Through the micro cap looking glass

Martin Pretty

Equitable Investors

If you are going to venture into micro cap stocks, you need to be wide awake to the fact that there are two alternate universes for the one market segment.

There is the conventional world where investors buy and sell interests in businesses that are striving to create value for their shareholders, some with greater success than others. Some of them are supported by institutional investors and reputable brokers, many are not.

But on the other side of the looking glass is an intriguing alternate universe where everything looks familiar yet, on closer, inspection, left is right and up is down.

In this alternate reality, companies make sensationalist announcements that have limited relevance to their prospects but nevertheless are released in the hope they prop up the share price. Stock prices rapidly rise because a company needs to raise more cash or an insider is selling, not because the company is having success and its fundamental value is improving.

In this alternate reality, form wins out over substance, facts and reality are a casualty. But only for a period of time.

How can you know which side of the looking glass a small stock is?

Firstly, let's set the scene:

  • There are over 2,000 listings on the ASX.
  • Nearly 1,400 ASX listings have market caps of less than $300 million, qualifying them as micro caps according to one of several competing definitions.
  • Around 1,000 of these micro caps have not generated a minimum of $5 million revenue over their last 12 months of reported financials.
  • Less than half of those companies with at least $5 million revenue have broker research coverage.
  • Nearly 80% of all micro caps do not have research coverage.

Investors have an oversupply of stock codes to consider and know that a portion of these codes aren't worth spending time on. As a result, there's virtually a whole ecosystem now devoted to generating a buzz and invoking FOMO (Fear of Missing Out).

"In our country"

"Well, in our country," said Alice, still panting a little, "you'd generally get to somewhere else—if you run very fast for a long time, as we've been doing." - Lewis Carroll, Through the Looking Glass

The conventional micro-cap world should look something like this:

  • Committed & passionate insiders seek the support of capital providers to further their vision.
  • Founders, executives and directors collectively retain a meaningful shareholding in the company that was paid for or earned as they pursue their vision.
  • Companies communicate meaningful news in a timely manner and executives and directors are available to explain their activities and progress to investors.
  • Founders who wish at some point to reduce their exposure and diversify their investments sell down progressively on occasions when there is no negative material news pending and with the intention of leaving something for the next holder. 

Through the looking glass

  • Promoters use other shareholders' funds to pay 100% of the acquisition of the operating business or businesses then gifts themselves a large free shareholding as part of the IPO process.
  • Companies manufacture announcements and sensationalise immaterial events, paying small shadow broking firms, social media influencers and others to generate excitement.
  • After generating hype not based on business fundamentals in order to drive up a stock price, the company raises capital at a "discount" to the recently inflated price and founders sell stock as part of the deal.
  • Promoters package up a "look-alike" company that is supposed to replicate a recent success story because it is hoped it will appeal to investors hoping for a repeat success.
  • Excessive fees permeate the business with insiders and promoters drawing fees at a variety of levels in the corporate structure.

When reality catches up

“Now, here, you see, it takes all the running you can do, to keep in the same place. If you want to get somewhere else, you must run at least twice as fast as that!” - The Red Queen in Lewis Carroll's Through the Looking Glass

The problem with playing the market on the other side of the looking glass is that the approach is generally unsustainable. An investor might survive by being nimble and a little lucky trading on momentum. Timing is never obvious but companies focused on perception over business fundamentals ultimately find the fundamentals catch up with them. Just look at some of the following examples:

  • An IPO in calendar 2018 in which the promoters took a “free-carry” of around $37 million worth of stock (at the IPO price) as the reward for bundling together a bunch of acquisitions to be paid for with new shares and cash from IPO investors - and the promoters also packaged in the sale for a nominal $1 to the IPO vehicle of a company that owed the promoters $5 million. The promoters argued their freely gifted shareholding aligned them with investors but in reality, the share price could fall 75% and the promoters would still have done extremely well while IPO investors were nearly wiped out. Needless to say, write-downs and earnings downgrades have followed and its stock price has plunged. 
  • A bold proclamation this month from a loss-making company that it "achieves 85% EBITDA improvement" when the actual EBITDA figure referred to, for one month, was a loss, albeit a smaller loss than a year earlier, and there was no mention of the level of sales growth. This is just another in a long series of positive sounding announcements released at a rapid pace but, despite that, the company's share price is now one tenth of its high point in 2017.
  • A company with virtually no revenue and a market cap less than $10 million asks investors to throw in another $1.5 million, which looks like enough to keep it alive for six months, allowing executives and directors to continue to draw income while they think about the next step to keep the gravy train going.
  • This week we witnessed alternative investment manager Blue Sky fall into the hands of the receivers after allegedly engaging in a range of unsustainable activities that helped fuel expansion of its market cap from ~$30 million in 2012 to ~$640 million in 2017. Notable allegations were that it overstated the scale of its operations and aggressively valued unlisted assets. Its founder, meanwhile, had cashed in ~$27 million in a share sale in August 2016.

"Remember, you can fool some of the people all of the time. Those are the people we need to concentrate on", says a man in suit and tie to his colleagues in a sketch by cartoonist Mike Shapiro for New York hedge fund manager David Einhorn's similarly-titled book, Fooling Some of the People All of the Time.

One of the lessons Einhorn discusses in that book is that even when you have done your research and you are confident something is wrong with the company, the market and regulators may not react for months or years - a potentially painful "eternity" if you are a hedge fund manager with a short position. But for everyone else, simply avoiding the problem and moving on to the next stock code is a quick win.

Equitable Investors

Martin established Equitable Investors and the Dragonfly Fund in 2017 after serving as an investment manager with Thorney Investment Group. Equitable seeks out unique opportunities with intensive research and constructive corporate engagement

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