Five Key Questions

I’m a big believer in simplicity.

Investing is complex, but a microcap idea usually boils down to a handful of key drivers, catalysts, and risks. You can improve your research process tremendously by focusing on what matters.

Here are five crucial questions you should ask yourself when looking at a new investment idea:

1. Is This a Company I Can Understand?

It’s fair to assume that the market is generally efficient in large caps. So many professionals and experts are looking at these companies, and the vast majority of the relevant information is already priced in. If the market tells you a company is worth $50 billion, you can, at the very least, assume it’s legit with an actual product and real customers.

On the other hand, very few professionals look at microcaps. Companies can pay (egregiously) for marketing and promotion to inflate their stock price. Excellent businesses can go unnoticed for years. The market is highly inefficient the smaller you go.

You must do the research yourself because nobody will spoon-feed it to you. If you can’t understand the business or the industry, it’s a very challenging start.

Of course, you can’t know everything. You must keep an open mind and look at stuff you know nothing about. Hopefully, you can learn and develop a better understanding in some cases.

That said, if I spend a few hours on a new file and feel like I don’t understand it any better, that usually goes in the ‘‘Too Hard Pile’’ for me. That’s it – I’m done. And I don’t care if the stock rips 100% in my face the following month as long as I passed for the right reason.

2. Is This a Company With Competitive Advantages?

The laws of economics make running a business a very competitive endeavour. To generate better-than-average returns over the long term, you need to own companies that compound their fundamental value at a higher-than-average rate. To make that possible, companies need a ‘‘moat’’ that insulates them from the competition.

Don’t get me wrong, you won’t find terribly strong moats in microcaps. No microcap that I know of benefits from network effects like a Meta or has the scale advantage of a Costco.

What you should look for is an emerging moat. Is the company dominating a small niche? Is the niche growing? Can they expand to adjacent areas over time?

You’ll save yourself a lot of trouble by avoiding completely commoditized industries or companies with no pricing power.

3. Can I Trust The Management Team?

On average, I think the governance at most microcaps is very subpar. Boards are either incompetent, don’t care, or fail to hold management accountable when results disappoint.

While I certainly like a strong board and pay a lot of attention to governance, I’m not looking to play an activist role and kick CEOs out of their companies.

If I find a company where the CEO has a solid track record, has shown he can deliver results, is non-promotional and focused on the long term, my odds of a successful outcome skyrocket.

Study management’s track record. Watch webinars and interviews they’ve conducted. Pay attention to what they discuss (long-term vs. short-term goals) and how they discuss it (promotional or not). Schedule a call with them. Ask them the tough questions.

My most significant positions tend to be in the companies where I trust the management team the most.

4. Does The Market Misunderstand The Opportunity?

So you’ve found a company you can understand. It has a moat. The management team is fantastic. It’s probably not trading at a cheap price, right?

For something to be cheap, it must have some hair on it. Something must look wrong to the market. Maybe the company had some hiccups in their last quarterly report. Maybe the outlook for their industry has deteriorated. Maybe insiders are selling.

Whatever it is, you must be able to identify what is the consensus and why the consensus is wrong. What do people misunderstand? How much research have you done to build your case and be confident in your assessment of the situation?

If you can’t explain why something is mispriced and how the market’s perception will change over time, you don’t have a strong enough thesis yet.

5. Can I Buy It Substantially Below Intrinsic Value?

Now, we’re talking about valuation.

So far, it’s been all about the qualitative (management, moat, story). The last question is about the quantitative.

You need to examine the numbers and the business trajectory closely and make assumptions about the future.

How much is this business worth? Can you buy it at a discount?

Dozens of books have been written on the topic of valuation. To become a successful investor, you must understand accounting and valuation. It’s too complex of a topic for me to elaborate on here, but I highly encourage you to educate yourself if needed.

I’m an Outsider, a self-taught investor who learned to invest successfully ten years ago without going to college. You can learn it too.

Few things are as costly as paying for potential that turns out to have been overrated.

- Howard Marks, Mastering the Market Cycle

You can do the best qualitative research in the world, but overpaying for something will hurt your returns.

Valuation matters. Don’t skip this crucial step.

Use these five questions to guide you and spend your time where it has the greatest impact. Most importantly, I think these questions will highlight some of the weak spots in your analysis and likely prevent you from making costly mistakes. At least, that’s my hope!

Investing profitably in microcaps requires significant effort and time. It’s absolutely possible to succeed if you commit to it. However, if you’re too busy, there is another option. You can opt for a professionally managed microcap strategy.

Either way, I’m here to help!

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Disclaimer

This publication is for informational purposes only. Nothing produced under the Stocks & Stones brand should be construed as investment advice or recommendations. Mathieu Martin, the author, is employed as a Portfolio Manager with Rivemont Investments. This publication only represents Mathieu Martin’s own opinions and not those of Rivemont. Rivemont may own positions and transact on any securities mentioned in this publication at any time without prior notice. At the time of this writing, the Rivemont MicroCap Fund does not hold positions in any of the companies mentioned. Always do your own research and consult a professional before making investment decisions.

If you’d like to invest in small public companies, check out this post.