap Stocks Is Inefficient
Stock analysts overwhelmingly cover large, well known companies. Their clients prefer to be in stocks of companies they know, and the investment firms they work for are forced to purchase large cap stocks so as not to exceed statutes by owning too much of a firm. When funds are operating with billions of dollars of assets, it doesn't make sense to invest in small companies - any investment returns from these will not materially affect the fund's performance because the position is too small.
One of the best books ever written on investing, Peter Lynch's One Up On Wall Street, explains this phenomena well. Lynch earned stellar returns running Fidelity's Magellan fund by buying hundreds upon hundreds of small positions in promising small cap stocks and holding them until the market realized their value.
Small cap stocks are valued inefficiently because of the lack of research on them, leading to misunderstanding of a company's business or prospects. Add to this the general investment community's unwillingness to invest in small caps, and you have a perfectly inefficient market for them, leading to bargains.
If we want the best returns for our portfolios, we have to take advantage of inefficiencies in the system.
3) Small Caps Can Become Big Caps
This one is obvious - you're not going to find the next Microsoft or Wal-Mart by investing in Microsoft and Wal-Mart. When Microsoft started trading on the NASDAQ in 1986, it's market capitalization was about 700 million. Today, it's worth 260 billion - giving you back your initial investment 370 times over (and that's not including dividends!).
Relating to point #2, once small cap stocks grow to a certain size, institutions and mutual funds can safely invest in them without worrying about statutory regulations or problems of scale. This leads to an influx of institutional money, sending stock prices up even farther. As market cap grows, these stocks get added to various indexes, which leads to investment by index funds that track them.
Small caps by their very nature have more and larger avenues of growth than large capitalization stocks. This, plus the intricacies of the financial markets, give them several advantageous characteristics for share price appreciation.
If we want the best returns for our portfolios, we need to own the best opportunities for revenue and earnings growth.
4) Small Caps Are Attractive Buyout Bait
Large companies are always struggling to deliver growth to their shareholders. Adding meaningful growth to a company with billions of dollars in revenues and earnings is not easily done. These large companies are often bureaucratic nightmares, slow to adapt with new trends and not nimble enough to stay ahead of changing markets.
Instead of taking the time, patience, and effort to develop new businesses, these cash rich mega-corporations often turn to acquisition as a quick fix for growth. Also, private equity groups will often buy these companies to restructure and then take them public again, reaping a big windfall. Buying small companies, even at a significant premium to market price, is often a drop in the bucket that delivers new opportunities in an instant. Take a look at some recent small-cap buyouts:
* Getty Images - bought for a 48% premium to the trading price.
* PETCO - bought for a 45% premium to the trading price.
* Russell Athletic - bought for a 35% premium to the trading price.
These are just a few examples. Small caps get acquired for significant premiums very frequently. If we want the best returns for our portfolios, we have to position ourselves for big buyout profits.
5) Warren Buffett Says So
No less an authority than Warren Buffett himself has guaranteed that he could earn 50% annual returns investing sums of around 1 million. How would he do this?
"...look for small securities in your area of competence where you can understand the business"
If we want the best returns for our portfolios, we'd be wise to listen to the world's greatest investor!
Sourced from here
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