In Agatha Christie’s crime novel, a young guest who can have witnessed a murder drowns in a basket filled with apples. In the fallacious place on the fallacious time – the fate of the unlucky partygoer is a metaphor for the fate of the unlucky investor who bites right into a losing stock and feels the implications.
Small cap investing is an analogous “negative art.” But along with avoiding losers and avoiding mistakes, small-cap investors must also display the “positive art” of finding winners. By achieving this balance and most significantly, small cap investors have the very best likelihood of harvesting alpha.
Investing in smaller, early-stage corporations presents specific pitfalls that make risk control a priority. Many of those corporations have unproven business models and inexperienced management teams. They often lack sufficient financial resources, which may result in significant dilution when trying to lift funds for operations. In some cases, the corporate’s value could fall to zero and investors could suffer a whole lack of capital. For this reason, a prudent investor should avoid all these corporations in addition to invitations to Christie’s Halloween party.
By ignoring the “bad apples,” investors can concentrate on the subset of corporations which can be more likely to do well, perhaps so well that they change into drivers of huge long-term returns. In fact, research shows that just about 40% of stocks lose money, while only 20% account for a lot of the returns.
So is there a recipe for locating such a standout investment, resembling a stock that returns $100 for each dollar invested and joins the so-called “100-bagger club”? Yes, there may be, and while it could be easy, it’s anything but easy.
The 100 Bagger Recipe
Multiple growth + earnings/intrinsic value + (earnings growth 25x) x (multiple expansion 4x) = 100x return
But there are other essential attributes to search for. So remember:
- Smaller is best. Why? Smaller corporations are inclined to adapt more quickly to changing market conditions and infrequently have faster growth rates.
- Prioritize corporations with differentiated services.
- Don’t underestimate the worth of a protracted runway and a big addressable market.
- A proven, long-term oriented management team whose incentives are aligned with investors.
- Focus on under-recognized corporations. Avoid crowded stores to get more value than you pay.
Historically, when an investor finds a subset of those corporations, they’re price holding on to so long as profits grow. Taking profits is standard procedure for investors because nobody desires to feel the regret of losing significant paper profits. But as Marks identified in his memo, the investor who had held Apple stock at a split-adjusted price of $0.37 in 2003 would have earned a 500x return by 2023.
When we’re searching for attractive investments, we should be as focused on avoiding the bad ones as we’re on catching the winners.
Over time, the winners will deal with themselves.
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