The Key To Finding Winning Stocks
Happy New Year’s Eve!
I hope everyone has a great day and even better night. 2021 was a great year for the markets and my portfolio. Let’s continue to find great opportunities in the market to exploit and make some money.
Before we get into the last letter of 2021, first a word from today’s sponsor…
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*See important disclosures.
How to find winning stocks
Everyone’s investing style is different. There are thousands of ways to make money in the stock market. Thousands of ways to blow up your account too. No one way is right. Find your niche and become the best you can be at it.
My niche is in the tiniest companies around. Microcap and nanocaps. Companies so small that anyone who is anyone on Wall Street can’t invest in them. When you are investing in microcaps and nanocaps being poor becomes your competitive advantage.
But I don’t just invest in any microcap. There is a ton of garbage companies out there and in microcap land it is even more prolific. Companies that are not even real. Pump and dump schemes. Business models so terrible they will never make the equity owners any money. You have to sift through a pile of garbage to find the gems.
I’ve created a quick checklist (not exhaustive) that I personally use to find winning stocks. A few things I look for:
Multidecade lows: Hated and unloved companies are my favorite. Industries that no one else wants to own. Think newspapers, radio broadcasters, coal miners, retailers, etc. Individuals tend to get over optimistic in good times and overly pessimistic in bad times. I like to use the nature of human psychology to my advantage. When a stock is priced like it will go bankrupt I get interested. If I can justify that the net present value of the future cash flows is more than zero, I will dive deeper into the financials. Most of the time the worst case scenario never happens.
Severely undervalued on traditional valuation metrics: Call me old school, but traditional valuation metrics still work in this tech centric market. Low price-to-book, depressed EV/EBITDA, NCAV and companies with more cash on their balance sheet than their market cap is worth. These metrics are just a starting point that I use to screen for winning stock picks.
Insider buying activity combined with historical low stock price: I get really interested in a stock when an insider starts buying the shares — my interest level perks up if the stock is trading at a multi-year low. Insider buying really only means one thing: they think their stock is undervalued and will appreciate from here.
Forced selling: I love when stocks are kicked out of index funds. This happens at least once per year due to the Russell Rebalancing. This creates an artificially forced selling event where stocks get hammered for up to one month as index funds are required to sell them — based on zero changes in the fundamentals. The Russell Rebalancing is one of my favorite events. And the best thing about the Russell Rebalancing, investors get the list of stocks to be kicked out of index months ahead of time.
Crowd source ideas from investors I respect: One of the best ways I have found winning stocks is to talk to professional investors that I respect. When a professional investor (who has been in the game for decades) tells me their top idea I will dig into it. Some of my biggest winners have come directly from other investors.
Watchlist: After building out a model, reading the financials, speaking with a management team and essentially running my full due diligence process, I will put a stock in a watchlist. This watchlist will have the current price and my internal “price target”. When the stock falls drastically below my price target I will revisit the research I have done and make a decision to buy the stock.
This checklist isn’t exhaustive but a quick start. Every winning stock idea is a little different from the last one. Even though every winning stock idea is a little different from the last one, there is one thing that stays constant — my research process. My research process consists of the following:
Read the financials: The first part in understanding how a business works is the read their financials. This includes the annual reports, quarterly reports, any 8-K out there, etc. After reading an annual report I usually can decide if I want to do additional research on a said company.
Build a financial model: After reading the financial statements I will build a financial model. This includes entering the data of at least ten years worth of financials so I can see how the company has performed in the past. Once the past data is inputted I will try to predict how the company will perform going forward in the future. I try to forecast financials from the bottoms up. Forecast how each segment will perform then aggregate it all at the top of the consolidated income statement. Discounted cash flow models get a lot of hate, but after building hundreds of these you will learn what drives returns.
Read and listen to earnings transcripts: In my opinion, reading or listening to earnings transcripts will provide more value that reading the financial statements. Four times a year the management team of a company will host an earnings call where they will talk openly to investor on how their business is performing and what they think will happen throughout the year. At the end of the earnings call investors will call into the management team and ask them questions. There is always great information to take from an earnings call. Information that doesn’t show up in the financial statements. If you are not reading earnings transcripts you will be out of the loop.
Speaking with management teams: After performing all of the above I will reach out to the management team and speak with them. A personal call with a management team allows me to evaluate the creditability of who is running a company I want to invest in. The great thing about microcap stocks is the accessibility of the management team. If you wanted to speak with Elon Musk or Jeff Bezos, good luck making that happen. But with a company that is only valued at $30 million, access to the management team is only one call away.
Model out competitors: At this point if I am really interested in a company I will start doing research on their competitors. This includes building a financial model, speaking with management teams, doing channel checks and essentially trying to figure out how this industry works and who is the best of the best in the industry. Running this process has sometimes lead me to invest in a totally different company than the one I was originally interested in.
Touring the company: When I really like a company and I want to take a major position I will try to set up a tour. Touring the assets of a company is a great learning experience. You get to see exactly how they generate cash flow. You will see all of the moving parts in the system of capitalism. And you will get to talk with non-executive workers and potentially get their opinion on what works and doesn’t work. I won’t always tour a company as it is a long and costly process. But when I think there is major upside I will try to set something up.
After identifying a potential investment opportunity and after doing my own personal due diligence on that investment, I usually don’t end up buying, but instead end up waiting. This ties it all back into my “watchlist”, highlighted above. I will set a price target on a potential investment and wait until the market re-prices that security to a level where I feel comfortable initiating a position.
This due diligence process can take weeks or months. It is time consuming and data intensive. But after all of my years working on Wall Street at a long/short hedge fund this is what I have found works. A process that involves deep fundamental research. If you know more about a company than anyone else you will be well positioned to make money when the time comes to buy a security.
When I was an analyst at a hedge fund we performed this process on larger companies in the small-cap and large-cap space. When I decided to become a private investor I had the realization that doing the same process, but on the most illiquid and smallest companies out there would be my competitive advantage. Microcaps are an asset class that is forgotten about by the majority of Wall Street. It is an asset class that is alpha rich for those willing to do the work.