Novice investors like you and me suffer from the misconception that micro and small-cap stocks are risky and dangerous investment propositions. This is why we have been investing our funds in blue-chip behemoth stocks.
However, we have paid a steep price for this because while the blue-chip behemoths are still lumbering in the hanger, the micro and small-cap stocks have taken off like rockets and are soaring in the stratosphere, giving multi-bagger gains to their investors.
We must also bear in mind that almost all of our favourite stock wizards such as Dolly Khanna, Vijay Kedia, Anil Kumar Goel, Brahmal Vasudevan etc have made a fortune for themselves by investing in top-quality small and micro-cap stocks. These wizards don’t touch large-cap behemoth stocks even with a barge pole.
We must also bear in mind the timely advice offered by Shankar Sharma to “Forget Large-Cap Stocks. Micro-Cap Stocks Will Give Upto 300% Gains”. Shankar also went out of his way to spoon-feed us with two micro-cap stocks, both of which have delivered mega gains to their shareholders.
However, Shankar also issued the chilling warning that the entire micro and small-cap sector is a “mine field” and that if we place our feet wrongly, we will have our heads blown off and suffer permanent loss of capital.
Fortunately, Peter Rabover, the fund manager of Artko Capital LP, with a proven track record for finding winning stocks, has provided valuable guidance which will help us navigate the mine field. He has prepared a check-list of five non-negotiable qualities that a micro or small-cap stock should have for it to qualify for investment consideration:
(i) The company must have high Returns on Invested Capital (ROIC):
Peter Rabover quotes from Charlie Munger’s timeless wisdom that “Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6 percent on capital over 40 years, you’re not going to make much different than a 6-percent return – even if you originally buy it at a huge discount. Conversely, if a business earns 18 percent on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result. So the trick is getting into better businesses. If you can find a fairly priced great company and buy it and sit, that tends to work out very, very well indeed.”
Peter Rabover advises that we must find good businesses that have consistent high returns on capital. A high ROIC generally goes hand-in-hand with a company with high competitive moats that allow the company to continue to earn outsized returns, he adds.
(ii) The company must have Quality Earnings and Consistent Cash Flow:
Peter Rabover emphasizes that over the long term, companies that can deliver consistent growth and low volatility in their earnings tend to not only perform well in the down markets but also command higher relative valuations in the up markets. He points out that quality-earnings companies tend to also have a consistent cash flow conversion rate in that they do not resort to accounting gimmicks such as pension accruals, “Big Bath” writeoffs, aggressive acquisition accounting or revenue recognition tricks.
(iii) The company must have a Clean Balance Sheet:
The third non-negotiable condition is that the company must have a low debt:equity ratio. While a little bit of debt in the capital structure is healthy and gives room to grow opportunistically, a lot of debt can lead to a lot of health issues.
Peter Rabover cautions that in addition to debt levels, we must also screen for hidden liabilities such as lawsuits, environmental or counterparty commitments etc.
(iv) The management must have high ownership of the stock:
Peter Rabover emphasizes that we must make sure that the management of the company is highly incentivized to create value. This will happen either when they own a significant ownership or when their compensation is structured toward creating value.
(v) The business model must be simple:
“Complexity breeds risk” Rabover says. He gives the example of a finance company packaging derivatives on obscure assets which is likelier to have black holes in its business model than a grocery retailer. We must be able to understand and explain what a company does in under a few minutes, he adds.
Now, the million dollar question that we have to work on is which are the micro and small-cap stocks that fulfill Peter Rabover’s description of winning stocks and which can give us multi-bagger gains?