Investing Pitfalls to Avoid
I’ve written much about what I
look for in a microcap investment such as profitability, sustainable growth,
and compelling valuation in the My Secret Recipe series of articles which
include: The
Index Card, Shopping and a Taste Test, Inspecting the Ingredients, and The Bargain Rack. However, I haven’t written
much about what I don’t want in an investment. These pitfalls are attributes
that may lead to a bad investment. In this article I lay out the major pitfalls
that I have found so that you don’t have to fall into them. I’m assuming in
this article that the company generally meets my criteria so you don’t have to
read through attributes that you already know I avoid such as unprofitable
businesses, no growth, etc.
While this guide can be
helpful, it is only outlines some of the pitfalls I try to avoid. I’m sure I’m
forgetting at least a few of these pitfalls. Also, when investing in microcaps
you will find that most companies have some aspects of at least one of these.
These negatives need to be evaluated in the context of all the attributes of a
company to determine if the positives outweigh the negatives.
Poor Share Structure
Some companies have very poor
share structures. The worst kind is usually when you have convertible debt
which converts at a discount to the market for the stock. That can create what
is known as a death spiral. Let me explain how this works. First, the holder
converts some of the debt at a discount to market prices and sells it at a
profit. The selling puts pressure on the stock price causing it to drop. Next,
the holder converts more of the debt at a discount to the now lower stock price
and in turn sells it at a profit. The cycle continues until the debt holder
converts and sells all of the debt. A big problem with this arrangement is that
each time the debt holder converts, he or she gets more shares for the dollar
because the stock price drops. What can happen in this situation is that a
company with a decent share structure can see their share quantity balloon.
Convertible preferred stock can also be structured with a death spiral. I will
never invest in a company with death spiral financing because it is a quick way
to see your investment dollars fall into the abyss.
Just because a company doesn’t
have death spiral financing doesn’t mean they have a good share structure. I
always investigate the total diluted share count for each company. In addition
to the outstanding common shares, one needs to examine any preferred stock
(especially convertible), convertible debt, options, and warrants. With that
information you have a view into what the total share count might look like in
the future and can factor that into your analysis. For example, if the share
count is going to double over time, the future per share earnings potential
might not look as good as it seems on first glance. I also look at the company’s
history of share issuance. If don’t like it when a company has a history of
handing out options like candy. I much prefer a company that treats their
shares like gold.
Weak Balance Sheet
The first thing I look at on a
balance sheet is the tangible
book value per share. When it is negative I have to be careful. Let’s say you have a
company that has a stock price of $1/share and is expected to earn $0.12/share
in the next year. If the tangible book value is slightly negative, let’s say
-$0.02/share, that is a cause for caution. When it is say -$1/share, that is
usually a cause for great concern.
A negative tangible book value
isn’t the only thing to cause caution on a balance sheet. Debt coming due soon
can be a cause for concern especially if it will be difficult to refinance that
debt. If a company cannot renew their debt or otherwise pay it off, there
usually are some pretty negative consequences. I like to examine a company’s
debt to see how big it is, the interest rate on the debt, and when the debt comes
due?
Along with debt, one also needs
to look at a company’s cash position. If they don’t have enough cash to operate
and don’t have access to debt (e.g. a line of credit), they may have to raise
money which will mean dilution of your holdings. Usually when a company raises
money by selling stock it is below market prices for the stock which will cause
a drop in the stock price. I much prefer to avoid companies that need
financing. A MicroCap Investors Worst Enemy is Dilution is a good article which delves into a
company’s future need for capital.
There is much more to analyzing
a balance sheet than I have said here. Some poor balance sheets can be OK where
as others are not. It is an art you have to learn.
Poor Quality of Earnings
Sometimes companies have great
earnings but they are of poor quality. For example, maybe they have significant
revenue but they can’t collect their bills fast enough. This will show up in a
metric called DSO orDays Sales Outstanding. When I analyze a company I
usually ignore the nuance of credit sales versus overall sales and just use
overall sales as credit sales levels are rarely disclosed. I have found that
when the DSO calculation gets above 90 days you need to look very
carefully. Repeated numbers that high can indicate that the
customers are of poor credit quality. I usually calculate DSO on a quarterly
basis.
Sometimes recent earnings are
not sustainable which also falls into poor quality of earnings. For example,
maybe there was a factor that temporarily increased gross margin. Maybe there
was some sort of one time gain that boosted earnings such as winning a lawsuit.
Maybe the company is just about to start paying taxes whereas they haven’t in
the past. Perhaps there was a large piece of revenue that came in that isn’t
repeatable. Earnings could grow dramatically when the large order is fulfilled,
but then sink afterwords.
Customer concentration can also
fall into this category. For example, if ACME Widget is receiving 80% of their
revenue from one customer, there is a huge problem if that customer goes away.
Customer concentration doesn’t necessarily scare me away but it often will
reduce the size of the position I’m willing to take on.
The main way to investigate the
quality of earnings is to read the footnotes in filings and the details in PRs.
What one has to do is to factor the quality of earnings into the valuation
model for the company. Just because some earnings are not repeatable doesn’t
mean the company is a bad investment. It is just a part of the entire analysis
that one has to do.
Low Gross Margins
I don’t like low gross margin
(GM) businesses because one small mistake or problem can often turn a
profitable business into an unprofitable business. Those problems can come in a
variety of ways. Some examples include increasing input costs, pricing pressure
from competitors, and loss of scale from decreased revenue.
While it is hard to be precise,
I’ve said before that a high GM business is one with a GM greater than 50% and
a very low GM business is one that is less that 20%. Also, one thing to
consider is that sometimes businesses can grow their GM as they increase scale.
Thus, the current GM isn’t always indicative of what to expect going forward.
Lack of Moat
Companies lacking a moat can be
a problem because they can rapidly go from producing good results to bad
results as it is difficult for them to differentiate. Mostly all they can do to
compete is to be a low cost producer or provide greater service. A background
article on moats is The Vision To See Economic Moats.
A good shortcut for knowing if
a company is in a commodity business and thus has little to no moat is if they
have low gross margins. Highly differentiated businesses usually have high
gross margins although that isn’t always the case.
There are three general
categories for these companies that I will address including commodities,
commodity product, and intellectual property risk.
Commodities
I usually avoid companies in
the commodity space or companies that service this space. I’m talking about
companies in the oil, gas, and minerals businesses. To win in this space you
have to be right about the commodity price and the business. I find that it is
hard enough to be right about the business that I don’t need to add commodity
price risk. In a pure commodity business, even being a low cost producer is no
guarantee of profitability as we have seen recently in the oil industry. There
are times where I will go out on a limb and invest in a company in the
commodity space but they are becoming increasingly rare. There are people that
specialize in this space that are very good but it isn’t for me.
Commodity Product/Service
There are companies that have
products or services that are commodities. Here I’m not talking about oil and
gas per se, but products that really aren’t differentiated. For example,
imagine a company that sells construction nails or a company that sells cheese.
Unless they have a special type of nail or a special flavor of cheese, they are
unlikely to be able to have any kind of pricing power. Services sometimes fall
into this category too. However, services often can be very sticky which means
that there is some level of pain involved in the customer switching to another
provider.
Intellectual Property Risk
Intellectual property risk is
probably most drastic in pharmaceutical patents although it does come up
elsewhere. A company with a great product that is about to come off patent can
suddenly be up against a slew of competitors. Also, sometimes you see a company
that has a great product but hasn’t done anything to protect it. Perhaps the
idea isn’t patentable. Sometimes, the best way to protect a product is with
trade secrets.
There can also be risks that a
company is violating a competitor’s present or future patent. This is often hard
to investigate but it is something to watch especially when there are similar
products in the market.
A great product that isn’t
protected will find itself up against competition eventually. In microcaps
sometimes this is OK because it is such a niche market. However, any product of
even moderate scale will soon find a competitor and that can be very damaging
to margins.
Excessive Management
Compensation/Lack of Alignment with Shareholders
Let’s go back to ACME Widget.
Let’s say that they have annual revenue of $3M and have $300K of net income.
However, the CEO has a salary of $750K and has a history of granting himself
significant blocks of options. Furthermore, this CEO has never purchased shares
on the open market and only owns shares that he acquired through option grants.
This CEO is not someone that is likely to have shareholders’ interest in mind
and appears to be treating the company as a piggy bank. I much prefer to have a
CEO that owns a lot of stock and pays himself a reasonable salary of say $175K
or less. A CEO that makes money when the stock goes up is more likely to focus
on doing the right things and is more likely to treat shareholders fairly. For
a more detailed analysis of this pitfall I suggest reading this article.
Overly Promotional
Management
One of the job’s of management
of a public company is to maximize the value of the stock. I’m a firm believer
that the first step in that process is to produce good results. While
management should be a cheerleader for the company, sometimes there are
management teams where it appears they think that is their first job. If I see
outlandish projections, that usually is a sign that management isn’t focusing
on job one (results) and often is more focused on selling stock. If the story
that management is telling sounds too good to be true, it often is. Beware
of Story Stocks is a
good article to read on the subject.
When you hear a story that
sounds outlandish, one thing I like to do is to check past management
projections. If they have a history of making their projections I’ll find them
much more credible than if they miss their projections. Again, I don’t mind
management telling the story because that is part of their job. It is just that
if they become too promotional, that is a sign to be careful. The worst
situation is when you uncover a company that is part of a pump
and dump.
Business Models with
Major Uncontrollable Risks
There are some businesses that
have some major risk that they can’t control that just scares me away. For example,
maybe the business is a pawn shop business and the government is looking to
increase regulation. Sometimes businesses like this are a value trap. They look
highly profitable but with one quick change their profitability decreases.
Another major risk can be an industry that is declining in size. I’d rather
swim with the current on a growing industry than swim against the current with
a shrinking industry.
Cyclic industries also fall
into this category. Some industries go through major boom/bust cycles. I will
certainly invest in cyclic industries but I much prefer if the industry isn’t
cyclic.
I find that reading the risk
section in annual filings (see Risk Factors in the 10-K for US companies) is a
good place to read to check for major risks like this that you might not see on
the surface.
Conclusion
Proper due diligence requires
that you examine both the positives and the negatives about a company. This
document provides a framework to look for some of the negative items. Next time
you are looking at a new investment, be sure to check the company against these
pitfalls. Also, please share any other pitfalls you would like to add to this
list by posting a comment below.
Happy Investing
Source;microcapclub.com
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