As published in CFA Institute Enterprising Investor on October 26, 2023
In mystery writer Agatha Christie’s novel Hallowe’en Party– the film version by Kenneth Branagh is out in theatres now—a young guest who may have witnessed a murder, is drowned in an apple-bobbing basket. (For those readers too young to know what ‘apple bobbing’ is, ask Siri.) The unfortunate party guest was in the wrong place at the wrong time, not unlike an unfortunate investor who bites into a loser and reaps the consequences. In his September memo, author, and distressed-credit investor Howard Marks refers to fixed-income investing as a “negative art”, where success depends, not on finding winners but on avoiding losers. The key in debt investing is not buying the companies likely to default on loans and drag down returns.
In his book Winning the Loser’s Game, Charles D. Ellis, compares professional money management to playing tennis and golf, where the winner is the person who has avoided errors, not the one who had the best shots during the match. Small cap investing also involves not only the “negative art” of avoiding losers, but this must be balanced with the “positive art” of finding winners too. Achieving the right balance between picking fewer losers and choosing more winners, and, as importantly, selecting a smaller subset of very big winners, offers strong potential for achieving alpha in small cap investing.
Investing in smaller, early-stage companies comes with specific risks which make controlling risk paramount. Many of these firms have unproven business models and inexperienced management teams. They often lack sufficient financial resources which could lead to significant dilution as they seek to raise funds for operations. In some cases, the value of the enterprise could go to zero and investors could see their capital destroyed. It should go without saying that the prudent investor should avoid these types of companies as they would an invitation to a Hallowe’en party in an Agatha Christie novel. The investor who avoids these “bad apples” will be left with a subset of companies that are likely to do well, in some cases so well they will become the drivers of great long-term returns. As research has shown nearly 40% of stocks lose money, while 20% of stocks drive returns.
Is there a recipe for finding such a stellar investment, one likely to join the “100-Bagger Club” alongside Canada’s Constellation Software? Yes, and like most things, it is simple but not easy.
Here are the key ingredients for a (e.g one-dollar returns $100 dollars):
- Multiple growth + Earnings/intrinsic value + (earnings growth of 25X) X (multiple expansion 4X) = 100 X return
Other key attributes to screen for are:
- Smaller is better. Smaller companies can often respond quickly to changing market conditions and tend to have rapid growth rates.
- Differentiated products and services.
- A long runway and a large addressable market.
- A proven, long-term-focused management team whose incentives are aligned with investors.
- Avoid crowded trades to obtain greater value than what you pay.
When an investor finds a subset of these companies, Taking profits is standard operating procedure for investors because no one wants to experience the regret of seeing significant paper gains dissipate. Yet, as Marks pointed out in his memo, the investor who held onto Apple stock from its split-adjusted cost of $0.37 in 2003 would have enjoyed a 500-fold return by 2023.
In conclusion, when bobbing for tasty investments, work just as hard to avoid the losers as to find the winners. Over time, the winners will take care of themselves.