By Jim Collins
It's always been interesting to me that as investors move down the scale in market capitalization they tend to lower the amount of due diligence they perform on potential investments. Every minute detail of quarterly earnings from giants like Apple and Exxon Mobil is analyzed intently, but for microcaps the analysis often begins and ends with "it's a good story."
But it is precisely those details that we love to pore over from the big boys that make any stock a good story. When those details are not present, a stock can be a blow-up waiting to happen.
Smaller companies provide less data to dissect than larger ones, but that actually makes the process of analysis easier and more straightforward. It's just a matter of sticking to core investing principles.
I only purchase stocks for my asset management clients at my firm Portfolio Guru, LLC that meet four key criteria. For inclusion in my portfolios a company must:
- Participate in a large and growing market
- Gain market share in that market
- Have defensible intellectual property
- Have a clear pathway to profitability
I attend more investment conferences than any sane man should, and always remaining true to those four key principles saves me a great deal of time. The ability to instantly exclude three out of every four stories I hear allows me to fully focus on the worthy 25%.
How do I perform the analysis? Let's go through the four criteria individually and I'll share some tips I've learned from 25 years of looking for the next great stock.
Market size and growth rate:
The first source for this data should be management of the company in question. If the management team can't instantly answer the market size/growth rate question--I experience this more than you might imagine--than you should be moving onto the next idea.
Even if you don't attend investment conferences, just head to the company's website and download its most recent investor presentation. If the target market is not clearly delineated, than management is either trying to hide a less attractive opportunity or simply doesn't know exactly what they are attacking.
One note: third-party data is always most valuable. Usually this will come from an industry association, trade group, etc. If a management's market data is sourced from "our own calculations" an investor must watch the inherent tendency to exaggerate, especially on the estimated long-term growth rate of the target market.
Market share data:
Following on from the last point, an investor should look for independent sources to verify a company's market share data. That is, assuming management is asserting market share growth. If the tone of the company's public presentations is "we've lost some share, but we're hopeful to regain it in the next few quarters", I'm onto the next idea before that sentence has been completed.
But, again, I want independently verifiable data to prove market share gains. Also, I want to know from whom this company is taking share and why. Watch out for short-term market share gains driven by price-cutting. I'm looking for sustainable share growth driven by a superior product and that should manifest itself in steady, prolonged market share growth not quarter-to-quarter spikes.
And don't forget to fact-check. If Company A says "we're taking market share from Company B" you must head to Company B's website and make sure they are not making the same claim about Company A. Numbers can be twisted and data can be massaged, so always do your due diligence.
Proprietary intellectual property
Due diligence is especially important when measuring intellectual property. I want to see issued patents, preferably ones that have been successfully defended in court. Infringement is the sincerest form of flattery! Obviously all patents begin as patent applications, so I don't discard data on patents filed, but I certainly subordinate it to the company's patent estate. Patent data is readily available from the U.S. Patent and Trademark Office, so go online an check it out.
Also, most companies have a product that in some way shape or form needs approval from a regulatory body. Whether it is the FDA, FCC, FTC, etc. or private standards bodies like Underwriters Laboratories, you must investigate whether that company has received the necessary approvals to market its product. Also, remember it's an interconnected world, so make sure to check whether that company is seeking/has won approvals from foreign regulatory bodies.
Pathway to profitability
If a company participates in a growing market and is gaining share through a proprietary product or process, the company should be able to make a profit, right???
Small companies rarely have current profitability and GAAP accounting rules force companies to account for future expenses upfront. So, I'm not looking for a $20 million revenue company with $2 million in reported net income. I just want to make sure that when they hit $200 million in revenues that profitability is there.
When I was a sell-side research analyst Fidelity was our firm's largest client. Fidelity requires its analysts to use a very basic financial modeling technique. A company's income statement should always be disaggregated into three factors:
How many widgets can they make? How much does it cost to make one? Knowing those two factors and adding in fixed operating costs gives a very simple calculation for break-even. From that benchmark it is easy to ascertain what the company's profitability will be once revenue rises above that break-even level.
Obviously those factors are easier to identify in some businesses than others, but, honestly, I have never found a company that I couldn't model using Units/Price/Cost methodology.
I started in equity research at Lehman Brothers as a 21-year-old and I'll never forget the self-described job description of one of that firm's highly-ranked analysts. He called himself a professional cynic, and to be a successful investor, you should be one, too.
Use my four key criteria, don't ever make excuses for companies that fail any/all of those tests, and your portfolio will be disaster-free.
Editor's Note: Jim Collins is the Founder and Editor of The Portfolio Guru, now exclusively published by the Outsider Club. He has 22 years of stock analysis experience as an equity analyst and financial analyst with some of Wall Street's biggest and most respected firms.
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