Reliq Health, Part 2: More symptoms…

RHT image

After publishing Part 1 of this analysis, I received a few more emails than I usually do, most of them negative. Most of them said something like “you are an idiot”, and while I can’t necessarily dissuade anyone of their opinion, I can say this: those readers probably misunderstood my intent. My intent was not to say that “Reliq is a bad company”, rather it was to communicate the idea that “mispricing and overvaluation happen more often than not, and here’s how to avoid getting sucked in”. Simply put, through my own experience, I’m hoping to show some folks what to look for so that they can avoid the next such debacle. For others, who have more experience and wisdom than myself, I will admit that I probably won’t be able to enlighten you. In that case, you need read no further.

In Part 1, I detailed the signs and signals that I used to exit my position, which although it was well into the money, could have been much more into the money had I waited longer   . For those of you that might have bought in when I was selling, or even later, you might be asking a similar question. Specifically, while I might be wondering “why didn’t I sell later ?” , you might be asking “why did I buy when it was so expensive ?”, or why did I wait so long to sell ?”. Ultimately, I can’t answer all of these, but I can provide some insight into how one might have read the signals a little better.

When I exited my position in Reliq, the three year chart looked like this:

RHT at Nov 27 2017

Obviously, with my crystal ball being out of order, I left a lot of money on the table. However, many investors started piling in after this point, which brings us to the why – or more specifically, why did other investors buy in ?

The typical financing process of a small cap company: To answer why others are buying when some are selling, it’s probably useful to explore the typical financing process of a small cap company. Unlike large companies, small caps are for the most part “undiscovered”. They are undiscovered and ignored for a number of reasons, primarily:

  • Recently, indexing has become popular, which ignores very small companies.
  • In Canada in particular, small cap is synonymous with mining & energy, which many investors avoid.
  • Small companies have no name (or brand) recognition.
  • Institutional money tends to come in late, when the market cap has expanded.

All of these factors are barriers to large amounts of money flowing into small caps, but the last point is perhaps the most important, and in the case of Reliq, the biggest reason why you (or someone you know) bought Reliq.

When a small company starts out, they obviously have to raise money, some of which comes from founders. However, they may go out to the public market to do a small  initial raise. As I mentioned in my first post, this is how I got involved with Reliq. The investors that participate in this raise are typically very risk tolerant, and understand that they may lose their entire investment. In turn, these initial shares are usually relatively inexpensive (usually under $0.50), which gives these early investors leverage – if things work out.

As the company starts operating, it will end up following one of two potential paths:

  • Things muddle along, or don’t go well: The company may still be trying to find out what it wants to do when it grows up, or it may have figured that out, but is just burning cash too quickly (this is likely where Reliq is). The company, recognizing the need for further capital, has an interest in raising that capital at the best possible prices. Good press means the price stays strong, and attracts investors. The “formula” is basically: New idea (or good idea) + good press = increasing investor interest = the ability to raise capital at higher prices. 

 

  • Things go well. The company starts becoming profitable relatively quickly, so much so that it becomes self financing. When this happens, it may or may not draw attention to itself through press releases, and the share price may (or may not) move significantly. If the share price does not move significantly, it may provide an attractive entry point, assuming there is a disconnect between price and perceived value. Mostly importantly, because the company does not require extra capital, it does not engage the investment banking community. It then typically disappears from investors radar, as only the most savvy retail investors find it, and institutions likely ignore it. Institutions ignore it because the market cap is likely too small, and trading is too illiquid. The next time it makes a significant splash in the press is usually when it is acquired at a significant premium to the normal trading price. 

For many of you, I am willing to bet more than a $1.00 that you found Reliq via the first path, not the 2nd. From the emails that I have received, most investors have suggested that they are “down significantly”, which means they acquired Reliq at prices north of the current (October 22nd) price of ~ $0.60.

So the First Red Flag I’m trying to highlight here is excessive press. You may recall that in my first post, I started to think about unloading Reliq in the latter part of 2017. Not surprisingly, Reliq had lots of coverage from the investment community at that  time (and later), as one can see from this snapshot of the BNN website.

Reliq BNN shot

At the same time that institutions are starting to sing the Reliq song, retail stock message boards start going bananas. The screenshot below shows a flurry of activity on the Reliq message board in late 2017, which likely only became more intense as time wore on.

RHT stockhouse

This kind of coverage & discussion is great for momentum, as retail investors pile on while the broader investment community provides the impetus that the retail investor needs. A retail investor at this time would have been looking at the chart, and would likely have been gripped with the thought that “I’m going to miss this one”, which is only driven home by the voice of brokerages and institutional investors. Those institutional investors may or may not have interest in the long term story, but they can finally participate in the action as the market cap is getting bigger (which is what they need) and increased liquidity allows them to move in or out more easily. Lastly, the increased number of eyeballs on Reliq also provides for an opportunity to raise capital, which is exactly what happened:

RHT financing 2

RHT financing 1

So, for many of you, the coverage from analysts and/or retail investors was likely the “push” that got you to buy into the Reliq story, and the takeaway from all of this is a lesson your parents might have imparted upon you as a child: be wary of that kid that’s always telling you how awesome they are. That being said, many of you are frowning right now, wondering if maybe I’m throwing out the baby with the bathwater. Which is why we’ll move on to our Second Red Flag, which will require that we look behind the scenes.

So let’s assume that you, like many, thought that Reliq offered compelling value, and you bought in at $1.00 in late 2017, approximately the same time that analysts were covering it. At this point you wouldn’t have known it, but you could have done quite well. In fact, you would have had no less than nine months during which you could have unloaded Reliq for prices well over the (assumed) $1.00 purchase price. During this time an investor would have had no less than four distinct sets of financial statements to guide their decision – and in those financials, he or she could have seen the writing on the wall.

Below I have taken data from the four sets of financials issued, starting with year end financials for 2017 (released on October 30th 2017),  to the most recent 9 months released on May 30th 2018. Rather than show each of the financials in detail, I am simply showing key data that I believe communicates the story. Additionally, one should be aware that all income statement and cash flow information for quarterly financials has been annualized. So, when you see revenue of $2,274,622 for the period ending December 31 2017, this is actually the total for the 6 months of $1,137,311 x 2, which provides us with a rough forecast for what we might expect over the full year. While this is imperfect, it provides us with something directional.

Reliq 4 statements.PNG

Investors who were doing their homework noticed the following:

Revenue is growing: Absolutely. Revenue continued to trend up each quarter, which every investor loves. Nothing to complain about here.

Cost of goods & gross margins are staying healthy: COGS, after strangely disappearing in Q1, resurfaced, but managed to stay fairly constant at ~ 20% – 25%.

Expenses are out of control: This is where the train starts to come off the tracks. Some investors apparently didn’t notice that while revenues were growing each quarter, expenses were growing even faster – and every passing quarter was looking worse.

Net income is getting worse with each passing quarter: This is probably redundant, given our statement about expenses, but if some investors didn’t look at the expenses in detail, they should have noticed that net income wasn’t improving.

So with the income statement firmly in the penalty box, one might have turned to the balance sheet, which actually stayed quite clean. On the balance sheet, all the action happens on the asset side of the ledger.

Cash is growing – for the wrong reasons: Without a doubt, Reliq managed to grow its cash balances, but only because of capital raises. Each new round of capital diluted previous shareholders, but did provide some de-risking to the balance sheet. Investors that bought in to Reliq were getting the signal that “you are being diluted, and the company has to perform that much better in the future”.

Accounts receivable start ballooning: As we all know, this is what popped the bubble recently. While growing receivables by themselves are not necessarily an issue, they have to be viewed in the context of total sales. In the case of Reliq, this issue first shows up on the statements issued February 2018. At that time, Reliq had billed a total of $1.1 MM in the six months of operations ending December 31 2017, or approximately $2.2 MM if one were to forecast for the full year. Of the total $1.1 MM billed, approximately 75% was waiting to be collected. By the time the next quarterly statements were issued, this percentage had increased to 87%, as receivables totalled $1.99 MM on total sales of $2.27 MM. Not good.

With the balance sheet offering up little comfort, other than a large cash balance, an investor could have turned to the cash flow statement in hopes that something positive might turn up. Unfortunately, that was not the case.

Operating cash flows, including and excluding working capital, are negative: The only saving grace is that on the final statements released May 2018, total cash burn suggests that Reliq could operate for somewhere between 2 and 6 years, if it continues to burn cash at the same rate, which is why this section is amber instead of red.

Valuation continues to climb: Lastly, under the cash flow information, I inserted a table to show how the increasing share count of Reliq and the increasing price continued to signal a risky proposition. For example, by the time Q2 financials had been issued, investors had the opportunity to sell Reliq (in March of 2018) at prices between $1.63 and $2.62. Even at the much lower average price of $1.44 during the preceding months, the valuation of Reliq suggested that it had to hit approximately $4.4 MM of EBITDA for the year to be valued at a very rich EV/EBITDA multiple of 30x EBITDA. Given the actual state of the six month financials, this would require an astronomical jump in revenues.

So, while I started this section saying we would investigate what I considered to be the Second Red Flag, I guess in actuality it was one big flag made up of lots of little ones. That being said, there are some among you that might be thinking that the financial statement information is a lot – an awful lot – to go through. So, with that in mind, I’d suggest that there was a Third Red Flag that was probably easier to read.

Back to the chart: I have stated before that I am not really a technical kind of guy. However, I still do pay attention to technical factors,  as I believe there’s information to be found both in the technical and fundamental information.

The problem with charts is that most of us only have the chart today, when we really need the chart from yesterday. What I mean is that if we look at a chart of Reliq today, hindsight tells us that we should have sold. The trick is interpreting the signals when they are happening, not after. With this in mind, I have re-created what the chart of Reliq would look like at four different intervals. Please note that since I am not a “hard-core” technician, the charts I show provide only high and low price, volume, and the 10 and 30 week moving averages.

December of 2017: Congratulations! You are now a Reliq shareholder, at the bargain price of $1.00. Like many of us, you are a busy guy (or gal), so you don’t have the time to poke through financial statements. With this in mind, you decide to take a look at the 1 year chart of Reliq, which looks like this:

RHT Dec 16 to Dec 17.PNG

All the action is off to the right side of the chart, and there are three key things that I would takeaway from this chart:

  • Both high and low prices (darker blue line and green line) are leading both of the moving averages, and have been since approximately August of 2017.
  • Both of the moving averages are nice smooth lines, which are starting to crest upwards, after having been basically flat for a year.
  • The 10 week moving average is leading the 30 week moving average, which simply confirms that recent prices have been strengthening.

This chart says good things, and if I see a chart that looks like this and the company has reasonable fundamentals, I typically try and buy as much as I can. So at this time (December of 2017), this chart is what I would call all green. 

March of 2018: Wow – this thing keeps on going. You may want to think of taking some money off the table, as you have now doubled your original investment. The chart is basically a stronger version of the previous one – all systems are go.

RHT Mar 17 to Mar 18

Key points that are worth mentioning here (as of March of 2018) are as follows:

  • High and low prices have continued to lead both moving averages, and there is only one instance where price threatens to break through the 10 week moving average.
  • As the price continues to climb, price volatility has increased a bit.
  • However, overall, the comments from the previous chart are still valid here. Things are still pretty green. 

June of 2018: Storm clouds are on the horizon, as price has slipped, and things are not looking quite as rosy. If you haven’t taken any profits, you may want to consider doing so, as this chart is flashing red. 

RHT Jun 17 to Jun 18.PNG

Unlike the previous two charts, you are now seeing a different story play out:

  • Other investors have gone through the most recent statements, and are worried. Selling is starting to happen, and high and low prices have broken through both moving averages, which is usually bearish.
  • The 10 week moving average is pointing firmly downward, while the 30 week moving average still has bit of upward momentum.
  • This chart is telling you to either sell or pay close attention in the coming months, if you aren’t already. That being said, one could still sell out at prices well over $1.00.

October of 2018: You will notice that this chart only goes up to October 1st 2018, not the 16th, where the real action happens. However, this chart, like the previous one, is telling you to move on.

RHT Oct 17 to Oct 18.PNG

While there is a short recovery in late June / early July, the bulk of this chart communicates the following:

  • Price has been trending down, and has been firmly below both moving averages since August 2018.
  • The 10 week moving average is clearly pointing down, and the 30 week moving average, having come off its peak, is starting to do the same.

This chart, which preceded the October 16th announcement, is telling you to “sell” in no uncertain terms. 

So even if all the other signals escaped ones attention, the story told by the charts, the Third Red Flag, was there to see without looking at press releases or financial statements. The key, as always, was to be paying attention and to not let hope guide ones investment decisions.

 

When I started this series, I indicated that Part 1 would be about how I determined to sell Reliq (unfortunately, too early), and that Part 2 would be about how others might have read market signals to avoid the significant decline in share price. After posting Part 1, not only did I receive emails telling me how abhorrently stupid I was (that’s ok, I have thick skin), but some emails asking should I sell ?

 If you are still holding Reliq shares, and are wondering what to do with them, I would say this. Bear in mind that I’m compelled to issue the usual caveat that I am not an investment advisor, simply an independent investor. That being said, what would I do ? 

Very simply, based on my investment style, all the information that is available to me today, and my experience, I would not be a buyer of Reliq today. In it’s current state, it does not fit my investment philosophy. That being said, I will continue to watch it. For you, your decision to hold, buy, or sell should be based on:

  • How risk tolerant you are. If this meltdown has cost you a lot of sleep, then it may make sense to unload the shares.
  • Your time horizon. Are you trying to make a profit in a week, a month, a year, or 10 years ? It is always harder to be right in the very short term.
  • Are you working with a lot of capital ?  If you have a lot, then this loss shouldn’t impact you severely and you could continue to hold – and hope.

The bottom line is that Reliq is now firmly in the penalty box, and will find it more difficult to raise capital, so it very much needs to remedy its problems. If it does make a dramatic turnaround, meaning that it significantly increases revenues and actually collects on those revenues, then we will see a dramatic run up in share price. However, if Reliq simply “muddles along”, and there is no significant uptick in revenues and cash flow, then the share price is likely to stay flat or drift lower.

As always, these are only my thoughts and opinions. Let me know if you found this post informative, or if you just have questions or comments. I can be reached at: greyswan2@gmail.com

 

 

 

 

 

Pioneering Technologies: Post Mortem?

PTE logo

For those of you that have been following this story, you have either thrown in the towel, or are curious as to whether or not this company is alive (or not). Since publishing the initial four part series back in June of 2018, the share price of Pioneering has managed to shed even more value. Anyone that purchased in June of 2018 (or prior to Q3) has lost money, and in no small measure.

Recently I received an email which was basically a “what now” kind of query. Which is why I am following up with this post. For ease of reading, and so that readers can skip to those areas that are of particular interest to them, I’ve decided to follow a point form format. Here goes….

Are you (Grey Swan) still long on PTE, and have you purchased more ? Yes, I am still long, and I have (at these prices) purchased more.

OK. You are still long, and have bought more. Are you insane? That depends on how you view your investment horizon. I tend to have a long hold period (less than 2 years is very short for me), and have held things as long as 10+ years. My most successful investment spanned an 8 year period. During that time, depending on when I might have sold, I could have lost ~ 65%. When I did eventually sell, I ended with a 1200% gain on the entire position, and that was before the shares peaked. The final tranche of shares that I sold realized a gain of 2600%. All that is to say that I am “crazy” by the standards of those who have short investment horizons, but perhaps not crazy for those that have long time horizons.

Why did I buy more shares ? The company is, without a doubt, missing short term revenue targets, and the market is punishing it severely. However, a quick rundown of the Q3 financials provides the following information:

  • There is no debt on the balance sheet: No debt means that insolvency risk is about as close to zero as one can get.
  • G&A expenses have remained static: Total G&A expense for the 3 and 9  months ended June 2018 was $1.5 MM and $4.5 MM respectively. One of the things I was looking for in these statements was no further growth in G&A. The fact that both of these, when extrapolated over 1 year, end up at the same place ($6.0 MM) is a good thing. This suggests to me that the G&A structure is basically “in place”, and that we hopefully shouldn’t see further growth in overhead.
  • Cash + short term investments aren’t all gone: The company has $5.7 MM in cash and short term investments. For the 3 months ended June 2018, they burned $1.07 MM, and for the 9 months they burned $2.02 MM. If we assume they continue to burn cash (and essentially cannot sell significant product volumes) at the 3 month burn rate, then they will use up their entire cash position in about 16 months. If this does indeed occur, then I will be losing a significant amount of money, and I will be eating more than my share of humble pie. However, I believe management is highly incented to make sure this does not happen. Which brings me to my next point.
  • Management still owns a significant number of shares: If you add up the 5 largest holdings of individual insiders (Dueck, Paterson, Pavan, Callahan, & Shah) they total ~ 23 MM shares, or about 35% of the fully diluted share count of 64.5 MM shares.  While it is probably true that these guys are all (likely) wealthier than you or I, they too have “felt the pain”. Collectively, this group of insiders has “lost” a combined ~ $31 MM ($1.50 peak price – $0.15 price today). You can imagine that they are likely very interested in seeing the share price move back in the right direction.
  • UL 858 compliance isn’t sexy: When was the last time you were at a cocktail party and someone wanted to talk to you about “a safer stove”. My guess is never. The concept that PTE is selling (kitchen fire safety) and the niches that it is targeting (Seniors, University, Co-op housing) are boring. Consumer awareness of this issue is still close to zero, as “compliant” stoves likely won’t show up in showrooms till some time in 2019. This story is not blockchain or cannabis, and that being the case, many investors will not become re-engaged with it until the financial results start telling a different story. In the meantime, I would expect that we will see a flat-lined technical chart at best.
  • UL 858 compliance isn’t sexy, but someone is still noticing: There were three recent press releases regarding partnerships with HPN select (purchasing group for Co-op housing), Millers Mutual (insurance company providing insurance discounts), and Buyers Access (purchasing group for multi-family housing). I would imagine that large organizations such as these don’t sit around and draw straws to see “who should we  partner with” or “what should we provide an insurance discount for”.  These are decisions that have to pass through various levels of decision making before they get the green light, and only then after they determine that this will also be good for their organization, not just Pioneering.  When the purchasing group you deal with carries a product, you (as a multi-family landlord) are far more likely to buy it – which in the long run means more sales. 
  • The opportunity is still there: If you do a quick Google search on “how many multi-family housing units in the USA” you will get a number of different answers. If you believe the U.S. Energy Information Administration, the number is around 16.5 MM, and that was in 2005. If you think the National Multi Housing Council is right, then the number is 17.8 MM. For the sake of clarity, these number represent the number of buildings that house 5 or more units. If you are include all rental stock, then this number is closer to 40 MM. These units aren’t going anywhere anytime soon – they are still sitting there. Granted, everyone won’t want to buy a “Smart burner”, but it stands to reason that some will.
  • The company is priced for oblivion. Right now (Q4 2018), at a share price of $0.14, the company has a market cap (using basic shares outstanding) of $7.2 MM. Adjusting for cash on the balance sheet, this implies an Enterprise value of $1.5 MM. If the product that Pioneering is offering is truly useless, and nobody wants to buy it, then this valuation is correct. In turn, if that is correct, then organizations such as HPN Select, Buyers Access, and Millers Mutual have made some very poor decisions. However, my guess is that someone out there finds value in the concept of reduced risk of fire, and in turn, a reduction in related issues such as false alarms and property damage. Like a lot of other shareholders, I’m just going to have to wait.

As always, these are only my thoughts and opinions. If you have questions or comments, I can be reached at: greyswan2@gmail.com

 

 

 

 

 

 

Need vs Want: Or why your neighbours are drowning in debt

A recent article caught my eye today with some glaring headlines: “Canada’s middle class is on the brink of ruin”. Pretty dismal stuff, but unfortunately, probably true.

When I was a kid, I have a very distinct memory as it relates to debt. Debt was something that was considered with great deliberation. Typically, one used it to purchase very significant things – homes, and in the case of my father, machinery that helped him do his job. Other than those situations, it was to be avoided at all costs. The concept of debt was inherently negative – one was exposing oneself to risk, so a great deal of thought went into the process before the paperwork was signed.

However, I do recall one time that my parents broke this rule, and it was a result of my insistence. We were shopping for clothes before going back to school, and my mother and I were waging a cold war. She had a pair of jeans in hand that fit, but weren’t “cool”. I had in my hand a pair of jeans that would cement my place within the grade school pecking order, and they fit. The choice was clear, to me at least. I insisted that the un-cool jeans simply didn’t fit, but my mother saw right through me. Nonetheless, she eventually relented, and with a great sigh, pulled out the credit card. I remember her reluctance to do so, and the memory stayed with me for a long time: she was going out on a limb for a non-essential item, and it was a big deal.

In 2017, this little anecdote is quaint – but unfortunately, that’s all it is to many people. Credit today is two things – easy to get, and easy to use. Because of this, we confuse the concepts of “want” and “need”, something which gives me instantaneous migraines. When I hear someone close to me say “We need to buy a new…” , I know the statement is almost always incorrect. In some cases, we do need something. For instance, when the neighbour’s kids accidentally nails our window with the soccer ball, we do indeed need a new window. But in almost all other instances, what is really being said is “we want a new car”, or “we want a new toy”. With the easy availability of credit, the concepts of “want” and “need” have become so muddled, that many people are unable to really differentiate between them.

The linked article goes into much greater detail than I can provide (or want to) here, but it’s the confluence of easy credit and “keeping up” that keeps people chained to jobs or careers they despise. The net effect is a large segment of society that might not be living that healthy of a lifestyle. How happy can you be when you get up to go somewhere that you don’t want to really go? You try and make yourself feel better via some retail therapy, thereby guaranteeing that you will go back to your job or career tomorrow. In the meantime, you are likely unhappy, and your family is suffering the fallout. Perhaps Mom & Dad are both doing this. Wow – what an awesome environment for the kids.

Don’t get me wrong – I’m not against working. I believe it’s important to find something that engages the mind and the spirit. We can’t all sit around gazing at our navels. But when we begin to dislike (or despise) our work, and are working only because we are desperate to keep up with payments, something is going to bust. Many people begin their careers with noble intentions, but get derailed by buying things they can’t afford, which turns the tables on them. The individual that once showed up at the office because they wanted to pursue a particular career is now showing up because they are being pursued by an unsustainable debt load and lifestyle. The job or career that was once a choice is now a necessity, and if it goes, the house of cards collapses.

So, you might ask, what is the point of this rant? I think it can be boiled down to some fairly old-school wisdom, which I’m sure everyone has heard before:

  • If you really need something because it’s a necessity, buy it. You have to eat.
  • If you want something, ask why? What happens if you don’t have it?
  • When you go to work, remember: you are trading your life for money. You can’t get more life.
  • Since you are trading your finite life for money, try & do something you actually like.
  • Lastly, spend money wisely. You traded your life to get it, so you are really “spending your life”.

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.

Grey what ?

Some of you might be asking this question, concerned that you’ve stumbled onto some really weird bird watching website. Well, don’t worry. This website might yet be weird, but it’s definitely not about bird watching.

Some time ago, I read a book that you might be familiar with, “The Black Swan” by Nassim Nicholas Taleb. The gist of the book is this: that in life, and particularly in the finance world, we as individuals are beholden to impactful & unpredictable events. While we often think we can predict what will happen, we are simply bad at predicting, or we characterize our predictions incorrectly. The net effect is that we, believing we can predict outcomes, get blindsided by what we can’t see, can’t understand, or just don’t understand properly.

These unanticipated events are “Black Swans”. The title refers to the fact that at the turn of the century, people believed all swans were white because no one had seen a non-white swan. The fact that a breed of black swan was eventually discovered highlights the fact that if one has never experienced something before, it doesn’t mean it can’t happen.

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