I have spent most of my career researching and managing investments in small capitalization companies. To me, that’s where the excitement is. There is nothing like discovering a gem of a company before others do, and then watching the world take notice and then watching shares of that company rise higher and higher.
Of course, it is never easy. Any small cap investor is going to own some big duds along the journey to finding that one ‘diamond’ that will offset losses from dozens of mistakes. You don’t get 10,000 per cent returns on stocks without sometimes risking losses of 95 per cent, or more.
So, risk is part of the game here. Most investors understand this, and know that small companies are risky. Many though, do not understand how risky they can be, and perhaps shouldn’t be investing in the space if they cannot handle the inherent volatility. Plus, it takes a special kind of investor to NOT sell a winner after a 100 per cent, 200 per cent, or 1,000 per cent price gain, and you really need to keep your winners running to succeed within the sector. So, with that in mind, let’s look at five things to watch out for in small cap land:
Equity financing at low prices
Small companies that are growing need cash. Unfortunately, if a company needs $5 million, it needs $5 million whether its share price is $10, or 10 cents. Obviously, the lower a share price then more shares are needed to be issued to raise the same amount of money. Dilution can be very large with low-priced financings, as shareholders of Prometic Life were reminded of recently. The company raised $75 million at $0.015, and thus there was a total of 23 billion shares outstanding at the company before a recent share consolidation. So even at less than two cents per share the company still needed the money. The end result: Prometic shares are down 93 per cent in the past year.
Insider selling even with weak share performance
Insiders will always need to sell some shares of their company, for dozens of reasons. When an executive sells some shares after they have risen, say, 100 per cent, we can completely understand the need to rebalance one’s portfolio. In such a scenario, the actual dollar value that executives have at risk in their company can still be higher than before, even with some selling. But, when insiders of a small company sell shares that have not moved, it is a much more ominous sign. Now, we are not talking about minor sales, but when an executive sells, say 50 per cent of their holdings with no gain on their shares it can, at times, mean they are throwing in the towel on the prospects for their own company.
Sales that don’t materialize as expected
Both Covalon (COV on TSX-V) and Reliq Health (RHT on TSX-V) have experienced this issue in the past year. Covalon announced a $100-million contract from the Middle East last year, but has yet to record significant revenue from it. The stock is down 54 per cent this year. Reliq had to restate some financial information, after it was determined that the timing and certainty of revenue was unclear. Small companies are supposed to grow sales, not miss or restate sales. Reliq stock is down 77 per cent in the past year.
Market cap too small
There are small caps, there are micro caps, and then there are the super micro caps. We recently ran a Bloomberg screen, and found more than 1,000 companies with a market capitalization of $10 million or less. But let’s think about the possibility of investment success with these companies. Just to maintain a public listing, when one considers listing fees, accounting charges and legal expenses, might cost a company $375,000 a year. If your company’s market cap is only $5 million, that’s about 7.5 per cent per year just to be listed, and you have really nothing to show for it. You haven’t hired anyone nor grown your business with that money. Think of it as a 7.5 per cent MER on a mutual fund. No one would buy that. Thus, these really tiny companies typically need to raise equity capital or add debt just to stay public. This money does not help them grow their business in any way. Most tiny companies only trade on greed: Investors will buy them on the hope that one day they are going to hit the big time, or hit the motherload (for a mining company). Trust us on this: just avoid any company with a market cap of less than $25 to $30 million.
Binary event small caps
We see giant losses all the time in the small cap health care field. Why? Well, it is exceptionally tough to get a new drug approved. This, though, never seems to stop small cap investors from running up the share prices of companies developing new drugs. Sure, every once in a while, a company will get regulatory approval and investors will win big. But, in Canada, how many of these can you name? We can, on the other hand, give you dozens of companies that have failed, and whose share prices have plunged, or have gone bankrupt. For example, VBI Vaccines (VBIV on Nasdaq) with a market cap of $74 million, is down 52 per cent this year and 65 per cent on a single day in June when its hepatitis B vaccine failed to meet its goals. Rather than take a shot on a company with a binary outcome, we prefer to invest in small cap companies that already have a product or service, and whose future is not based on any form of government approval.
Peter Hodson, CFA, is Founder and Head of Research of 5i Research Inc., an independent research network providing conflict-free advice to individual investors (https://www.5iresearch.ca).
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