Buying Micro-Caps in the Red
After looking at some of the yardsticks used by Confident Trader to identify stocks with upside potential, I’d like to make one critical point relative to small and micro-cap investing.
Not all micros are making money when it’s time to buy. I know, it sounds counter-intuitive, but there are many great small cap companies that are thriving despite showing a lot of red ink on the books. So, why buy a company in the red – especially a micro-cap?
This is where financial reports add valuable information that can turn what looks like a loser into a buy-and-hold for the long term – something we recommend to the Confident Trader family.
Examining the Financials
There are any number of reasons a solid company will show quarterly, even annual losses. These are companies most often overlooked by both self-directed and institutional investors, making them diamonds in the rough. You just have to sort through them.
Company Expenses
There’s a reason the company is in the red at the moment, one of which may be company expenses. So look to see where the money went.
The company’s financials may indicate high R & D expenses on a product nearing the end of the pipeline – a product you believe has real growth potential. Sometimes, a company takes one time “charges” in a quarter after buying down debt, acquiring another company (growth) or for simple tax reasons. None of these, of and by themselves, is reason enough to cross a company off your watch list.
On the other hand, if the company’s board of directors voted big bonuses for top management while the company’s sales are dropping, you might want to avoid a company so reckless.
The question you need to ask is “Why is the company currently in the red and when will that situation turn around? If a micro is in the red because it’s turning revenues into company expansion, great. If it’s being spent to buy the CEO a new yacht, not so good.
Company Sales
Goods or services, do company sales show a steady, multi-quarter uptrend? If revenues are being spent to create a larger, more efficient infrastructure, you must next determine when that investment starts paying dividends in the form of profits.
Also, where are the bulk of sales taking place? Even though most markets are currently down for the year, individual companies with primary markets overseas are doing well thanks to the lowering value of the dollar.
So, it’s not just how are sales, it’s also where are sales? I constantly look for small and micro-caps with strong overseas sales. These businesses will grow at a much faster rate than larger companies operating largely in the U.S. market alone.
Production Capacity
What does the company sell and does it have the production capabilities in place to meet market demand?
A good example of companies that fall into this category are oil and gas juniors – micro-caps drilling wells, leasing equipment and getting the oil refined and to the market.
Based on current drilling activities, the company will project number of barrels of oil in the ground, what kind of drilling will be required to reach it, how many access roads to the site have to built and so on – in other words, many small caps find themselves in the red as they bring product to market. This quarterly shortfall must be weighted in your stock analysis.
All of this can get to seeming way too complicated and sometimes is. In the final analysis what really counts is whether the company is making progress or not. Are things steadily getting better? Are revenues steadily increasing? Are the losses steadily decreasing? Are the large institutional investors taking positions and adding more shares than they are selling? Is the market moving the price up? If so the stock is a pretty good bet.
Market Capitalization versus Debt
Well-capitalized companies still borrow for expansion and development so it’s not at all unusual to see a growing company with a great deal of debt on the books. A closer examine of the company’s annual report and prospectus will reveal the reason for losses that you may determine are temporary.
Of course, perform the usual due diligence looking at the company’s market share (growing or shrinking), new management, acquisitions of competitors or even patents or licenses. There are any number of reasons not to hold companies with debt.
There are just as many reasons to hold companies with debt. The key is why?
Best regards, and happy trading
Tim
