8 Different Classes Of Investing Pitfalls You Must Avoid by Mike Schellinger, Old School Value
What You’ll Learn
- What to look for in microcap stocks
- 8 different classes of investing pitfalls you must avoid
- Simple rules of thumb on what is good and bad for each
- Why you must do proper due diligence to be profitable
I’ve written much about what I look for in a microcap investment such as profitability, sustainable growth, and compelling valuation in the My Secret Recipe series of articles which include: The Index Card, Shopping and a Taste Test, Inspecting the Ingredients, and The Bargain Rack. However, I haven’t written much about what I don’t want in an investment. These pitfalls are attributes that may lead to a bad investment. In this article I lay out the major pitfalls that I have found so that you don’t have to fall into them. I’m assuming in this article that the company generally meets my criteria so you don’t have to read through attributes that you already know I avoid such as unprofitable businesses, no growth, etc.
While this guide can be helpful, it is only outlines some of the pitfalls I try to avoid. I’m sure I’m forgetting at least a few of these pitfalls. Also, when investing in microcaps you will find that most companies have some aspects of at least one of these. These negatives need to be evaluated in the context of all the attributes of a company to determine if the positives outweigh the negatives.
8 Investing Pitfalls to Avoid
Poor Share Structure
Some companies have very poor share structures. The worst kind is usually when you have convertible debt which converts at a discount to the market for the stock. That can create what is known as a death spiral. Let me explain how this works. First, the holder converts some of the debt at a discount to market prices and sells it at a profit. The selling puts pressure on the stock price causing it to drop. Next, the holder converts more of the debt at a discount to the now lower stock price and in turn sells it at a profit. The cycle continues until the debt holder converts and sells all of the debt. A big problem with this arrangement is that each time the debt holder converts, he or she gets more shares for the dollar because the stock price drops. What can happen in this situation is that a company with a decent share structure can see their share quantity balloon. Convertible preferred stock can also be structured with a death spiral. I will never invest in a company with death spiral financing because it is a quick way to see your investment dollars fall into the abyss.
Just because a company doesn’t have death spiral financing doesn’t mean they have a good share structure. I always investigate the total diluted share count for each company. In addition to the outstanding common shares, one needs to examine any preferred stock (especially convertible), convertible debt, options, and warrants. With that information you have a view into what the total share count might look like in the future and can factor that into your analysis. For example, if the share count is going to double over time, the future per share earnings potential might not look as good as it seems on first glance. I also look at the company’s history of share issuance. If don’t like it when a company has a history of handing out options like candy. I much prefer a company that treats their shares like gold.
Further commentary on share structure can be found in The Importance of Share Structure.
Weak Balance Sheet
The first thing I look at on a balance sheet is the tangible book value per share. When it is negative I have to be careful. Let’s say you have a company that has a stock price of $1/share and is expected to earn $0.12/share in the next year. If the tangible book value is slightly negative, let’s say -$0.02/share, that is a cause for caution. When it is say -$1/share, that is usually a cause for great concern.
A negative tangible book value isn’t the only thing to cause caution on a balance sheet. Debt coming due soon can be a cause for concern especially if it will be difficult to refinance that debt. If a company cannot renew their debt or otherwise pay it off, there usually are some pretty negative consequences. I like to examine a company’s debt to see how big it is, the interest rate on the debt, and when the debt comes due?
Along with debt, one also needs to look at a company’s cash position. If they don’t have enough cash to operate and don’t have access to debt (e.g. a line of credit), they may have to raise money which will mean dilution of your holdings. Usually when a company raises money by selling stock it is below market prices for the stock which will cause a drop in the stock price. I much prefer to avoid companies that need financing. A MicroCap Investors Worst Enemy is Dilution is a good article which delves into a company’s future need for capital.
There is much more to analyzing a balance sheet than I have said here. Some poor balance sheets can be OK where as others are not. It is an art you have to learn.
Poor Quality of Earnings
Sometimes companies have great earnings but they are of poor quality. For example, maybe they have significant revenue but they can’t collect their bills fast enough. This will show up in a metric called DSO or Days Sales Outstanding. When I analyze a company I usually ignore the nuance of credit sales versus overall sales and just use overall sales as credit sales levels are rarely disclosed. I have found that when the DSO calculation gets above 90 days you need to look very carefully. Repeated numbers that high can indicate that the customers are of poor credit quality. I usually calculate DSO on a quarterly basis.
Sometimes recent earnings are not sustainable which also falls into poor quality of earnings. For example, maybe there was a factor that temporarily increased gross margin. Maybe there was some sort of one time gain that boosted earnings such as winning a lawsuit. Maybe the company is just about to start paying taxes whereas they haven’t in the past. Perhaps there was a large piece of revenue that came in that isn’t repeatable. Earnings could grow dramatically when the large order is fulfilled, but then sink afterwords.
Customer concentration can also fall into this category. For example, if ACME Widget is receiving 80% of their revenue from one customer, there is a huge problem if that customer goes away. Customer concentration doesn’t necessarily scare me away but it often will reduce the size of the position I’m willing to take on.
The main way to investigate the quality of earnings is to read the footnotes in filings and the details in PRs. What one has to do is to