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Investing in low P/E nano caps


DTEJD1997
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Hey all:

 

Good to finally be a member here...

 

I am starting to refine my strategy of investing in nano-caps.

 

I am looking to invest in incredibly cheap ones based off of earnings & cash flow.

 

In the past couple of years there have been several instances of me getting into nano-caps with P/E's of LESS than 3.  Assuming the business is not flawed or in a crashing terminal decline, I don't see how you can go wrong.

 

A P/E of 1 or 2?  How can that be?  It is very rare, but does happen from time to time.

 

The first example of this is "Mexican Restaurants" (CASA).  It briefly traded at a P/E of just over 1.  Hit a low of $.21/share, with 39 weeks earnings of $.20/share.

 

Another example is "Meritage Hospitality" (MHGU).  This traded as low as $1.25/share in the lat 52 weeks, and is earning $.65/share.

 

Other examples include "Rurban Financial" (RBNF) and many other small community banks.  In RBNF's case, bought at about $2.50/share.  A little over a year later, trading for $9/share and earning $1/share in net earnings.  "True" earnings are even higher than that as they have amortization expenses.  Stock has also started up a dividend again. 

 

RBNF was not the only small community bank that was left for dead by the side of the road...

 

Most of these stocks trade at a significant discount to book value, sometimes tremendously so.  They frequently have issues with them, and are thinly traded.

 

There are a few other examples, but I guess the point I'm trying to make is that if you can take the time to build up your database & knowledge of different stocks, you will see very odd pricing anomalies.  They don't come about as often as I would like, but I'm a small investor with limited capital.

 

I find these things a few times a year, and that is actually more than enough for me, as I have limited funds. 

 

I would think if you can find these companies, it almost does not matter the market does.  The valuations are just so cheap, you have an incredible margin of safety.

 

So in the future, I'm going to be on the watch for more of these things and keep my powder dry so that I'm ready to go when they come about.

 

Anybody have any experience/thoughts about doing this?

 

 

 

 

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As a former CASA shareholder let me caution you that these types of stocks can look cheap and remain cheap for year after year after year....  I would look for stocks with a plausible catalyst to unlocking the value. Otherwise you could hold for many years and never realize a gain.  The price may jump around a bit, but so few shares trade that it would be impossible to make money trading in and out of some of these stocks.  It is hard enough just o get a full position and to get out again even once. I'd have to look it up but IIRC I held CASA for almost 5 years and lost money when I sold.  That was years ago (before 2007) and it is still looking cheap today. 

 

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I'll second the "they can stay cheap forever" line.  The reason they're cheap in the first place is that, being so tiny, there is no real price discovery mechanism the way there is for picked-over mid- and large-caps.  A double-edged sword.  I think a basket approach is key because the catalysts are somewhat unpredictable, and only happen to a proportion of these in any reasonable length of time.  Going-private, acquisitions, etc. can all provide liquidity.  Value blogs highlighting them can bring a broader interest, and hence liquidity.

 

There do seem to be some incredible opportunities in this space.  But it can be tricky.

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The dynamics for value realization are different for tiny stocks but they still exist.  Patience is required, many of these stocks stay cheap for years and then one day will be purchased or merged.  I'm reminded of Western Lime, they traded in the $5k a share range for a decade, then were purchased for $50k a share.  The price jumped 10x in a day, that doesn't happen with large caps.

 

I am wary of micro-caps with catalysts, I think investors overpay for them, and too often they don't pan out.  I'd argue that George Risk's dividend isn't a catalyst at all, many microcaps pay 4/5/10% dividends.  In George Risk's case the fact that the CEO passed away could be viewed as a catalyst.  The new CEO, Stephanie Risk is a third generation Risk.  There is a lot of research showing that the third generation of a family company doesn't have the same attachment or drive that the first two do, and they generally sell.  I have a few holdings that are second generation with a very old CEO.

 

As for low P/E stocks, there are a lot of them.  CASA was an incredible deal, I'm kicking myself for researching them and walking away.  I would have doubled or tripled my money on that one.  Here's the crazy thing, I wrote it up, and OTCAdventures wrote it up and it continued to stay low, then shot up.  So the information was out there, it wasn't as hidden as one might think.

 

I see a lot of cash boxes that are EV/EBIT or EV/E of 1-2x, they look expensive at first, but once you back out the hoard of cash they're cheap.  Many stocks in the P/E 5x range, I've seen a number of EV/FCF multiples of 3x or less, some 1x or less.

 

Patience is required with these companies, invest with the expectation that you'll be in there for years.  You need a big undervaluation and a dividend to make waiting worth it.  There is a company I'm thinking of that's worth 3x their market cap easily, they pay a substantial dividend.  It might take a decade for value to be realized, but it would be worth it.

 

Diversification is also worth considering here.  With how boring this space is you'll invest and then have nothing to do for another year until the next annual report comes out, no news, nothing.  Given that most of these stocks do nothing over a year it's worth spreading things out so something is always jumping.  I'm thinking of one company I own, they report once a year (heck most of what I own does), it moved up 15% and has stayed there since.  The company is worth double, and the CEO has made note of it in the annual letter, I'm waiting on that right now.

 

Another benefit is research time is limited for these.  For example I received my 2012 National Stockyards annual report in the mail yesterday.  I read the entire thing, every word, number and note in 10m.  I have three years worth of annual reports for them, it would take me 30m to re-read them all.  In 10m I was up to speed on what happened and what to expect, I only own one share of them, so now I'll wait a year to see where things are next March.  So many tiny stocks are like this, spend an hour researching, purchase then be patient.  It's really such a simple thing.  I'd rather read about 20 companies, purchase three and wait then spend the same amount of time trying to parse through all the crap on a large complicated company.  Small companies are simple to understand usually and simple to analyze.  I find simplicity cuts down on mistakes helping me make better investment decisions.  Sure I'm not some genius analyst unravelling the mysteries of the market, but I don't care, I'm content to be looking at the little ignored things over and over.

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Per usual, I greatly agree with oddball on most all of his points.

 

I think that a lot of times too, there are a lot of catalysts for these smaller companies that don't come up so easily. Often though, management will buy them out.

 

Let us remember that it is a form of bias to say "this one stock I held went no where, and I know a lot of people who had a small stock that went no where, so they must all go no where..." In terms of liquidity, that often scares people off too, but there are often wild liquidity swings that happen. I have spent literally a year trying to buy shares of companies, and wouldn't get all I wanted- then, there was suddenly a ton trading! All this said, when they move against you, it can really take a psychological toll if you aren't ready for it.

 

Granted, negativity towards nanos is pretty beneficial to us nano guys because it keeps some of the good deals out there longer. I suppose that this means that we are not at the peak of a bull market, because if we were, I would guess that nano prices would be bid up by people looking for the next growth play?

 

Also, there are a lot of big caps that essentially stay the same place forever too- generally, I want to buy part of a business that I like. Small companies provide that.

 

It just so happens, that I really like CASA as a business, but think it's a bit expensive (relative to other stocks out there) at the moment... That said, I could think of worse things than owning a pretty well run chain of mexican restauants in Texas that is trading for 1/2 of book and earning money. I could think of much worse things! Think of what the private value of it should be!? I would think a good bit more than it presently is.

 

A lot of the reason for price suppression too, is that often times, funds don't come in and bid the prices up to make the market efficient. Though there are instances of it. If I were to raise a bit of capital from outside investors, I would still try to buy a lot of these smaller firms, simply because there is so much low hanging fruit out there. With companies like SODI (especially when it was sub $3/share) it should have been a no brainer for everyone AND had the added bonus of trading liquidity (as is evidenced by the changing form 13s on it).

 

As with anything else, there are no strikes- just wait for your right pitch.

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I'd argue that George Risk's dividend isn't a catalyst at all, many microcaps pay 4/5/10% dividends.

 

 

Which?

There are tons of high-dividend microcaps. I own DSWL and ARGO.L and both have a dividend yield near 10%. But I would argue that share buybacks are almost always better - if there is sufficient liquidity - for the undervalued microcaps since that's creating more long-term value.

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I'd argue that George Risk's dividend isn't a catalyst at all, many microcaps pay 4/5/10% dividends.

 

 

Which?

 

There are a lot of them that pay good dividends. Chicago Rivet, Micropac, Itex, AirT, and a host of others. You just have to look for them. I think that this is another example of where a baby can get thrown out with the bathwater, simply because it is a small company.

 

As a side note, I have always found it interesting that in our society, there is a huge emphasis placed on the importance of small business. However, when it comes to a small business being in the capital markets, they totally get the shaft and will often have trouble raising capital, getting a loan without a personal guarantee (despite being a crazy great business with a ton to back the loan with), and are generally scorned by investors.

 

I find it sad that so many small business owners will invest their savings in the very businesses that are trying to destroy them on a daily basis (the really big players)- say, a family pizzeria investing in a mutual fund that invests in YUM!, DPZ, or PZZA... The small business owners ultimately don't get a chance to invest in/with their small business brethren (for whatever reason)- IBAL, SYTE (in the sake of disclosure, I have a 13D filed with Sitestar), and EVI come to mind as some family businesses that are so small that few look at them. For our Pizzeria family, how about an investment in PZZI? How many of the PZZI franchisees are invested in the stock? My guess is VERY few. I suppose that this hinges on what their financial advisor tells them to do, or they don't know how to go about finding these companies. Or, the instances of fraud and pump and dump schemes are so blown up in the media and movies, that people get scared of "penny stocks".

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Or, the instances of fraud and pump and dump schemes are so blown up in the media and movies, that people get scared of "penny stocks".

 

I think this is the case for the vast majority of market participants.  Whenever I am talking about microcaps at work, people automatically think I am crazy for investing in them.... And I work in trading.

 

Personally, I invest only in listed microcaps. I avoid unlisted microcaps, OTCs etc for one reason only;  I can't shelter OTCs, unlisteds, or pinks from the taxman with my RRSP, or TSFA, therefore increasing my hurdle rate for returns substantially.

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Or, the instances of fraud and pump and dump schemes are so blown up in the media and movies, that people get scared of "penny stocks".

 

I think this is the case for the vast majority of market participants.  Whenever I am talking about microcaps at work, people automatically think I am crazy for investing in them.... And I work in trading.

 

Personally, I invest only in listed microcaps. I avoid unlisted microcaps, OTCs etc for one reason only;  I can't shelter OTCs, unlisteds, or pinks from the taxman with my RRSP, or TSFA, therefore increasing my hurdle rate for returns substantially.

 

I don't know where you're at but I'm able to invest in some of the most illiquid stuff out there in my IRA through Fidelity.  If it's tradable I can buy it, and it's sheltered!

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Or, the instances of fraud and pump and dump schemes are so blown up in the media and movies, that people get scared of "penny stocks".

 

I think this is the case for the vast majority of market participants.  Whenever I am talking about microcaps at work, people automatically think I am crazy for investing in them.... And I work in trading.

 

Personally, I invest only in listed microcaps. I avoid unlisted microcaps, OTCs etc for one reason only;  I can't shelter OTCs, unlisteds, or pinks from the taxman with my RRSP, or TSFA, therefore increasing my hurdle rate for returns substantially.

 

I don't know where you're at but I'm able to invest in some of the most illiquid stuff out there in my IRA through Fidelity.  If it's tradable I can buy it, and it's sheltered!

 

Amazing.  In Canada we are limited to exchange traded stocks in RRSP and TSFA.  I use Questrade as it is pretty much the cheapest broker in Canada.  Theoretically, I could hold that Rwandan bottler Bralirwa in my RRSP (if my broker could get a hold of it... which it can't), since it is listed on an exchange, but I am forbidden from SODI etc.

 

I could put my entire net worth in out of the money calls on Salesforce and it would be just fine in my RRSP or TSFA according to the gov.  Good thing the government is protecting me from boogeyman of OTCs

 

 

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Or, the instances of fraud and pump and dump schemes are so blown up in the media and movies, that people get scared of "penny stocks".

 

I think this is the case for the vast majority of market participants.  Whenever I am talking about microcaps at work, people automatically think I am crazy for investing in them.... And I work in trading.

 

Personally, I invest only in listed microcaps. I avoid unlisted microcaps, OTCs etc for one reason only;  I can't shelter OTCs, unlisteds, or pinks from the taxman with my RRSP, or TSFA, therefore increasing my hurdle rate for returns substantially.

 

I don't know where you're at but I'm able to invest in some of the most illiquid stuff out there in my IRA through Fidelity.  If it's tradable I can buy it, and it's sheltered!

 

When you said that on the taxable accounts, I assumed you were in Canada. Is there not a way for you to set something up in the US?

 

I hear you on the whole perception in the market thing. When a baby gets thrown out with the bath water, there is often a lot of bathwater being thrown out... However, there is still a baby being thrown out!

 

Since we are talking about the perception of micro caps, I will openly wonder:

 

I would be interested to know how many of the stocks that micro cap bloggers have talked about, which are frauds where they totally got it wrong... A SHORT list of SOME of the really good ones would include: Oddball, Whopper, Bruce @ Pink Sheets, OTC Adventures, Valueprax, Greenbackd, Adventures in Capitalism, Above Average Odds, Barel Karsan, Value investing journey, Alpha Vulture, Walrus Value, Geoff Ghannon, and probably the BEST example: Shadow Stock which, I hold on a pedestal, even though he has slowed down his posts. Keep in mind, this is a SHORT list of micro cap blogs.

 

Now, this list would have to exclude things where anyone talked about how terrible a stock was- such as my posts on FCCC or CATZ- or Walrus Value and the Cupcake shops (CRMB)... not that they are frauds, just awful investments... As of now, there are only a few bad ones that I can think of off the top of my head, would be when a value blogger was paid to do research on a company and got it wrong- it was talked about on here, but the name escapes me. The stuff surrounding Life Partners was pretty intense (and I don't know how it turned out as I have not followed it). But by and large, I think that the micro caps that most value guys talk about are legit. Generally, if there is a screw up, it was over a projected growth rate or not understanding a business (such as how I got SVU wrong).

 

If I didn't invest on my own, I would have no issue throwing my retirement to any 5 of above mentioned guys and let them manage it so long as they stuck to the small companies they have historically talked about... I'd bet that as a collective they would absolutely KILL the index funds and most money managers out there. While I am talking about it, I would actually have no issue with DTEJD1997 managing my money... He is a hell of a stock picker.

 

Don't know if that all made much sense or was even concise, but I am curious as to others thoughts on the matter (especially if they disagree with me).

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I have seen some value bloggers getting it wrong on those Chinese RTO companies in the early days when the fraud rumors started, but when it wasn't yet that obvious that everything was just totally fake. At that time they looked like very good buys based on the financial statements. But those companies weren't unlisted microcaps or penny stocks...

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When you said that on the taxable accounts, I assumed you were in Canada. Is there not a way for you to set something up in the US?

 

 

 

I can buy OTCs and the like in a standard taxable account no problem.  It would just be incredibly poor planning. My returns would have to be astronomical in comparison to what I achieve in my RRSP and TSFA to make it worthwhile investing outside these accounts.  In my RRSP I get roughly 30-35% cash back on my tax return for each dollar I throw in and I pay taxes on it when I take it out as an old man.  In my TSFA, I pay 0 capital gains.  RRSP accounts are capped at 18% of income a year, and TSFA is $5500 a year.  The unused space in these things gets carried forward 10 years...  So while I will be investing outside of these accounts eventually (once I have maxed them out), I wont have to do that for years.

 

Now being a dual citizen, you have me wondering if I can open a IRA account as well on top of the RRSP and TSFA.  Somehow I doubt it, but it would be awesome.  Any dual citizens care to chime in?

 

I hear you on the whole perception in the market thing. When a baby gets thrown out with the bath water, there is often a lot of bathwater being thrown out... However, there is still a baby being thrown out!

 

When CFAs and other financial professionals I work with won't even open a report on companies because they are so small, I know there is bound to be opportunity for mispricing :)

 

Great sources you posted and I think it is clear most of these guys should eat the market over the long haul.  Sure some frauds will show up proving the bloggers wrong.  I've seen a few... but the winners should more than offset the occasional fraud.

 

In other news, if any of you are looking for a quick little data screen which pulls some cheapos, I also stumbled on a nice little screen yesterday...

 

  http://extremevaluestocks.com/stocks.php

 

I have no affiliation with this site, just liked the list and quick stats it spit out.

 

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When you said that on the taxable accounts, I assumed you were in Canada. Is there not a way for you to set something up in the US?

 

 

 

I can buy OTCs and the like in a standard taxable account no problem.  It would just be incredibly poor planning. My returns would have to be astronomical in comparison to what I achieve in my RRSP and TSFA to make it worthwhile investing outside these accounts.  In my RRSP I get roughly 30-35% cash back on my tax return for each dollar I throw in and I pay taxes on it when I take it out as an old man.  In my TSFA, I pay 0 capital gains.  RRSP accounts are capped at 18% of income a year, and TSFA is $5500 a year.  The unused space in these things gets carried forward 10 years...  So while I will be investing outside of these accounts eventually (once I have maxed them out), I wont have to do that for years.

 

Now being a dual citizen, you have me wondering if I can open a IRA account as well on top of the RRSP and TSFA.  Somehow I doubt it, but it would be awesome.  Any dual citizens care to chime in?

 

 

 

Not to derail this into a discussion on taxes, but I'm not sure the advantage is as great as expected.

 

In the US an IRA is tax deductible when someone contributes but all withdrawals are taxed as normal rates.  So if I'm in the 25% tax bracket now and when I'm old and gray I'm in the 15% tax bracket it works out.  A Roth IRA is after tax money now, but everything grows tax free, and all withdrawals are tax free.  So the Roth works better in theory is one is in a low bracket now and expects to be in a higher one later, or if they think taxes will rise.

 

Then there's the whole taxable account issue.  A taxable account isn't terrible if you buy a stock and hold it for more than a year, then taxes are 15% on that holding, a capital gain tax.

 

So let's assume with a company that you buy it and have to hold it 15 years before it pops.  You invest $1000 today, and in 15 years can withdrawal from an IRA.  The stock sells for $3k which is about 13% a year:

 

The person is in a 25% bracket when they start and when they quit.

 

Traditional IRA: $1000 contributed from $1000 in earnings.  Sell at $3000 and pay 25% on $3000 for a net gain of $2250.

Roth: $1000 invested, but $1333 earned to contribute the $1000.  Sell at $3000, no tax, net gain of $2667

Taxable: $1000 invested, but $1333 earned to contribute: Sell at $3000, 15% capital gain tax, net gain of $2217

 

Buying and holding in taxable is almost equal to the traditional IRA, clearly the Roth is the best deal going.  But given the choice of a taxable with a long holding period, and a traditional IRA (or whatever it's called up there) I would go with the taxable if you intend to hold a long time and you have more options.  The tax hit isn't terrible all things equal.

 

Now let's get back to talking about those tiny stocks!

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Enjoying this thread.  My experience of investing mostly in Canadian nanocaps over the last 13 years is that this strategy can be extremely lucrative.  Finding low P/E nanocaps (less than 3 or 4X earnings) that are high quality companies and growing at decent rates is investment nirvana in my opinion. In these cases you get a massive double compounding effect (Davis Double) where you get the growth in the earnings combined with the growth in the valuation multiple (which can triple the stock price by itself).  In my experience, if it's a growing high quality company, it will be found out by the market soon enough and rerated.  Unfortunately these don't come along very often (usually in distressed markets - there were a number of these available in late 2002 and early 2003 when small caps were hammered and certainly again in 2008/2009), but when they do come along you need to really load up.  I have also seen them show up in very obscure securities like capital pool companies - unfortunately you need to probably turn over at least 100 rocks for each gem that you find in these securities.

 

blainehodder, if you are a Cdn/U.S. dual citizen, you may want to change your tax strategy with regards to TFSA (and RESP if you have kids).  I will send you a private message so as not to derail this great discussion.

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Oddball, bone chip, Ragnar , or other posters, what would be the minimum number of these nano caps would sensible to hold?

 

The largest holding I have, by market cap, is TPHS (coming in at $62.7mm) and it is the largest BY FAR. Especially considering that I am not left with much ALJJ since I tendered shares. Literally, by market cap, these 2 holdings are multiples of the next one (UWN coming in at 17.5mm). So, by my actions, I think it is sensible to hold nothing but nanos. I don't think I would want to own less than 4, but own more than that.

 

I don't really believe in a whole lot of diversification, but then again, I don't have a super large fund. Even if I did, I would make every effort to invest in these small companies for as long as it was possible/reasonable to do so. I know that a lot of people on this board seem to have owned ITEX.

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I would say the minimum number to hold is one!  haha

 

But seriously, I would advocate simply moving into positions as you find them advantageous.

 

I have meaningful positions in about 10 different nano-caps.  My largest cap company is about $2.5BB, followed by $600MM.  The smallest company is about $1MM.

 

Some of my friends/associates say they have $X of capital to invest and what would I recommend?  They are always too anxious to "get in the market".  I always reply to get familiar with things FIRST.  Then, when you have some knowledge, just start slowly moving into positions as the situation presents itself.  Be patient & pick your spots.  As has been said many times "There are no called strikes, wait for your pitch".

 

I would think in the space of a couple of years, you could probably deploy a significant amount of capital if you wished to do so.

 

Right now, there are some opportunities, but not a lot (relative to other periods). 

 

With that being said, I think GOFPY & DSWL bear close watching.  There are also a couple of other stocks that I think are ripe for investment.

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What is you definition of nano-cap?  I have found most if not all the best bargains in stock with market caps below $400m.  The number depends upon how comfortable you feel with the business.  If you can find some nice recurring revenue business that has shareholder friendly management then you can concentrate.  My top holding is about 32% my top 5 are bout 62% of my portfolio and top 10 about 86%. 

 

Packer

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Packer:

 

My definition of a "nano-cap" is a very small market cap company!  Specifically, I would say somewhere around maybe less than $25MM.

 

My largest position was never a "nano-cap" but it was a "small cap" company at one point.  Some of my positions in it are up 4X, so it has grown to about 30% of my portfolio.  I am still holding it, as I expect it to do very well this year, and hopefully double again....

 

Is a $600MM company "Mid-cap"?  I always forget...

 

My top five are also about 2/3 of my portfolio.

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