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Here's an artful—and hands-on—approach to micro-cap investing

Proactive Investors Friday, 12 October 2018 ()
“Investing in stocks is an art, not a science, and people who’ve been trained to rigidly quantify everything have a big disadvantage.”  –Peter Lynch Think back to your college days. How many times did a professor assign a project and the first emotion you felt was fear, with heart-pounding stress coming in a close second? Your fear and stress were likely an immediate response to what seemed like a complicated and overwhelming project. But once you took a step back and began breaking down the project into more manageable, three- and four-hour tasks, the assignment wasn’t nearly as scary.  There's a saying, sometimes attributed to Mark Twain, that says the secret to getting ahead is just getting started. Investing is no different.  By the end of my sophomore year in college, with a couple of finance and economics courses under my belt, I was sure my understanding of financial statements and valuation ratios would carry me to investing success. After all, if I can determine price/earnings and price/book multiple, surely, I can figure out whether a stock was priced for perfection or being sold for pennies on the dollar.  While my college professors imparted a rudimentary understanding of fundamental financial analysis to me, they failed to explain the artful intricacies that go along with being able to decipher an income statement. And if you believe, as I do, that investing is three parts art and one part science, I'm sure you can appreciate the potential dangers of making decisions under the assumption that price/earnings multiples tell you everything you need to know. WATCH: Recent cannabis stock volatility not dampening industry prospects A scientific approach to stock analysis tends to focus on financial statements and primary valuation metrics. And while there are highly educated teams comprised of mathematicians, physicists, and statisticians making vast sums of money in the stock market, often a singularly left-brain approach to investing fails to produce market-beating results.  Remember, if everyone has access to the same information — and in this case, I am referring to financial statements and valuation ratios — you probably don’t have an investment edge. When investing legend Peter Lynch shared his view that investing in stocks is an art, not a science, he wasn’t suggesting we all begin studying charts, plotting out moving averages, and brushing up on our understanding of Relative Strength Indicators. Lynch’s point was that while we must determine whether a company is financially sound, we also need to adopt an artful approach to our investing. And that means being willing to look where others won’t and developing the ability to think outside the box in a manner most cannot.  Filling Wall Street's research void—by yourself Analyzing microcap companies doesn’t need to be paralyzingly stressful, but it does require a set of skills most self-directed investors either lack or are unwilling to learn.  You see, Wall Street makes its money by charging companies large investment banking fees. But since micro-cap companies with market capitalizations below $500 million rarely generate hefty investment banking fees, big Wall Street investment shops have little motivation to publish investment research on these micro-cap stocks.  So, this means you need to learn how to be an investigative investor when it comes to analyzing a micro-cap company. Always begin with some basic financials merely to determine whether the company is at risk of running out of money over the near term. Then, after some fundamental analysis, you need to shift gears and set the problem-solving and logical side of your brain aside and start relying on your creative and intuitive side. Micro-cap investing: an artful approach Micro-cap companies aren’t always unprofitable enterprises, but many are. So, if you’re using traditional valuation ratios to try and make sense of unprofitable companies, you’re probably going to abandon a ton of stocks that have enormous potential. And remember, while the financials of a $25 billion company can provide a realistic roadmap for what that company can be expected to accomplish over the next six to 12 months, for a $20 million growth company, the financials are apt to be stale an hour after they’ve been filed with the SEC.  An artful approach to investing requires you to look behind the balance sheet. For every 10 minutes you spend studying a micro-cap’s mix of assets and liabilities, you should spend 40 minutes or an hour understanding the company’s total addressable market, product growth potential, and industry expansion prospects. Analysis in action In mid-September 2018, I published a story on Proactive Investors about how Alliance International Inc (NYSE:AOI) changed its name to Pyxus International (NYSE:PYX) to better reflect the company’s transformation away from a tobacco packaging and growing company and into cannabis and other non-leaf growing areas of the industry. What attracted me to Pyxus wasn’t the company’s financials; it was management’s vision and the story that executives were pitching to investors. And within an hour of reading past earnings transcripts and press releases, it was clear Wall Street was missing a great story. READ: Tobacco player Alliance One International turns over a new (and greener) leaf as Pyxus International Since that article first ran on Proactive’s website, Pyxus’ stock has run up from less than $20 to as high as $52. But the company’s financials haven’t changed a bit. So, why did the stock more than double?  Simply put, the company’s story gained traction and Pyxus morphed from an undiscovered gem into a short-term momentum darling.
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