Why pick stocks ?

There are a great many finance blogs out there, and many of them are clear when it comes to “active management”. Various studies have shown that active managers rarely beat the market indexes, so the question is clear: if the professionals are lousy stock pickers, why try to do it for yourself ?

For many of us, that’s the only information we need in order become index investors. Nonetheless, as the saying goes, “variety is the spice of life”, and my approach has always included an element of active investing. To be clear, I am not against indexing. Rather, I’m simply explaining why I still actively seek out and pick individual stocks. To be even more clear, I’m not suggesting everyone run out and do the same (I doubt you will). Think of this as a glimpse into my view of the markets. If it’s entertaining, then I’ve done my job. If you learn something, as unlikely as that might be, then even better.

I follow a two pronged approach in my investment philosophy. I have two “buckets” of money: shorter term liquid investments which I can use for anything, and longer term and less liquid investments which are distinctly earmarked for retirement. Note that short term money can migrate to the long term bucket, but long term money never migrates the other way. Once it is “locked in”, it stays there. I should also clarify that “retirement” means “golden years” kind of retirement. In the meantime, I may not be working a standard 9 to 5 job, but I am not retired either.

The long term bucket is, for the most part, invested in companies that show steady growth and pay steady dividends – think consumer staples (Kraft), pipelines (Enbridge), and REITs. In this bucket, I am far less active, but I keep an eye out for bargains nonetheless. For instance, when oil started to go into a tailspin in 2015, I didn’t look at oil & gas producers, but rather at the pipelines that transported the commodities. The market, acting as it sometimes does, decided that pipeline companies should also be re-priced, despite the fact that pipeline tolls are designed to largely eliminate commodity risk. In any case, this bucket is not unlike an index fund, as it typically holds very large and very stable companies that change very little over time.

It’s in the short term bucket that I am most active. In this bucket, I favor the very small, the misunderstood, and the ugly. When all the stars align, it can be all three. Some of you reading this may be nodding, and you are probably saying that this is a classic deep value approach. This is partially true, as I will explain.

Early in my investing career, I tried various approaches, with various degrees of success. To make a long story short, I discovered that picking large cap value stocks at steep discounts was more difficult than it appeared to be. While there are sometimes bargains to be had, the market tends to be efficient with big names. I also tried momentum investing, with little success, as my charting skills were poor to say the least. Finally, over time I realized what should have been obvious – that the smaller end of the market, and the very small end of the market, was where true inefficiency came to hang out.

At this point, I’m sure many of you are no longer nodding in agreement, but rather shaking your heads in disapproval. Dreaded penny stocks, the veritable scourge of the investment world, are vilified by many, and for good reason. Many of them are over promoted shell companies that are intended only to enrich insiders. However, some of them are real companies with real intentions on making a better mousetrap. The trick is to separate the wheat from the chaff, and then, to separate further.

When I look at these very small companies, I tend to look for specific things such as:

• A high level of management ownership that has stayed relatively steady or increased over time.
• Management that has deep pockets. Think of Tesla and the way Elon Musk has backed it.
• A company that is not just a resource or commodity company.
• A history of operations. I’m looking for a company that has been at it for a while.
• Low debt levels.
• A minimal amount of outstanding options or warrants that will create excessive dilution.
• A product that is relatively simple to adopt or implement, or clearly solves a problem.
• A strategic advantage with respect to relationships or location.
• Hopefully, a reasonable price to book value ratio.
• No analyst or investment banking coverage. The idea is to be the first person at the party!
• Lastly, a nice flat lined chart that indicates current investor sentiment is indifferent.

I may have missed some things, but this list encompasses the bulk of the factors I look for. Once I’ve found a potential company, I call them to see how approachable they are and to see if I can glean any more information. I call customers who use the product to ask about their experience with the company, and I call distributors who sell the product. I try and talk to anyone who deals with the company or uses the product to get a better understanding of how good or bad the product (and the company) is.

This process probably sounds time consuming, but I’ve come to consider myself a full time investor. This being said, I can assure you I don’t spend eight hours a day on the phone. Because the company in question is usually not a hot prospect at the time, the share price is usually fairly flat, so there is little risk that something material is going to happen right away. I will have these conversations over long periods of time, and will make notes accordingly. If the research turns up good information, I slowly add to my position. Rarely do I put in a large volume order, as with small companies, one can move the price quickly. Once I have a significant position, I monitor things – and wait, sometimes for a long time.

As you can imagine, this process is not for the faint of heart or for the impatient, so it tends to weed out those shareholders. But the payoffs, when they do occur, are well in excess of normal returns. While there is always the risk that a company can go bankrupt, thereby handing you a 100% loss, when these companies turn the corner, they pay off far beyond ones expectations. It only takes one to move an entire portfolio, as I discovered a few years after starting to pursue this “tiny ugly company” strategy. Over the period of 24 months, I watched the share price of one of my holdings move from under $0.20 to over $6.00. That single holding moved my entire portfolio significantly, and made up for everything else that was just plodding along.

So, at the end of the day, I’m an active investor almost entirely in the darkest, smallest recesses of the markets, as this is where one can truly find companies that may provide abnormal returns. By purchasing a basket of companies like this, risk is diversified. It’s not necessary for all of them to do well, or for that matter, for the bulk of them to do well. While I can never say that “XYZ Corp is going to go from $.25 to $100”, I do know that there is a reasonable probability that some of these will muddle along, some will go bankrupt, and one or two will perform beyond my wildest expectations. My job is to stay curious and keep looking for the small, the ugly, and the misunderstood, as these are the companies that will provide those abnormal returns over the longer term.