I have put together a brief guide for you to use when conducting due diligence on small cap stocks.
When analyzing a stock, there are essentially two different approaches that an investor can take: Fundamental Analysis and Technical Analysis. These are the two major schools of thought when it comes to investment analysis, yet they are at opposite ends of the spectrum.
When conducting due diligence on a small cap stock, the best approach to use is a thorough analysis of the fundamentals of the company in question, otherwise known as fundamental analysis.
FUNDAMENTAL ANALYSIS (FOR VALUE INVESTORS) refers to the analysis of fundamental aspects of business like financial statements and financial ratios and other factors like economic and others affecting the business to analyze the fair market value of its share/security. This method involves determining the fundamental drivers behind the value of an investment. If you are a long-term value investor, then you will be using fundamental analysis to evaluate potential investments.
TECHNICAL ANALYSIS (FOR TRADERS) Involves studying historical price data (charts) and using a variety of indicators (moving average, bollinger bands, RSI, etc. ) to predict future price movements. Technical analysts will analyze past trends and changes in price of shares by studying historical information of business. In other words, technical analysis is just a fancy term for ‘Charting’. If you are a day-trader or swing-trader, you will be using technical analysis to time your entries and exits into and out of positions.
While these two approaches have their differences, this does not mean there is no overlap. Some investors will stick to one method, but the best investors will use a combination of both technical and fundamental analysis.
Ideally, you should be using fundamental analysis for your stock selection process, while also implementing technical analysis strategies to aid in timing entries and exits.
FUNDAMENTAL ANALYSIS - HOW TO DO IT?
The first step in your stock selection process should always be a thorough analysis of the company in question.
A comprehensive fundamental analysis means gathering every available piece of information about a company, and more specifically, about the quality of the asset or business model, the share structure, and the people running the company.
For small caps, I use a three-step checklist and if a company does not tick all three boxes, then I will usually stay away.
☑ ASSET QUALITY / POTENTIAL ☑ MANAGEMENT TEAM ☑ CAPITAL STRUCTURE
1) ASSET QUALITY
The first step in our due diligence checklist starts with an evaluation of the quality/potential of the asset or business model in question.
There are a few different factors in determining the quality of a business model or asset.
Who are the main competitors? Does the company have a competitive advantage in the industry? A competitive advantage can be a result of a company’s cost leadership, product differentiation, or first mover status.
Does the company have a strong balance sheet? What is the current cash position? Any debt obligations?
Does the company have any erroneous expenses? Are the managers salaries reasonable salaries?
What is the valuation of the company?
For small cap investors, the two methods of valuation to know are: Discounted Cash Flow (DCF) and Relative Valuation.
DISCOUNTED CASH FLOW MODEL (DCF)
In essence, a DCF model estimates the value of an estimate using expected future cash flows and discounting those cash flows to the present. Discounted Cash Flow models are quite complex and require a deep understanding of a company’s financial statements.
A much simpler and more convenient way to get a company’s valuation is to use a relative valuation model...
RELATIVE VALUATION MODEL
Relative valuation is the notion of comparing the price of a company to the market value of similar companies.
To do this we need to use relevant multiples (P/E, EV/SALES, EV/EBITDA, etc.).
The multiples used in a relative valuation model must be a relevant proxy for a company’s value. For example, we cannot compare the average age of employees of different companies to determine their value, that would make no sense. We need to use metrics that are directly associated with a company’s intrinsic value, such as: sales, market cap, net income, and many others. Also, the companies we are comparing MUST BE RELATED in terms of industry and business operations.
Here is a very simplified version of a relative valuation model:
We are looking for the valuation of company E.
Let’s assume that companies A,B,C,D, and E are all in the same industry, this is called the “peer group”.
So, we would find the average P/S multiple for the peer group, which is 5.0x.
Now, we know that company E is doing $25M in sales. Thus, we take the average P/S multiple of the peer group (5.0x) and multiply by the sales of company E ($25M).
We end up with an implied relative valuation of $125,000,000 (5.0*$25M) for company E.
Valuation is as much art as science. Instead of obsessing over what the true dollar figure of an equity might be, it is most valuable to come down to a valuation range. For instance, if a stock trades toward the lower end, or below the lower end of a determined range, it is likely a good value. The opposite may hold true at the high end and could indicate a shorting opportunity.
Next up on our due diligence checklist is the management team.
2) MANAGEMENT TEAM
What to look for?
Look for management teams that have a track record of success in their respective fields.
An example of a management team/group that I like to follow is the AugustGroup, which is backed by billionaire mining entrepreneur, Richard Warke. In the last decade he has had a slew of successful buy-outs and has built up a strong network of managers surrounding him as well as deep-pocked, loyal investors. The likelihood of him succeeding again is probably higher than someone who has never done it before.
Also, look for management teams that have skin in the game, meaning there is a high % of insider ownership among executives.
Another thing to keep an eye on is insider buying/selling. The buys and sells of company insiders are all publicly available through the SEDI website.
What to watch out for?
Someone once told me that “Leopards don’t change their spots,” and it has stuck with me ever since. Pump and dump groups will always be pump and dump groups.
Look for stock charts that have fallen off of cliffs and have been dead ever since and STAY AWAY from groups or people associated with these deals.
3) CAPITAL STRUCTURE
Lastly, it is important to be aware of the structure of a deal and how the deal came to be.
Make sure to look closely at previous funding rounds and try to avoid companies that have issued a large amount of founders shares or penny paper.
Also make sure to look at the escrow release periods for any previous funding rounds. Usually, stocks will tend to drop on escrow release dates, as this is when previously locked-up shares will become free-trading.
RTO’s vs IPO’s
When a private company decides to go public, it basically has two options: Reverse Take-Over (RTO) or Initial Public Offering (IPO).
IPO's tend to be more costly and complex; however, as an investor I prefer RTO's due to the fact that there are no legacy shares available.
The table below compares the two options:
MORE ON RTO’s
During the RTO process, a de-listed company will enter into a qualifying transaction to acquire a private company and will then apply to re-list. Often times, companies will choose to take the RTO route when going public because it is more cost-effective and faster than the IPO route. In addition, a company going through an RTO has instant access to capital once the term sheet is signed.
However, RTO’s also come with downsides and as an investor you should be aware of these.
In RTO’s, there will be legacy shareholders from the de-listed company who will be holding shares, likely at a cost of pennies. There will also be shareholders from the private company who will have positions in the newly formed public company with a portion of their positions being 'un-escrowed'.
If the shares are not tightly held, investors can end up getting rinsed in a shell washout.
This is the case with every RTO and there is no workaround. The best private companies will not want to go public through an RTO unless they can find a shell that is tightly held and has a small number of outstanding shares.
The best shell structures and RTO transactions will also require shareholders from private rounds to agree to temporarily 'lock up' some of their shares through an 'escrow release'.
This concludes the SmallCapInvestor due diligence checklist.
Once again, if a company does not tick all three boxes, then it is probably best to stay away.