Whether You Like Risk Or Not
No Luck Required
One of the most common questions I get is probably the most basic: How do I pick the companies I like?
Well, before getting into it, I'd just like to say that there is no system for finding stocks— nothing that will result in a single pick or a list of picks that are guaranteed to profit and grow.
In fact, the only guarantee in this equation is that anybody who claims to have figured it out is full of it.
That said, there are ways to reliably slice big chunks of risk from your portfolio.
So while a system for picking stocks may not be realistic, a system for removing companies from consideration is as basic as basic gets.
In fact we all do it, whether we know it or not, when we make decisions on where to invest our money.
However, as with all things, there is a way to do it haphazardly and by the seat of your pants…
… And there is a way to do it scientifically.
The approach you choose, is what will determine what sort of trader you are in the long run: A successful one, or a broke one.
Identify The Dangers… Hint: They’re Not Hard To see
When it comes to microcap companies, we know the primary source of risk arises from four basic characteristics inherent to smaller companies:
- Lack of revenue
- Untested business model
- Lack of cash
- Untested product
We know these factors are the main sources of risk because these problems are the first ones to vanish when a company leaves its early, volatile phase and positions itself for long-term growth.
So it follows that effectively minimizing these shortfalls in companies still in their early stages would therefore increase their chances of reaching higher market capitalizations.
No major revelations yet, but then we add just one more variable to squeeze a bit more firepower out of our microcap vetting mechanism...
We forget dividends. Because a small, profitable company looking to grow shouldn't be giving its profits away as a carrot for shareholders — it should be reinvesting in research and development, expanding payroll, expanding infrastructure, etc.
So to address those needs, I've broken down these risk-canceling characteristics into four requirements:
- No Dividends: Early-stage companies need to be reinvesting their cash, not doling out profits.
- Strong Profit Margins: A good profit margin isn’t essential, but it is indicative of stability and future growth.
Gross Margins of 30% or Better: This implies the business model works and will continue to keep the company profitable moving forward.
- Positive Cash: This is the lifeblood of young companies. It means if all else fails, they can still afford to open their doors tomorrow.
The next step: Apply these parameters.
If you do a raw search across all markets for companies with market capitalizations of $200 million or less — the standard definition of "microcap," you'll be overwhelmed with 19,700 results.
However, take away dividends, and that count is down to 18,900.
Add gross margins of at least 40%, and that count falls to 1,780.
Add a net profit margin of at least 8%, and you're now down to 290 companies.
Finally, add a positive cash-to-shares ratio, and that list is down to just 90 companies.
That takes you from almost 20,000 to a very lean and highly de-risked 90— a reduction of 99.5% of the field.
However, that still leaves you with 90 companies to sift through — and it's this remaining 0.5% that's going to be the hardest to whittle down.
There's No Shortcut to Thinking
And that's where you need to start looking at every company individually and making judgment calls based on non-numerical factors like industrial and economic trends, product positioning, partnership agreements, and existing and impending legal battles.
Is this company involved in a business that has a future, or is it on its way out?
Does this company have a product that is about to make all of its competitors obsolete?
Put all that together, and you'll get your shortlist.
Now you have to ask yourself if this method for eliminating risky stocks is really loyal to the spirit of microcap investing. Aren't high risk and high volatility the telltale signs of high profit potential?
Well, I'm not going to get into philosophical questions, but I will say that yes, if you want to hit that five-figure gainer, you'll need to dial back on all that de-risking.
And yes, I have a method for that, too.
Need Some Risk In Your Life
It seems counterintuitive, but to seasoned investors, the frustration of untapped potential is sometimes enough to warrant the most speculative swing possible.
And for those who are properly hedged against loss, big swings are sometimes the most important of all.
Take Reid Hoffman, for example — a famous, now-legendary venture capitalist.
Already a multi-millionaire, he decided to risk a mere $40,000 on a social networking start-up about 10 years ago.
When Facebook had its IPO in 2012, Reid's investment was worth just shy of half a billion.
It wasn't the biggest risk of his career, but you better believe it was the biggest home run.
Before I continue, I want to reiterate — just as I did when I was talking about de-risking — that there is no such thing as a system for finding a winning stock.
The only methodology with any scientific validity whatsoever is based on excluding bad candidates in order to increase the chance of success with the remaining pool.
Sounds pretty simple if you ask me: the systematic exclusion of candidates unlikely to achieve the desired results.
So here's how I adapted the method...
De-risking your microcap stocks involved filtering based on:
- Cash/share ratio
- Profit margin
- Gross margin
- No Dividend
To re-risk your microcap stocks so as to maximize profit potential, you need to flip this equation on its head a little bit.
Here's How We Do It...
Profit means favorable earnings reports. Favorable earnings reports mean appreciating share prices...
So if you want to buy something at the very start of its life cycle — in other words, with the highest degree of remaining potential — you need to exclude profitability.
It's painful, but it needs to be done.
Applying your filters, you should specify a maximum zero-profit margin... In fact, if you're looking for the early development-stage companies, you want no earnings at all.
You want to stick to the no-dividend rule... and you want to stick to the positive cash rule, because taking risks on insolvent companies — regardless of the state of their research and development — is never a good idea.
So let's run the algorithm and see what we get:
First step, keep the market capitalization between $4 million and $50 million. No need to go bigger. Bigger companies no longer qualify as development-stage.
No need to go smaller either. Even re-risking should be measured.
Next step, set maximum dividends at 0.
Next step, set maximum gross margins at 0.
Next step, set maximum profit margins at 0.
Then we look at average volume. You want this company to trade, but not too much. Too much trading indicates that it's too well known among speculators. Too little means too few know about it, which for me equals too much risk — even for this bracket of microcap companies.
Set the minimum at 10,000 shares a day to cover the pricier stocks and the maximum at 150,000 to cover those true penny stocks.
Finally, set your cash at positive, with the minimum cash-to-share ratio at 0.2.
You've just whittled a field of more than 5,000 companies — with a total market capitalization of between $4 million and $50 million — down to 35 companies.
35 companies that show all the signs of future prospective but have shaken all those symptoms of decline.
Now, does that mean these 35 are going to deliver those orbit-changing gains?
Taking that field of 35 down to three or so will take most of the effort and most of the thinking.
You'll need to look at what they do and, most importantly, the future of what they do— because companies in this segment cannot be anything but forward thinking.
Properly apply those parameters, and you'll get a handful of stocks with the absolute highest profit potential — by process of elimination.
Of course, your personal methodology for those final 30 or so companies is what's really going to matter, and yes, I do have my own.
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