As a small cap specialist, we often look at companies with high risk high return. They may be an innovative tech company with great potential market. They may be an unloved turnaround story. The key is that the share price will skyrocket once their ideas or turnaround strategies work.
As these companies tend to be small and high risk, the way we enter into a position is to take a small holding and then add to the position when the business becomes less risky and as we gain more confidence in management. Quite often the business outcome for a small business are binary. That is, they may have a single product that either sells or it doesn’t.
As Management prove themselves by having continued success, we will increase our weighting in the portfolio, by backing our winners.
A good example of this is when we bought Greencross (GXL) shares at $1.20. We had seen the company when the shares were 60 cents and we kept an eye on the stock until we saw that the management actually executed on what they said they were going to do. At 40 cents the company was on a PE of 8x historical earnings. The Managing Director was an ex-Veterinarian, Glen Richards who subsequently became well known as a judge on the TV program “Shark Tank”.
When we first met Glen, we had no confidence in him as he hadn’t done any deals, appeared trigger shy on pulling the trigger on a deal, and at that point you only have three choices;
1. Decline the investment
2. Watch the investment
3. Back the investment
Its years of experience in meeting management that gives you some intuition and feel for what management might achieve, however intuition can also turn out to be wrong. In the case of Glen Richards, we waited, watched the stock appreciate from $0.60 to $1.20 and then purchased shares on a PE of 12x at $1.20. Subsequently a few years later we sold our holding at $6.80 on a valuation basis. Yes, the shares traded close to $9.00 at one point after that, but we had made good money and markets tend to overshoot.
Investing requires patience, especially investing in exciting high growth high risk stocks. We focus on what the market expects and what the companies achieve. Stocks can be a ten-bagger after management actually executes and proves its ability. That’s how we invest in high risk high return stocks.
Till next week happy investing.