Thursday, September 25, 2014
Special Situation Investing
The U.S. stock market has come under renewed pressure. In the short run prices are falling across the board. Before long, though, the fear is likely to dissipate. Investors then will put all that cash back to work.
Special Situation growth stocks thrive in periods like this. Capital always seeks out its highest return. Every once in a while the market loses its bearings and measures those returns in non-financial ways, like website clicks or probable barrels of oil reserves. It invariably comes back to money, though. Special Situation growth stocks produce the best returns because they consistently make money, they increase those earnings quickly, and the price to get into the stocks isn't particularly high. They are under priced in relation to their true value.
Special Situation growth stocks share a number of characteristics. They're in the "Post-venture, Pre-institutional" segment of the market. The companies are out of the development stage. But the stocks still haven't been picked up by the mutual fund community to any meaningful extent. They have several years of experience with clear-cut track records. Finances are solid. Management is proven. The products and services have unique elements, so margin potential is high. The companies are scalable with superior returns on invested capital. Some external financing might be necessary to fund exceptionally fast periods of growth. But dilution tends to be modest because cash flow generation usually is sufficient to support growth internally.
There are three basic types of stocks we focus on. The first are "natural breakouts." These often are the most profitable. They also are the most difficult to find. This group consists of companies that are middle of the pack growth companies -- that catch fire. They've spent years cultivating their business. Now it's taking off. If you wait too long to purchase these shares they get discovered by other investors instead. Get in too early, you run the risk of buying the story instead of the facts. The only way to discover a "natural" is to scan the universe for signs of acceleration, and dig down into every one. Most are aberrations. But a few are the genuine article. In those cases the payoff can be terrific. Examples include Profire Energy ("American") and Highpower International ("Fuel Forethought").
The second group are established growth companies with upside kickers. Investors are inundated with stories about companies that are gonna' do this or gonna' do that. In their younger days those investors probably were swept up by some of these stories. They've learned the hard way that it's a hard world. Very few of these things ever pan out. So investors as a group don't pay a premium for them in the market. Special Situation growth stocks already have a proven business, though. That gives them an edge. The core operation is delivering 15%-25% growth or more. Unlike the start-ups that investors are accustomed to, new initiatives at these companies tend to be well thought out and adequately financed. Their success rate is higher. Not all of those initiatives prove successful. It's still a hard world. But even when they don't you haven't paid for the kicker. And the core business keeps rolling along. Examples include Northern Technologies ("American") and Pure Technologies "(International").
We include a handful of high risk selections, as well. Management at these companies have an established track record, either in development work or at previous employers. But the commercialization phase is just starting. Risk is elevated because there is no core business to pay the bills if things get delayed. It's do or die. But this type of Special Situation growth stock normally has a disruptive technology aimed at a huge industry. Even modest penetration can lead to unusually high stock price appreciation. Because of the risk we have to keep this segment to a low percentage of the entire portfolio. The payoffs can be fantastic, though. Even small positions can amplify the portfolio's entire return. Examples include Tesla Motors ("Fuel Forethought") and Lightbridge Technology ("Fuel Forethought").
Special Situation growth stocks don't grow on trees. You need to know what to look for. And it takes a lot of looking. Computer screens are great at generating leads. Watch the news. Study the IPO market. There's no end to where the ideas can come from. The key is to know what you're looking for and to do the work yourself. Even at the institutional level -- perhaps especially at the institutional level -- the last thing you want to do is listen to a research analyst or broker's buy recommendation. That ship has sailed by the time they figure it out and finally tell you about it. Do the work yourself. Then trust it.
Sound portfolio management controls risk and helps generate consistent, superior returns. Academic studies suggest 5-8 stocks provide sufficient diversification. We generally own 20-25 stocks ourselves, to make sure the volatility is kept in check. Every stock you buy looks like a winner the day you buy it. Experience shows that 10%-20% won't work out as expected, though. And only 10%-20% are going to achieve their maximum potential. The 60%-80% in the middle are solid growth companies. That component frequently outperforms the market all by itself. The super winners invariably are bigger than the losers, moreover, lending further ammunition. Our advice is to equal weight the portfolio. Nobody can predict how each stock will go. Use a systematic approach. Do the basic analysis correctly. The math will take care of the rest.
It's pretty simple. Special Situation growth stocks have a well established track record of success extending back to the mid 1970s. We think that trend will continue.