Tips for Investing in Small-Cap Stocks

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In this podcast, Bill Mann, director of small-cap research at The Motley Fool, joins Motley Fool producer Ricky Mulvey to discuss:



Tips for Investing in Small-Cap Stocks


© Provided by The Motley Fool
Tips for Investing in Small-Cap Stocks

  • How to think about allocation for smaller companies.
  • Key small-cap metrics to watch.
  • Boring businesses that warrant more attention.
  • A closer look at a real estate brokerage, a coffee supplier, and a Bitcoin holding firm that masquerades as a software company.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

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John Mackey, former CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Bill Mann has no position in any of the stocks mentioned. Chris Hill has positions in Amazon.com, Chipotle Mexican Grill, and Trex. Ricky Mulvey has positions in Kroger, Netflix, Redfin, and Trex. The Motley Fool has positions in and recommends Amazon.com, Bitcoin, Chipotle Mexican Grill, Netflix, Redfin, and Trex. The Motley Fool recommends the following options: short February 2023 $7 calls on Redfin. The Motley Fool has a disclosure policy.

  

This video was recorded on Jan. 14, 2023.

Bill Mann: I think that what you really want to do is focus on companies that seem to be doing want-tos, as opposed to has-tos. You will see companies out there that are smaller companies that are going out and they are investing, they’re investing in new factories, they’re investing in new initiatives. They are actually showing you that they have some financial strength.

Chris Hill: I’m Chris Hill and that’s Motley Fool Senior Analyst Bill Mann. He’s also the head of Small Cap Research here at The Motley Fool. Ricky Mulvey caught up with Bill to talk about how to narrow your search for small-cap stocks, key metrics to watch, why boring businesses can make great investments, and one business that deals in the sexy world of rust prevention.

Ricky Mulvey: These are the companies that are harder to cover on the show because…

Bill Mann: Yes, exactly.

Ricky Mulvey: I mean, we’re not talking about Amazon and Netflix as much. These are the waters that institutional money dare not fish in.

Bill Mann: That’s exactly right. That’s why small caps are a place where every investor should try to pay attention, because it’s not easy.

Ricky Mulvey: Before we dive to some of the individual names. If you’re a beginner, how do you approach capital allocation for these companies? If you’re investing, like this is not your 401(k) money necessarily, but you’re saving a couple of hundred bucks or 100 bucks every month and you’re looking to invest in some stocks. How do you think about investing in small caps with that budget in mindset?

Bill Mann: One of the things I think that a lot of people tend to get wrapped around with small caps is to think of them as being higher risk because they are smaller companies and they think that if you’re buying a small-cap company, that you are buying a pre-revenue company or a company that has something wrong with it. Small-cap companies are not the dent-and-scratch section of the market, they are simply companies that some of them are newer, but some of them are just simply smaller. But you have companies that are household names that just happened to be smaller. When we first started running the small-cap service at The Motley Fool, we put Chipotle in there. Now Chipotle is a multibillion-dollar company now, but it was at the time a very well-known company that was on the rise, so I think when you’re thinking about small caps, maybe the best thing to do is to not be too fancy about it.

Ricky Mulvey: I don’t know if this is good news or bad news for you in small-cap land. But more companies are in the territory since we last did the show, a few months back, since then you got more to choose from.

Bill Mann: I think that’s probably bad news.

Ricky Mulvey: Since then it’s become more expensive to borrow money and I’d also say that investors have less patience for unprofitable companies where the real value is in the data and the friends we made along the way, let’s just say.

Bill Mann: Ricky, was there a question in there? I just was going on to tell you about my next thing.

Ricky Mulvey: Go for it. I have a question and I’ll get to it in a second.

Bill Mann: Okay. I think it’s really important to realize that when you go to business school, every MBA program, every stock analysis course starts with something that’s called the rational actor, and what is actually the case is when you have a large rise in the stock market, people tend to behave the same way and you have a large drop in the stock market, which we have had. People tend to behave in the same way as well and the way that they behave when things get bad is that they lower their perceived risk and so they move away from these exact companies, so yes there are more of them, there are more small caps. Some of these small caps, I think it should be said, our small caps on their way to zero. They may never come back to where they were before, but those are the types of companies that we need to be focusing on.

Ricky Mulvey: I mean, are there metrics that you’re paying closer attention to, for these smaller companies? I mean, for me a couple of the ones I’ve been looking at lately are maybe zooming in more on stock-based compensation and the current ratio.

Bill Mann: Yeah, I think stock-based compensation is something that you should always pay attention to in a very simple metric, and I know metrics are really, really great for radio shows, people love that. To be asked to break out, the abacus, but just as a rough estimate, just taking what their stock-based compensation costs were and comparing it to their revenues and then some companies, you’ll see it’s 40, 50, 60 percent. There are some companies where their stock-based compensation exceeds the amount of money they brought in, and not as profits but as sales, and you have to as in any case where you ask yourself why.

Is it because this is a brand-new company with a really whiz-bang technology and that’s just where they are, their cycle? Or are you talking about a company that is not particularly shareholder friendly and the management team is taking whatever it can regardless of outcome for shareholders? It’s definitely one with every measure, though, you need to put those things in context. I think one of the biggest things that you can look for with small-cap companies is you want a company that shows some growth in revenues, but at the same time not taking on a lot of debt.

Ricky Mulvey: Yeah, and that’s to clarify the current ratio is your current assets over current liabilities. I’m thinking if I’m doing some more, let’s just say speculative shots, that’s a way of saying is this company going to drown or be able to come up for air, if the economic cycle turns in a little bit.

Bill Mann: 100 percent. It has to be said that in the same way that your mortgage at your house doesn’t speak ill of you or your financial future, there is not much that is illegal, immoral, or fattening about companies that take on debt. But the thing that you need to ask yourself in every situation is, are they doing this because it is an advantage for them, or are they doing this because they have to? With smaller-cap companies, usually the margin for error is a little bit thinner, so if their current ratio shows a high degree of leverage in the system, maybe that’s a company that you should pass by and get your excitement some other way.

Ricky Mulvey: Maybe get to one of those in a little bit. Themes to watch. Right now when you’re doing your research, are you more interested in the comeback stories? Let’s just call them the dogs of the S&P 500 or the ones that haven’t reached that rarefied air yet?

Bill Mann: I think that when you come to a period of time that we’re in now, a lot of times in the market, the times that feel worst are the times that when you’re actually being given a gift. Because when people flee segments of the market, they don’t tend to differentiate between the quick and the dead. We saw this in 2022. What was the one segment that really did OK? It was the oil and gas segment, and that was because for years, people have just moved away from that segment of the market. I think that’s true now, so rather than just saying.

Well, these companies were the bottom end of the S&P 500, and now they are small caps. I tend to think of it this way. If we have, as investors moved in the same direction and we’ve moved against or away from certain sectors of the market or certain industries. What are the best-performing companies in that industry, and are they small, and have they been cast off in the same exact way? Because people are simply just trying to share risk and the good news in small caps, and it never feels like good news, is that’s something that when you see that there is a lot of opportunity out there.

Ricky Mulvey: It’s the reverse of real estate where instead of looking for what is it the worst house and a good neighborhood you’re looking for the best house in the worst neighborhood. 

Bill Mann: I’m doing real estate wrong, too. That’s what you’re telling me. 

Ricky Mulvey: The other filter I’ve been thinking about and love it when we get self-referential on here. But I had a conversation with Jim Gillies and Iain Butler a couple months ago about hidden moats. Jim described it as a willingness to claim a mountain that nobody else wants. Is that a good filter to you, like a couple of examples for me are like a company like Trex, which does composite decking of fake wood that doesn’t necessarily rot? Or like Graco, which just makes highly specialized fluid-handling equipment where you’re not seeing a lot of entrepreneurs on Shark Tank trying to get into those areas. Is that a good filter to look for small caps?

Bill Mann: Absolutely. One of my favorite companies ever is the WD-40 Company. You wouldn’t think of WD-40 as needing its own company because all it is a silicon spray. But it is a mountain that not only nobody else has tried to afford. They couldn’t possibly do it at this point because WD-40 has come to the top of the mountain. They’ve built a fortress. They’ve put a moat around it and they filled the moat with WD-40, which as you know, is slippery. There are absolutely companies like that and they don’t tend to be sexy. You go to a cocktail party and you say you’ve bought the WD-40 Company and people are going to look at you in a certain way. That way doesn’t seem to be one of admiration. Yes, it is absolutely the case that there are tons of companies that have those types of moats that are things that you should think about when you’re thinking about investing in smaller companies.

Ricky Mulvey: Well, it’s not just that I’ve been thinking more lately about like trying to recognize my biases as an investor. One of them is I just love story lines. It’s easier for me to shut out because I get producer brain so I can shut out a company where I’m like, yeah, that’s boring. It’s not that it’s a bad company. I just find it less interesting than digital advertising or media and entertainment.

Bill Mann: I’m having a hard time because I really do think since you’ve brought up Graco, or you said Graco?

Ricky Mulvey: Graco.

Bill Mann: I have no idea how it’s pronounced. I’ve only seen it written. We should call them. Fluid-handling equipment. What could possibly be more boring than that? But you know what’s not boring? The amount of money that that company makes. I think that there’s absolutely something to be said for the story lines that start with, why would someone be interested in that?

Ricky Mulvey: Speaking of nonboring companies. How about some of those platform tech companies? A lot of them have been coming back down to earth. I’ve been having a lot of debate, primarily with myself lately, about a company like Redfin, where it’s a company that in my mind has a real value proposition, which is that it’s cutting the 3 percent Realtor commission and building in a model where you have a company and sales agents that benefits the buyer and seller. But it’s also a platform e-tech company with a ton of problems going into a down real estate market that nobody knows when it’s going to end.

Bill Mann: Redfin, it is a company that I like and admire. I particularly admire their CEO, who’s a man named Glenn Kelman. I also admire the fact that they have built a really powerful brand. Because of the promise of lowering the realtor commission, of making them themselves to be a default substitute for what is a process that, let’s face it, everybody hates this process. You have Redfin, which right now is in a market that is retrenching. But I don’t think that you could suggest to me. Not even you Ricky would suggest that we are done buying and selling houses in this country.

Ricky Mulvey: People need to move.

Bill Mann: People are going to need to move. Maybe they don’t want to move as much as they did even a year ago because of interest rates or things of this nature, but they need to. You’re talking about a business that at its core has its own velocity. It’s just going to continue to happen. Redfin, they have made mistakes along the way and they’ve been very open about the mistakes that they have made. But through those mistakes and through those learnings, if you’ve got a CEO like Glenn Kelman, I think you’re going to end up with a very powerful platform that has a lot of advantages when things turn around.

Ricky Mulvey: Something that I’ll give him credit for because I’m about to not give him credit for a few things in the company, take credit away for a few things. Is their layoffs are terrible, and the way that Redfin has managed them versus their competitors, like there’s one real estate brokerage website that I don’t want to name. The CEO goes on CNBC and says, this is our third round of layoffs. However, I’m confident that this is the bottom of the market and things will turn around from here. Glenn Kelman does the exact opposite, which is, we’re doing layoffs. This is why, this could last months or it could be years. I don’t know. Part of the reason is because he was the CEO of the company through 2008, I think.

Bill Mann: Which are you saying? Which do you prefer?

Ricky Mulvey: What do you mean? I know I prefer the lack of confidence because I rather have a CEO that’s learned from history versus making a confident forecast.

Bill Mann: I completely agree. Now, I do think that CEOs know very well that part of their job is rallying the troops and speaking through their company’s strengths. But there is a sense of humility and probably a better way to put it is the sense of their own role in reality. It’s reality-based management, which you don’t see with a lot of companies. I happen to agree with you that that is something that you should absolutely admire about how he is making those decisions. You’re right, they’re painful decisions, and he doesn’t want to be where he is, but he’s not overselling what’s coming down the pike.

Ricky Mulvey: This is a company that’s got about $500 million in cash on the balance sheet, 1.9 current ratios. We continue that theme. As we continue this therapy session, the things I’m really concerned about, Bill, it’s still issuing too many shares. It’s got high stock-based compensation. You like companies where the leadership is tied to the masts of the company. This has relatively low inside ownership, where 3 1/2 percent of the shares outstanding belong to insiders.

Bill Mann: I think that those two things are especially with a small-cap company. I don’t think that you could go to a massive company like the person who is running IBM right now, you would not expect them to own 15 percent of the company. You would expect for the founder or longtime CEO of a small-cap company to own more than he does. Unfortunately, for companies that depend on stock-based compensation, I think you’re going to see a lot more dilution in 2023 than you did in 2022 because a lot of times what companies are doing, they’re saying, Ricky, your stock-based compensation last year was $50,000. This year we’re going to make it $75,000 because you’re incredible at what you do. But if the stock is down 40 percent, what you’re talking about is a number of shares that isn’t 1.5 as much. It’s three or four times as much across the board.

Ricky Mulvey: I should note that I do own stock in Redfin, but I have a ton of confidence there.

Bill Mann: Yeah. But, Ricky, if you can’t pick out the things that are risks or are negatives about the company that you own because every single company has them. Every single one. If you can’t do that, I don’t know that you’re thinking about it deeply enough.

Ricky Mulvey: Fair enough. But on the theme of inside ownership for these smaller companies, I mean, especially tougher business environments like right now, how do you see decision making change, whether it’s capital allocation, hiring, change, when your company insiders own a lot of the stock?

Bill Mann: It’s not so much that I can point to changes, what I tend to think that you see is more decisions that are optimized on the longer term in the same way that nobody puts premium gas into a rental car. I think that if the management team does not have that deep incentive of ownership of the company, there is a risk that they will make decisions that are much more short-term oriented and while we all love to see a stock go up very quickly because of short-term things, they aren’t necessarily sustainable over the periods of time that you would want that to happen.

Ricky Mulvey: I’m going to steal that line about premium gas in a rental car. One small cap that I want to check up on that I know you have more negative feelings on, but actually, you’ve predicted that they would do something on the show is MicroStrategy. It’s a Bitcoin holding firm that masquerades is an enterprise software company. Its CEO, Michael Saylor, had declared that it will never, not ever sell Bitcoin. It turned out that it sold more than 700 Bitcoins at an average price of about $17,000 late last year.

Bill Mann: Never came pretty fast.

Ricky Mulvey: Never came pretty fast. How do you see that one coming?

Bill Mann: They had to. I take Michael Saylor at his word that he doesn’t want to sell any of their Bitcoin, and I do think how you describe MicroStrategy is fairly accurate. They have almost no revenues from their software operations. It is a Bitcoin holding vessel is what it comes down to, but there’s also leveraged Bitcoin holding vessels so to the extent that they have to fulfill the terms of the debt that they hold. Sometimes those choices get taken out of their hands.

Ricky Mulvey: Margin calls, you tend to pick up the phone on those.

Bill Mann: Right. You’d best.

Ricky Mulvey: Well, I’ve been thinking about the story quite a bit because this is a leader where I’ve found some of my investor biases where I believed what the guy was saying about the future of Bitcoin. What was it? This is like owning blocks of Manhattan in cyberspace and there was such a confident and charismatic delivery with it that I didn’t buy the stock, but I found him credible and it’s one of those things where for me at least it’s been a lesson of don’t necessarily look for charisma and overdone confidence in your companies’ CEOs.

Bill Mann: I think it’s so important because you really do, and I’m not saying that someone who also happens to be really good at sales or at getting you to buy into what it is that they are trying to do is snowing you. I wouldn’t suggest that, but you do need to keep your cloak of skepticism up as high as you can when you are dealing with an incredibly charismatic CEO and whatever else it is that we think of Michael Saylor he definitely absolutely is that.

Ricky Mulvey: As we continue the theme of current ratios, MicroStrategy has a current ratio of about 0.8, and that’s basically the same as Kroger, but what are numbers without context.

Bill Mann: Exactly.

Ricky Mulvey: This wasn’t the theme of debt. Did you get a chance to check out Westrock Coffee?

Bill Mann: Yes, I did.

Ricky Mulvey: Westrock Coffee is another small cap that I wanted to check in on. We’ve had the CEO on the show and I think, well, it’s interesting because it went public via SPAC, but it actually has customers in revenue. Now, I avoided investing in it because I personally liked the CEO and I am noticing that bias where I recognized charisma and that thing and it could be totally wrong. I want the company to do well, and it has a real customer value proposition selling coffee and tea extracts to different quick-service restaurants, trying to build a facility to make ready-to-drink coffee. When you looked at it, what were your impressions of the company?

Bill Mann: Well, I have to believe that when you talk about small caps, you have to be a little bit careful because I spent a little bit too much time when you sent this over instead of looking at Westrock Coffee, I looked at the WestRock Corporation, which does corrugated cardboard and I thought, well, that’s an interesting sidebar company to go along with coffee, but they actually are two different businesses. I think that as you’re talking about any company that it’s in consumer packaging and I would really describe this as being a supply chain company, but they do provide their own goods, incredibly well capitalized.

It seems like the CEO is a man named Scott Ford and it seems very much like he’s got a great experience in the industry and the consumer packaging industry, so they’re not particularly brand driven so I actually think that this company is pretty interesting as one that, as you say, came public through SPAC, which while SPACs were neither immoral, illegal, or fattening, they were away for a whole lot of lower-quality businesses to get onto the public markets, but that absolutely doesn’t mean that all of the companies that came public via SPAC were lower quality.

Ricky Mulvey: If you’re fishing in these waters, you’ve bought a small-cap company. It’s probably more difficult now than it was 12 months ago to look at your investments. What’s your mindset advice right now if you’re fishing in these waters that institutional money dare not enter?

Bill Mann: I think that what you really want to do is focus on companies that seem to be doing want-tos as opposed to has-tos. You will see companies out there that are smaller companies that are going out and they are investing, they’re investing in new factories. They’re investing in new initiatives. They are actually showing you that they have some financial strength. It may not make the company look better over the short term because any type of an investment like that does in fact reduce their overall capital. But it may be a sign that they have a degree of confidence that you just can’t find from a company that just as a manager or a CEO who’s talking a big game, look for the quieter companies who are expanding in some ways seem like they’re being very smart about their application of new capital and I think you can find some winners if you really focused on that.

Ricky Mulvey: Something about being opportunistic when others are fearful.

Bill Mann: Yeah. That’s exactly it.

Ricky Mulvey: Bill Mann, always great catching up with you.

Bill Mann: Thanks so much, Ricky.

Chris Hill: As always, people on the program may have interest in the stocks they talk about and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Chris Hill. Thanks for listening. We’ll see you tomorrow.

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