Buying Equity in Smaller Companies: 8 Valuable Lessons

This week the Small Cap team take a look at eight of the lessons they have learned over the years. An important read for any investor who fancies the smaller end of the market.

SUMMARY

Smaller companies investing is a source of constant learning. In this article we discuss 8 valuable lessons in how to most effectively employ capital in this high returning asset class which we’ve learnt over the years. In our opinion the nature of investing means lessons learnt are valuable opportunities to improve future returns. 

1. Be patient - never chase

"Patience is bitter but its fruit is sweet" - Aristotle

​When investing in smaller companies you will constantly be presented with opportunities to chase stocks which have already started moving on the back of news-flow, results or nothing at all. Once a stock starts moving which you are looking to buy, it is natural to wonder if it will ever come back or if you risk completely missing the opportunity. FOMO (Fear of Missing Out) will often emerge in these situations and you may feel compelled to take action as a result.

However, in our experience, chasing stocks rarely works. Even if it looks like a stock is unlikely to trade back down to your level it is worth remembering that all the recent buyers of that stock are sitting on profits they’ll be tempted to realise into strength. As a result, it is very unusual for a stock to move upwards in a straight line, and profit taking driven opportunities are likely to emerge. 

Patience is your friend when investing in smaller companies. 

2. Capital raisings can be great opportunities

“Opportunities are usually disguised as hard work, so most people don’t recognize them”
​- Ann Landers

​Capital raisings often present great liquidity opportunities in smaller companies, and they are often offered at a discount to the prevailing stock price at the time. As with all market opportunities, the most attractive capital raisings in the highest quality companies will be in most demand and vice versa. 

Assessing the merits of a capital raising does take considerable effort, and some investors simply don’t have the time or willingness to do so. At DMX Asset Management, we will only participate in a capital raising if we know the company extremely well, were intending to increase our position size in the stock in the future anyway, and the company has a clear plan to allocate the new capital in an earnings accretive and sustainable manner. Ticking all these boxes means saying no to many deals as part of the process, and arguably saying no to these deals is equally as important as saying yes to the right deals. 

Example: A good example example of a worthy and attractive capital raising in recent months came from Konekt (ASX:KKT) late last year. Konekt raised capital for a highly earnings accretive acquisition which is consistent with management’s long term and well communicated strategy. In our opinion the stock is extremely cheap at present so we gladly took advantage of the capital raising opportunity. For more details on Konekt see our recent piece.

3. Develope a few key long term broker relationships but pay close attention to trading costs

“Wall Street is the only place that people ride to work in a Rolls Royce to get advice from those who take the subway.” - Warren Buffett

​In our experience there are a few key noteworthy brokers in the market who are involved in developing capital raising opportunities for reputable companies in  the ASX listed smaller companies’ universe. This is a high value add service which we are thankful the broking community are providing.

However, having said this, long gone are the days of brokers charging 3% commissions to trade equities without any value add services. Some old school broking houses do still attempt to charge high commissions for trading smaller companies but as a general rule commissions have been decreasing for many years and are now relatively low. 

Maintaining trading costs at a minimum has significant long term performance implications so it is a worthy focus in our opinion.

4. Maintain calm and strategic thinking in the face of market volatility

“Sometimes there is no time to wait for the sea to calm down. If you have to reach your target, let your voyage start and let the storm be your path.”  - Mehmet Murat Ildan

​This is a lesson that will be relatively new to younger investors since it has been quite a few years since we’ve experienced the volatility previously considered normal in the global equity markets. However, the recent re-emergence of volatility is unlikely to be an isolated incident in our opinion. Volatility tends to feed off itself as it highlights to the market that the risks of owning equities are alive and well. 

As most value investors do, we like volatility. It allows us to take advantage of opportunities which would not be on offer in a low volatility environment. Bring on the rest of 2018. 

5. Don’t believe the hype

​“People are sheep. TV is the shepherd.”  - Jess C. Scott

Often, the market will discover a company which is promoting what appears to be a revolutionary idea or product. The momentum in this type of stock will attract more and more speculators who are afraid of missing out on the next big thing, driving further share price appreciation.  However, on a closer examination of the financials of the company, it is more than often the case that the story or ‘hype’ far exceeds the reality and as a result there is significant ‘hot air’ built into the share price, which can quickly deflate. In recent times on the ASX, Getswift (ASX:GSW) and Big Un (ASX:BIG) are noteworthy examples of the market getting far too ahead of itself, with significant gains quickly evaporating. 

​When we invest we ensure that the fundamentals of the company support our investment decision and, that we are not paying up for ‘hot air’.

6. Never let the market force you into taking action

​“Does the walker chose the path or the path the walker?” - Garth Nix

​Developing and sticking with a long term investment plan allows you to maintain far more control over your investment process than your average investor. As you get to know to know the market better you come to realise that the vast majority of investors feel the market is forcing their hand rather than the other way around. 

We recommend spending time developing and fine-tuning your investment plan, and following it through without becoming distracted by market moves. 

7. Keep your eyes on the long term prize

​“You can’t build a long term future on short term thinking.” - Billy Cox

​Thinking long term is one of our core philosophies at DMX Asset Management. As with most other investing disciplines it takes consistent work to develop a true long term mindset.

Once you start thinking in a truly long term manner it becomes easier to see the fundamentals of a business and to look through all the short term noise. And importantly, in our experience your performance tends to improve as soon as you stop focusing upon short term stock movements and news-flow. 

8. Trust yourself

“I don’t like to gamble but if there’s one thing I’m willing to bet on, it’s myself.” - Beyonce

​Trust yourself: two simple words which imply a lifetime of ongoing learning and getting to know yourself. In our experience the best investors in the market remain humble in the knowledge that there’s always another lesson coming, and they never feel like they have mastered their craft. However, incrementally trusting yourself more and more as you evolve as an investor is a positive path to be on, and one which tends to reflect itself in improving returns over time. 

CONCLUSION

​We remain firmly on the smaller companies investing learning curve and look forward to building upon our strong track record by remaining humble and open minded.