Yellow Flags I look for in Microcaps

Some things I look out for when researching.....

I wrote this post several months ago and have been on the fence whether to post or not. I finally decided to share.

Much has been written about red flags, deal breakers, non-starters, no-goes, etc. when it comes to investing. This post is a list of yellow flags I look for in microcaps when I’m conducting research, although I suppose they could be applied to larger companies. Though they aren’t always deal breakers, they have my Spidey sense tingling when I see them. There is some overlap in ideas here and this is more art than science.

If I rub you the wrong way, I apologize. I am just doing my best to avoid large drawdowns. I’m just a random dude who writes a free blog about microcaps, keep that in mind and keep your expectations reasonable.

Stockhouse (or really any) bulletin boards blaming shorts

This stock has likely performed well in the past and current investors have jumped onboard. The posters are often generalists and may not do in-depth due diligence. They are heavily anchored to when they bought shares and seem to blame short sellers for the stock being down. We usually know who is short and why they would be short. We are always 2-3 weeks away from a major breakout in the share price due to a committee review, quarterly financials, new sales from recent product launch, etc.

These bulletin boards are full of posters saying things like “the shorts are keeping this down”, “after next q the stock will rip once the market sees the numbers”, “you’ll see, this thing will moon before the end of the year”. We could lump things in like: “this property is next to (insert large company name) and they are a target”, “the drill bit results will speak for themself”, “the market doesn’t understand the grade of ore”, “once it’s legal you’ll see this thing run” and “after this round they will be able to get to breakeven and sell the company (eventually)”. Of course here in Canada, we are full of capital incinerators looking for hydrocarbons, shiny metals in the ground or a bunch of charlatans trying to raise capital to differentiate the devils lettuce.

The current investors posting (if they actually own shares) can’t be objective. Something has changed and they haven’t changed their expectations. It could be growth rate, margins, multiples or some combination of them all.

At the time of writing I would consider CTS.to to fit here. I have no idea about the business so don’t take it personal. These may make good shorts, although I’m too chicken. I cut my teeth here with some gold and silver miners just before the GFC and it was painful.

Nothing but victory laps on Twitter

You can see these by searching for the ticker on Twitter/X. It’s full of nothing but people taking their various victory laps on the name. I’m excluding the autogenerated trader ads of course. There is usually a ton of price charts posted and investors bragging about how much of a “bagger” this is. There is rarely a discussion on risks with the business and the valuation. I think what’s hard for many investors to understand is that they are looking back and should be looking forward. How was the business performing 10 years ago when the price chart started? What was the valuation then or what was the market’s expectations? What amount of capital is required to continue this momentum? What is a reasonable multiple for this business? These are all questions that are avoided and sometimes belittled.

Due to the large outperformance of the initial 5-10 years, investors may still be ahead of the market even if they held an underperformer for the next 10. I mean Walmart underperformed at times over the last 10 and 20 year period despite being way ahead if you held it since the IPO.

I am all for taking some credit for your achievements. It’s a skill I am still developing. If that’s all you do publicly then maybe you may get humbled by the market gods at some point.

If the business is still mispriced, then there is a chance of superior forward returns. I mean XPEL went from 10 to 80 and at 10 many were saying the run was over. There are many examples of “great” businesses trading at high valuations continuing to outperform, but there are many examples of these “great” businesses actually turning out to be typical businesses and share prices coming back to reality. Given my skillset I tend to stay away from these examples when they have a very high valuation.

“One Decision Stocks” or NeverSell

To me there are no one decision stocks. Everything needs to be monitored. You may make only one transaction (to buy shares), but you are always making a decision to keep it in the portfolio. If you are not quitting, you are sticking with the company. I understand this is my nuanced perspective. These are usually very strong businesses with strong leadership that are trading at really high multiples. Thus expectations are high and outsized returns may require even stronger execution in the future than in the past.

Investors here are usually more objective and recognize the high valuation, but they will say things like “this always trades at a premium”. That may be true for their experience in this company, but if you invest long enough almost everything can get down to 16x earnings (or whatever is average for that industry) or lower. The investors can’t fathom their beloved company not executing perfectly and the market not caring about their business. Or even if they execute well, the multiple coming down faster than the growth rate can keep up.

Again these are usually strong business and can/should be monitored for a mis-step. The shareholder base may lose their mind and oversell the company. The narrative shift is strong and the business performance may be fine, but the narrative during any mis-step is overdone. Anyone remember when MSFT was trading less than 10x EV/EBIT because Google was offering similar products for free (or whatever the narrative was at the time)?

Insane Valuations that are different this time

Insert whatever the current bubble/theme is (AI at time of writing). These are usually “innovative” or “disruptor” stocks. 2021 amirite? These are usually very fast growing companies that have some sort of strong market position. Investors/traders don’t really care if the business is a real business (you know the kind that makes money) only that the company is mentioned by the media and by popular traders. These have a strong and very defensive shareholder base/cult that doesn’t really talk about valuation. The shareholder base can be mostly retail and may have an unusual cult following due to some technology, platform, product, social mission, founder, etc. Many of the industries do better than anticipated over the long term, but you may have already paid for that with the high initial valuation.

If you questioned the business or opportunity, you are likely mocked and made fun of. “We have something special and we’ll worry about making money later.” is something you may hear from this example. Ironically, these investors usually mock the oil/gas and precious metals investors mentioned earlier but they are very similar.

There are so many covid winners it’s crazy. Take a look at this gem as an example.

And another….

And another one….

To be fair, I don’t follow either of these companies. The only thing I know about them is they were heavily promoted by grifters.

A personal example of this came before covid when I was still at my day job. I had many of the workers tell me to buy Aurora Cannibis. We even had salaried employees leave well paying jobs to join ACB in the hopes their career would benefit from it’s fast growth. It worked out less than stellar.

The Warren Buffett of…., or the next Berkshire….

I’m sorry but, there is no next Buffett. The scenario that made Buffett successful is not the one we have now. He is brilliant, no doubt. That is not the reality of the “Next Buffett”. The person may actually have better capital allocation skills, but not the same set-up.

I would be skeptical of a company whose shareholder base constantly says the CEO is the “next Buffett” or similar. There are success stories, but there are many more failures. Given that I can honestly say I’ll likely never spot the next Buffett of anything, I just stay away.

Superior Style of Investing

This relates to who may be a major holder or who is mentioning the company on social media.

Things come and go. What worked in one cycle doesn’t work in the next. Former high flying fund managers and investors that were hyper successful in one cycle have a very hard time adapting to new realities. The hardest part for them is to admit their success was as much luck as skill. Heaven forbid they are actually just average stock pickers who got lucky. Who was the best investor over the last decade? What did they own or invest in primarily? Was that the same as the decade prior? It never is. Cycles happen, it’s our reality. Don’t fight it. Accept it and benefit from it. We are here to make money.

Anything in Canada that ends up having a larger market cap than Royal Bank

That’s it. Nortel, BlackBerry, Valeant, Shopify are the examples here. Not worth the risk to me. When they do pass RBC it’s hype driven. If you happen to own one of these before it surpasses RY, congrats. Now lighten up or completely sell the position. You’ll thank me later.

CEO on Twitter/X or other message boards

This isn’t the CEO or company profile posting a news release and leaving it at that. I have never been the CEO of anything and likely never will. From what I understand, it is a very busy and demanding job. If I was in that role, I would want 100% of my attention on the business. If the CEO is a reply guy, troll or at all engages in non-productive behavior in social media I’m out. It’s that simple.

Some Closing Thoughts

The combination of enough time passing and mental rigidity has allowed me to fall into several of these multiple times. Being honest with myself, I will fall for several of these again. The hardest part is swallowing your ego, admitting you did something dumb and moving on. You don’t need to make it back the same way you lost it. You likely have already found better uses of capital.

Comment below if you have more examples or think it’s valuable to make a list of positive indicators that I have found. I’ve been tossing around some investing lessons/post mortems posts.

Thanks for taking the time to read.

Dean