Welcome back to your Extreme Small-Cap Profits email course.
We’re now on Day 6 of 12.
If you missed yesterday’s email, we had a look at where you might find super profitable small-caps.
The ones that skyrocket in months are usually found in high growth industries. Of course, that’s not always the case.
But if you can get on the other end of an emerging high growth stock, you can potentially double your money in less than a month.
This is exactly what happened to sensor technology company, Panorama Synergy Ltd [ASX:PSY].
Before the first month of 2018 was over, Panorama climbed 100%!
The only way to capture such explosive small-caps is to consider their application, potential, and the size of the market they serve.
Today, you and I are going to take a deeper look into the businesses behind the small-caps. After all, small-caps are not just pieces of paper gyrating up and down.
Behind every one is a business.
More than just a piece of paper
In my day trading hay day, all I cared about was numbers.
I wanted to buy something at three and sell it at nine. It didn’t matter what I was buying. I simply reacted to price movements, buying and selling numbers.
I see people do this all the time.
They buy stocks because they ran up in the past and are still only worth only a few cents. Or their decision to buy is based on some type of ratio, like the price-to-earnings (P/E) or price-to-book (P/B) ratio.
This isn’t how you should approach small-caps. They’re not just prices on a graph.
Forget about prices for a moment.
A far better way to think about it is that you’re buying and selling businesses. And what you’re buying is a business’s earnings potential.
Consider you had the option to buy two businesses, Microsoft Corporation [NASDAQ:MSFT] or IBM [NYSE:IBM].
I know both aren’t small-caps, but humour me for a moment.
Both produce products in high demand. Microsoft creates software, IBM creates computer hardware.
For Microsoft to sell one more copy of software, it costs almost nothing. For IBM to sell one more computer component, they’ve got to manufacture and ship it.
Now, which business would you prefer to own?
Of course you’d rather own Microsoft.
Not only do they have products in high demand, selling one more copy of software after it has already been developed costs the company almost nothing.
Thanks to their favourable business model, Microsoft has a profit margin (how much of revenues flows into profit) of 23%, whereas IBM only has a profit margin of 14%.
Clearly the more valuable business is Microsoft.
What is valuable?
Now it should be easy to answer the following question. What makes a business valuable? Why could it potentially be worth a lot more than its current price?
Why are earnings valuable?
As a shareholder, you’re often entitled to earnings. Therefore, it’s in your best interest that a business earns as much as possible by spending as little as possible.
That’s why when a business dramatically increases earnings, the stock price usually skyrockets.
To see what I mean, let’s take a look at GetSwift Ltd [ASX:GSW], the logistics management software small-cap.
In 2017, the company was signing deals left right and centre.
They signed contracts with Fruit Box Group, Cross Town Donuts, Commonwealth Bank, Pizza Hut, and 10 other companies.
Before listing in 2016, GetSwift generated revenues of just over $100,000. One would expect 14 new customers to significantly boost sales and earnings.
So investors jumped on the stock while they had the chance.
Then in December last year, GetSwift inked an agreement with online giant Amazon.com, Inc. [NASDAQ:AMZN].
The mere association with Amazon made investors think GetSwift had something great.
Source: Google Finance
That year, GetSwift’s share price rose more than 1,100%. It put the stock in the top five of the ASX’s biggest gainers in 2017.
As small-cap investors, we want to jump on these kinds of opportunities early.
That means we need to first identify companies with great products or services, which can service an extremely large market.
But what if we miss the boat?
Whatever you do, don’t overpay
No business is worth an unlimited amount of money.
Sometimes it’s easy to forget this when talking about the explosive potential of small-cap stocks.
Investors end up paying dollars for a stock that might only be worth cents. They come up with ridiculous growth assumptions to justify their purchases. They don’t end up buying growth. What they’re buying is inflated expectations.
If we cast our eye back to GetSwift, this could be one stock investors have over hyped. The company is being accused of poor market transparency, according to the press.
GetSwift’s lack of information has encouraged investors to sell the once darling stock.
In 2018, the software logistics firm dropped more than 20%.
It’s not a massive drop. But it just goes to show because a stock is going up, that doesn’t mean you should jump on.
Source: Google Finance
This doesn’t mean all rising stocks are too expensive.
Some stocks trade at more than 50 or 100-times their earnings. Meaning investors are paying $50 and $100 for each dollar of current earnings.
Even at such a price, they could make for amazing investments. It really depends on a case-by-case basis.
And it would seem online retailer, Kogan.com Ltd [ASX:KGN] might be one of those stocks.
At the start of 2017, Kogan had a P/E ratio of more than 170-times earnings. Yet in that same year, the stock almost quadrupled.
Source: Google Finance
Investors bought the stock because revenues were growing by double digits, profits grew by more than 360% and the company was using cash to aggressive grow operations.
Of course, Kogan’s story is long from over. But for now, the business is heading in the right direction.
That about does it for Day 6.
You’re half way through. Only six more days until you graduate and become a small-cap investing master.
Today was just an introduction to looking at the business behind the stock. Tomorrow, in Day 7, we’re going to dig even deeper.
Don’t worry if you’re not a number person. I’ll explain how you can find out if a small-cap has legs in less than 10 minutes with nothing but elementary maths.
Editor, Money Morning