Every investor, analyst, and research firm has their own philosophy when it comes to investing and we’re no different. Investing is just as much an art as it is a science, and in a lot of ways it’s an expression of yourself; for example, do you care about environmental issues? There’s an ETF for that. Do you know a lot about agriculture, how to maintain land, how to grow produce, and understand what farm products will sell? There’s farm investments for that. Investing is an expression of your competence, your concerns, and an expression of yourself.
At Small Cap Connoisseur, our tagline is Delivering Timely Analysis of Small Cap Stocks, but that’s really just a short line to ensure potential readers understand very quickly what we do. Our investment philosophy is a bit harder to sum up in one line. Small cap stocks are generally just what we analyze, but our investment style and what companies we recommend are generally focused on specific criteria, although we are industry-agnostic in what we actually analyze.
For us to actually offer a buy recommendation, a company has to fill all or most of our criteria to ensure we feel good about the margin of safety (no, of course we did not coin that phrase), so if we’re wrong the result hopefully won’t be catastrophic. We want to ensure there’s enough wiggle room in our analyses that we are significantly more likely to be profitable (hopefully by a large margin) over the long term than it is likely that we will not be.
So you might be wondering what that criteria is.
The first thing we check is profitability. This may seem like a no-brainer, but unfortunately in the startup world and the small cap and nano cap stock world, everyone is quick to forgive lack of profitability in favor of things like growth or favorable superficial metrics like price-to-sales ratios. While being currently profitable isn’t necessarily the most important piece of criteria, if we can’t see the path to profitability in the very near future, we’re going to pass. We have to be able to rationalize that profitability can materialize quickly and doesn’t require the moon to be lifted in order to achieve it.
Another criteria is favorable price to book ratios. We want to know that not only is the company making earnings in the current and subsequent periods, but we also want to know that the company isn’t over-levered (excessive debt) and that we’re getting a good deal based on current equity. In other words, if the company were to be liquidated today, how much would we theoretically receive? The closer it is to $1 received back for $1 invested, the more likely I want it! If it’s negative equity, I’m either going to pass or look over everything else with a fine-tooth comb.
What about cash flow? Cash flow is possibly even more important than profitability since a company can be wildly profitable on paper, but without the cash to back it up, that “profit” means nothing. We look at free cash flow and ensure that it is as strong, or stronger, than the profit number. We want to ensure that cash from operating activities is consistently strong over multiple reporting periods, and that the cash from investing activities isn’t anomalous, or if it is, we look into why and if the company has or is expected to receive a solid rate of return from the investment.
Like any good financial analyst, we also take a look at typical financial ratios, and ensure they’re in line with the industry the company is in. But honestly? A lot of times you don’t need to go crazy running ratios and you’ll miss the forest for the trees when doing so. We want to ensure the fundamentals of the company are solid so we also jump out of the financials and look at what the company actually does, how it operates, what its strategy is, and how it compares to its peers. All of that stuff is very important in the investing world, but it’s harder to quantify so a lot of numbers nerds avoid it in favor of the “hard” stats of the company from the financials. You can expect our analyses will tell the story of the company, why we believe it is or isn’t worth investing in based on what’s under the hood physically and operationally, and of course back that up with the numbers as well.