You’ll Find This Profit Formula behind Every Genuine Small-Cap Success

Stock rising, small caps

Welcome back to your Extreme Small-Cap Profits email course.

We’re now on Day 7 of 12.

If you missed yesterday’s email, we looked at one of the most important factors helping small-caps rocket up 100%, 500%, and even 1,000%.

That factor is earnings.

If a company says earnings will be 50% higher than last year, herds of investors jump into the stock. They all want to capture some of that growth.

In yesterday’s email, we saw that happen to GetSwift Ltd [ASX:GSW].

While the company didn’t put figures to their upcoming earnings, they signed contracts with 14 new customers. Investors expect earnings could skyrocket in 2018. So they piled in now while they had the chance.

The stock ended up climbing 1,100% last year.

The whole idea is to jump into small-caps before this even happens. You want to find stocks with the potential to significantly grow earnings in a short timeframe.

That way, when earnings do rocket up, usually, so will your shares.

Today we’re going to take a more in-depth look at the businesses behind the shares. Having the ability to read financial statements will do you a world of good as an investor.

So let’s dive right in.

Cash is king

I’m sure you’ve heard the expression: ‘cash is king’.

It essentially means cash flow — cash flowing in and out of the business — is extremely important.

And it should be pretty obvious why.

If a business cannot meet their immediate payments, there’s a good chance they’ll go under, taking your money with them.

Let’s use IBM, which we looked at in yesterday’s email, as an example.

Big Blue has a lot of expenses in any given year.

They need to pay their employees, rent, interest on debt and any other costs to keep the business alive each month.

On top of this, IBM needs to pay for the raw materials and labour to build computer parts. If they want to increase output, they’ll need to spend even more cash to do so.

All of this adds up in a year. 

In 2016, such expenses cost IBM around U$67.5 billion. Thankfully, for IBM shareholders, Blue Big makes more than enough in sales to cover expenses.

But imagine if they didn’t. What would happen if IBM couldn’t meet their immediate obligations?

The company would probably try to cut costs, to decrease the amount of cash they need to pay within a given year.

They might also try to renegotiate terms with their creditors.

IBM might even take on more debt to get through what could be a tough trading period.

If all else failed, IBM would go under. They’d file for bankruptcy and pay off their debt with what little they have left.

This is why, as an investor, you always need to be thinking about a business’s cash flow position.

How long is the runway?

For small-cap stocks, cash flow is extremely important. I would argue it’s even more important for small-cap than it is for Blue Chips like IBM.

And that’s because they have far fewer options.

Unlike IBM, small-caps don’t have as much power to renegotiate lending terms. They also usually don’t have extremely high share prices, which companies can use as currency to raise capital.

The idea for many small-caps is to grow…and grow fast.

But early on, many use existing cash to fund operations. Therefore, it can be useful to know how long this cash will last before the company needs more.

I like to call it the runway of a business.

As an example, let’s take a look at the $140 million technology lighting company, Bluglass Ltd [ASX:BLG].

In 2017, the company’s costs far exceeded sales.

Bluglass generated $684,855 in sales and racked up more than $3.6 million in expenses, most of which went to employees.

If we look at Bluglass’s cash flow position, they paid out far more cash than they received.

They saw more than $2.5 million in cash go out the door during the 2017 financial year.

How did they finance this loss? They issued shares.

Instead of debt, which comes along with interest payments, Bluglass issued more than $7.7 million worth of shares to keep operations alive.

As of 30 June 2017, Bluglass had $8.5 million in cash on their balance sheet. That means if costs remain the same, Bluglass is looking at a runway of a little over three years.

If they can’t grow earnings significantly by that point, the company might again have to issue more shares, diluting existing shareholders.

With this information, you can make a judgement call on whether Bluglass can grow earnings within that time.

Maybe you believe it’s plenty of time for Bluglass to ink some contracts and aggressive add to their customers base.

On the other hand, you might think it’s not nearly enough time for the industry to adopt Bluglass’s LED technology.

Stay away from debt funding

Bluglass is one of the more typical cases.

Many small-caps have expenses far exceeding revenues. To fund operations, they issue shares.

While it’s not ideal to buy a business that might potentially ask for more money, it’s far better than if the company has too much debt.

Early on, businesses don’t have reliable streams of cash. Sales might go up 50% one year and 5% the next. Earnings are lumpy.

The last thing small businesses need is large interest payments digging into cash reserves.

I’m not saying you should only invest in debt free small-cap (while it might not be such a bad idea). But be cautious of too much debt early on.

Coming up next…

That wasn’t so bad was it?

With only a little bit of maths, you should now be able to tell if an Aussie small-cap has legs or not. Add in a bit of common sense, and you now know how to stay out of a whole lot of trouble.

That about does it for Day 7.

Tomorrow, in Day 8, we’re going to look at something a bit different. So far we’ve been focusing on how to buy profit small-cap stocks.

The other half of the equation is to sell them. And that’s exactly what I’m going to talk about tomorrow.

See you then.

Cheers,

Härje Ronngard,
Editor, Money Morning  

Harje Ronngard

Harje Ronngard

With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.

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