"The highest rates of return I've ever achieved were in the 1950s. I killed the Dow — I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that." —Warren Buffett
Warren Buffett once stated “I’d be a bum on the street with a tin cup if the markets were always efficient.” The statement represents Buffett's emphatic refutation of the Efficient Market Hypothesis. All serious value investors are aware of the fact that the long-term appreciation of their portfolios depends on their ability to exploit temporary market inefficiencies. The point I find puzzling is why so many value investors insist on doing battle where the competition is the most severe, specifically in the large-cap arena.
Allow me roll out yet another Buffett quote: "The important thing is to keep playing, to play against weak opponents and to play for big stakes." Where does one find these weak opponents? For the average investor, the low hanging fruit is found in among the smallest of the publicly traded companies. In other words, the best place to look for dramatically mispriced stocks is by examining stocks with very smallest market capitalizations. I came to that realization a number of years ago and that single epiphany is responsible the majority of the wealth which I have accumulated.
Market Efficiency and Microcaps
While no market is completely efficient, larger capitalization stocks contain a number of characteristics which allows their quotes to reflect a more accurate assessment of their intrinsic value.
These characteristics include:
1) High Liquidity
2) Significant Short Positions
3) Extensive Analyst Coverage
4) Options Available for Protection or Hedging Strategies.
5) Arbitrage Opportunities
6) Tight Bid/Ask Spreads
Few tiny companies possess the aforementioned characteristics; as a result, relatively small competition exists in accumulating the stock and in many cases, pricing efficiency is greatly reduced.
Typically, when a large stock is mispriced a combination of the above listed characteristics help to drive its price back to equilibrium. In most cases a typical investor must be extremely savvy to spot a significant mispricing in a large, complicated equity. The typical exception is when one is able to purchase stocks during periods of extreme market pessimism. Otherwise the investor had better have an intimate understanding of not only the business but also the economics which surround the business. In other words, he must be a good deal more educated and insightful than his competition in evaluating the stock.
In the case of most small companies, the 10-Ks are much shorter and the businesses are much easier to understand. It is much easier for an individual investor to uncover a substantial mispricing and it is much more likely that the market is not privy to the mispricing. Many times the market does not realize that a tiny company is materially undervalued until the stock has moved precipitously. Generally the low float of the company combined with increased volume alerts the market when the stock rises and hits the Price Percentage Gainers list. The stock then attracts momentum players which can quickly drive the price towards its intrinsic value.
Volatility And Risk Are Different
James Montier made a very salient point about the difference between volatility and risk in investing. According to the Capital Asset Pricing Model (CAPM), 2007 was a much safer time to own stocks than 2009. The reason is that the prices for stocks were much less volatile in 2007 than 2009. Of course the average investor who bought stocks in 2007 was crushed in the next two years while the average investor who bought stocks in 2009 experienced extraordinary gains. Such revelations led Montier to write a chapter entitled CAPM is CRAP, in one of his books.
Without a doubt, microcap stocks on the average are more volatile than their larger brethren. That said, in most cases they are not any riskier to own so long as the investor does his due diligence and is not forced to sell the companies when their valuations are at their lowest point. In other words, investors must be prepared to hold a tiny stock until it appreciates near its intrinsic value. If the investor is spooked or forced into selling during times of economic distress, he or she will almost invariably lose a higher percentage of their investment than they would have, if they had invested in a larger less volatile stock. To paraphrase Buffett, you should not invest in stocks if you are unwilling to watch your capital depreciate by 50 percent in value without becoming unnerved.
It is worth noting that small stocks tend to drop more during times of extreme market pessimism. On the other hand, these periods provide investors with a chance to buy tiny companies at extremely favorable prices. It is no coincidence that most net/nets are tiny companies. During late 2008 and early 2009, stocks trading at discounts to their current assets less total liabilities were abundant.
Companies such as Hardinge (HDNG, Financial) and Orbotech (ORBK, Financial) which possessed virtually no chance of filing bankruptcy, were available at huge discounts to their current assets while holding little or no debt. While these companies were losing money in accrual terms, they were beginning to generate excellent free cash flow. Witness the Statement of Cash Flows for HDNG:
Hardinge was not only turning up on net-net stock screens, it was also turning up on screens which identified companies which were increasing CROIC. The company had paid down most of its debt and was reducing its inventory but the market was not focusing on the improvements in the balance sheet nor the improving economics of the machine tool business as their balance sheet reveals.
Conclusion
Individual investors can learn from the investment style Warren Buffett used in the late 1950s and early 1960s. Buffett achieved extraordinary returns by focusing on tiny, undiscovered stocks which were severely mispriced.
Investors must be prepared to accept extreme volatility when buying tiny companies. They also must also be careful not to invest funds which might have to be withdrawn before the tiny stocks appreciate to their intrinsic value.
Individual investors who focus on the mispricing of microcap companies have a large edge over investors who focus on larger stocks. This fact is largely due to the lack of competition and the simplicity in understanding the business and the economics of the smaller companies.
Warren Buffett once stated “I’d be a bum on the street with a tin cup if the markets were always efficient.” The statement represents Buffett's emphatic refutation of the Efficient Market Hypothesis. All serious value investors are aware of the fact that the long-term appreciation of their portfolios depends on their ability to exploit temporary market inefficiencies. The point I find puzzling is why so many value investors insist on doing battle where the competition is the most severe, specifically in the large-cap arena.
Allow me roll out yet another Buffett quote: "The important thing is to keep playing, to play against weak opponents and to play for big stakes." Where does one find these weak opponents? For the average investor, the low hanging fruit is found in among the smallest of the publicly traded companies. In other words, the best place to look for dramatically mispriced stocks is by examining stocks with very smallest market capitalizations. I came to that realization a number of years ago and that single epiphany is responsible the majority of the wealth which I have accumulated.
Market Efficiency and Microcaps
While no market is completely efficient, larger capitalization stocks contain a number of characteristics which allows their quotes to reflect a more accurate assessment of their intrinsic value.
These characteristics include:
1) High Liquidity
2) Significant Short Positions
3) Extensive Analyst Coverage
4) Options Available for Protection or Hedging Strategies.
5) Arbitrage Opportunities
6) Tight Bid/Ask Spreads
Few tiny companies possess the aforementioned characteristics; as a result, relatively small competition exists in accumulating the stock and in many cases, pricing efficiency is greatly reduced.
Typically, when a large stock is mispriced a combination of the above listed characteristics help to drive its price back to equilibrium. In most cases a typical investor must be extremely savvy to spot a significant mispricing in a large, complicated equity. The typical exception is when one is able to purchase stocks during periods of extreme market pessimism. Otherwise the investor had better have an intimate understanding of not only the business but also the economics which surround the business. In other words, he must be a good deal more educated and insightful than his competition in evaluating the stock.
In the case of most small companies, the 10-Ks are much shorter and the businesses are much easier to understand. It is much easier for an individual investor to uncover a substantial mispricing and it is much more likely that the market is not privy to the mispricing. Many times the market does not realize that a tiny company is materially undervalued until the stock has moved precipitously. Generally the low float of the company combined with increased volume alerts the market when the stock rises and hits the Price Percentage Gainers list. The stock then attracts momentum players which can quickly drive the price towards its intrinsic value.
Volatility And Risk Are Different
James Montier made a very salient point about the difference between volatility and risk in investing. According to the Capital Asset Pricing Model (CAPM), 2007 was a much safer time to own stocks than 2009. The reason is that the prices for stocks were much less volatile in 2007 than 2009. Of course the average investor who bought stocks in 2007 was crushed in the next two years while the average investor who bought stocks in 2009 experienced extraordinary gains. Such revelations led Montier to write a chapter entitled CAPM is CRAP, in one of his books.
Without a doubt, microcap stocks on the average are more volatile than their larger brethren. That said, in most cases they are not any riskier to own so long as the investor does his due diligence and is not forced to sell the companies when their valuations are at their lowest point. In other words, investors must be prepared to hold a tiny stock until it appreciates near its intrinsic value. If the investor is spooked or forced into selling during times of economic distress, he or she will almost invariably lose a higher percentage of their investment than they would have, if they had invested in a larger less volatile stock. To paraphrase Buffett, you should not invest in stocks if you are unwilling to watch your capital depreciate by 50 percent in value without becoming unnerved.
It is worth noting that small stocks tend to drop more during times of extreme market pessimism. On the other hand, these periods provide investors with a chance to buy tiny companies at extremely favorable prices. It is no coincidence that most net/nets are tiny companies. During late 2008 and early 2009, stocks trading at discounts to their current assets less total liabilities were abundant.
Companies such as Hardinge (HDNG, Financial) and Orbotech (ORBK, Financial) which possessed virtually no chance of filing bankruptcy, were available at huge discounts to their current assets while holding little or no debt. While these companies were losing money in accrual terms, they were beginning to generate excellent free cash flow. Witness the Statement of Cash Flows for HDNG:
Period Ending | FY2010 | FY2009 | FY2008 | FY2007 | FY2006 |
Net Income/Starting Line | -5.23 M | -33.31 M | -34.30 M | 14.93 M | 13.95 M |
Operating Activities | |||||
Depreciation, Depletion & Amortization | 7.04 M | 8.50 M | 9.44 M | 9.45 M | 9.54 M |
Depreciation & Depletion | 5.70 M | 7.20 M | 8.10 M | 8.30 M | 8.50 M |
Amortization of Intangible Assets | 1.34 M | 1.30 M | 1.34 M | 1.15 M | 1.04 M |
Deferred Income Taxes and Investment Tax credits | — | — | — | — | — |
Deferred Income Taxes | — | — | — | — | — |
Income Tax Credit | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Other Cash Flow | -792,000.00 | 11.22 M | 33.53 M | -2.43 M | -1.23 M |
Funds from Operations | -967,000.00 | -13.24 M | 9.94 M | 22.19 M | 22.22 M |
Extraordinary Items & Discontinued Operations | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Funds from/for Other Operating Activities | 18.10 M | 42.39 M | -203,000.00 | -14.88 M | -15.50 M |
Incline (Decline) in Receivables | -609,000.00 | 20.43 M | 10.02 M | 8.06 M | -2.83 M |
Incline (Decline) in Inventories | 622,000.00 | 41.47 M | 2.91 M | -21.45 M | -10.47 M |
Incline (Decline) in Accounts Payable | 12.52 M | -3.57 M | -6.04 M | -4.86 M | 4.25 M |
Incline (Decline) in Income Taxes Payable | — | — | — | — | — |
Incline (Decline) in Other Accruals | 8.65 M | -13.75 M | -3.08 M | 830,000.00 | -3.94 M |
Incline (Decline) in Other Assets or Liabilties | -3.08 M | -2.19 M | -4.01 M | 2.54 M | -2.52 M |
Net Cash Flow/Operating Activities | 17.14 M | 29.15 M | 9.74 M | 7.30 M | 6.72 M |
Capital Expenditures (Additions to Fixed Assets) | |||||
Additions to Other Assets | 2.59 M | 0.00 | 0.00 | 0.00 | 0.00 |
Hardinge was not only turning up on net-net stock screens, it was also turning up on screens which identified companies which were increasing CROIC. The company had paid down most of its debt and was reducing its inventory but the market was not focusing on the improvements in the balance sheet nor the improving economics of the machine tool business as their balance sheet reveals.
Period Ending | FY2010 | FY2009 | FY2008 | FY2007 | FY2006 |
Assets | |||||
Cash and Short Term Investments | 36.42 M | 24.70 M | 18.43 M | 16.00 M | 6.76 M |
Net Receivables | 47.57 M | 42.30 M | 61.10 M | 72.78 M | 78.08 M |
Total Inventories | 105.31 M | 97.27 M | 144.96 M | 158.62 M | 132.83 M |
Progress Payments & Others | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Prepaid Expenses | 11.26 M | 9.31 M | 10.96 M | 8.57 M | 9.22 M |
Other Current Assets | 1.36 M | 732,000.00 | 398,000.00 | 1.03 M | 747,000.00 |
Current Assets Total | 201.93 M | 174.30 M | 235.85 M | 257.01 M | 227.64 M |
Long Term Receivables | 157,000.00 | 923,000.00 | 1.85 M | 1.98 M | 3.68 M |
Investment in Unconsolidated Subsidiaries | — | — | — | — | — |
Other Investments | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Property, Plant & Equipment Net | 56.63 M | 54.71 M | 59.60 M | 61.53 M | 64.05 M |
Property, Plant & Equipment Gross | 156.71 M | 144.64 M | 183.39 M | 180.43 M | 176.75 M |
Accumulated Depreciation | 100.08 M | 89.92 M | 123.79 M | 118.90 M | 112.70 M |
Other Assets | 15.84 M | 12.74 M | 12.05 M | 41.14 M | 36.74 M |
Deferred Charges | 2.11 M | 2.03 M | 6.29 M | 247,000.00 | — |
Tangible Other Assets | 85,000.00 | 183,000.00 | 1.32 M | 78,000.00 | 5.78 M |
Intangible Other Assets | 13.64 M | 10.53 M | 10.72 M | 34.77 M | 30.96 M |
Total Assets | 274.40 M | 241.76 M | 308.42 M | 361.52 M | 330.41 M |
Liabilities | |||||
Short Term Debt & Current Portion of Long Term Debt | 2.27 M | 1.93 M | 24.55 M | 8.46 M | 10.28 M |
Accrued Payroll | — | — | — | — | — |
Income Taxes Payable | 6.20 M | 4.37 M | 6.38 M | 5.13 M | 6.36 M |
Dividends Payable | — | — | — | — | — |
Other Current Liabilities | 34.40 M | 22.18 M | 33.26 M | 26.69 M | 22.54 M |
Current Liabilities Total | 76.40 M | 44.76 M | 84.24 M | 67.54 M | 70.64 M |
Long Term Debt | 2.78 M | 3.10 M | 3.57 M | 19.36 M | 67.58 M |
Provision for Risks & Charges | 31.40 M | 24.55 M | 47.49 M | 10.34 M | 29.23 M |
Deferred Taxes | 2.06 M | 3.58 M | -1.41 M | 4.06 M | 1.43 M |
Deferred Income | — | — | — | — | — |
Deferred Tax Liability in Untaxed Reserves | — | — | — | — | — |
Other Liabilities | 3.85 M | 4.24 M | 6.40 M | 5.07 M | 4.43 M |
Total Liabilities | 116.49 M | 80.23 M | 140.29 M | 106.38 M | 173.30 M |
Shareholders Equity | |||||
Non-Equity Reserves | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Minority Interest | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Preferred Stock | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Common Equity | 157.90 M | 161.53 M | 168.13 M | 255.14 M | 157.11 M |
Common Stock | 125,000.00 | 125,000.00 | 125,000.00 | 125,000.00 | 99,000.00 |
Capital Surplus | 114.18 M | 114.39 M | 114.84 M | 114.97 M | 59.74 M |
Revaluation Reserves | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Other Appropriated Reserves | -32.75 M | -23.42 M | -44.43 M | 2.33 M | -18.14 M |
Unappropriated (Free) Reserves | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Retained Earnings | 53.64 M | 59.10 M | 92.70 M | 128.84 M | 116.44 M |
Equity in Untaxed Reserves | — | — | — | — | — |
ESOP Guarantees | 0.00 | 0.00 | 0.00 | 0.00 | 0.00 |
Unrealized Foreign Exchange Gain (Loss) | 33.72 M | 23.31 M | 21.84 M | 25.54 M | 12.88 M |
Unrealized Gain (Loss) on Marketable Securities | 0.00 | 0.00 | -3.91 M | -3.64 M | 0.00 |
Treasury Stock | 11.02 M | 11.98 M | 13.04 M | 13.02 M | 13.92 M |
Total Liabilities & Shareholders Equity | 274.40 M | 241.76 M | 308.42 M | 361.52 M | 330.41 M |
Common Shares Outstanding | 11.61 M | 11.61 M | 11.47 M | 11.48 M | 8.84 M |
Conclusion
Individual investors can learn from the investment style Warren Buffett used in the late 1950s and early 1960s. Buffett achieved extraordinary returns by focusing on tiny, undiscovered stocks which were severely mispriced.
Investors must be prepared to accept extreme volatility when buying tiny companies. They also must also be careful not to invest funds which might have to be withdrawn before the tiny stocks appreciate to their intrinsic value.
Individual investors who focus on the mispricing of microcap companies have a large edge over investors who focus on larger stocks. This fact is largely due to the lack of competition and the simplicity in understanding the business and the economics of the smaller companies.
