A very simple research process

My research process

Summary:

• Financial statements (income, balance, cash flow)

• Fully diluted capital structure (warrants + options.)

• Qualitative factors of company

• Capital allocation efficiency

• Insider ownership + incentive structure.

I don’t do Comparables analysis, only absolute value. If the entire stock market is overvalued, doesn’t make sense to do relative valuation, right?! I essentially look for cheap EV/EBIT stocks. But this doesn’t mean I don’t pay up for growth. Growth is value, in it’s early stages, as long as the growth becomes profitable and reflects in the bottom line eventually. This list is particular to microcaps but can be applied to all business. These are my steps.

1. Financial statements- 90% fail.

I prefer cheap p/e growth stocks. Long operating history and at or near profitability. A lot of companies will tell you they are almost profitable but will take years for them to become profitable. Best to wait until they do, even if the stock price went up by then, it reduces a lot of the risk. I prefer high gross margin businesses so that when they reach enough revenues, operating leverage kicks in and every incremental revenue thereon comes down to the bottom line (net income.) This is a topic by itself. I like recurring revenue companies. Make sure there is no customer concentration risk. If there is, wager the chances that they won’t lose their customer, if they lose them to competition, or if the customer doesn’t see value in their service/product.

I like very clean balance sheets and prefer net cash on hand. However, debt is not a bad thing, and as long as their profits from operations can eventually pay down the debt, I am ok with it. However, factor the debt into your valuation (EV/EBIT.)

Cash flow. Make sure they collect on their income! Growing account receivables is a bad thing. Income can be tricked but cash is very hard to lie about. Depreciation and amortization are real costs. Don’t look at EBITDA metrics that management feeds you!

I don’t invest in pre-revenue companies unless it’s a significant net-net with a clear catalyst.

2. Fully diluted capital structure- be careful of perpetual share issuers

You want your company to treat its shares like gold (unless it’s growth by acquisition company). The worst thing that a company can do is issue shares at low prices because then the valuation of the previously high company comes drastically down. Issuing shares at low stock prices is equivalent to burning money. That’s why look for healthy balance sheet and profitable stocks so that they may never do this.

Specifically look for warrants, stock options, and convertible dentures (W, O, D) and their strike prices. Anything that has a low strike price will severely impede the company valuation (if the quantity of the WOD is great enough.) Often times if the size of the WOD is big enough, it will put a ceiling on the stock price because people will treat it as arbitrage (short the stock, and exercise the WOD.)

I like less dilution, preferably no dilution, except stock options are inevitable and some are even good to encourage management to raise stock price.

I like a low share count (under 80MM shares fully diluted.)

3. Qualitative factors- most important and company specific

Financial statements tell you the past performance of the company, not the present and future. Do your research on competition, customer satisfaction, if it has a moat, whether they can grow revenues, maintain their margins (competition,). Look for contracts, deferred revenue on the balance sheet, and revenue backlog. Companies usually say in this in their quarterly MD&A and news release. There is so much company and industry specific things to look for I don’t know even know what to write here. Bottom line, just make sure they can maintain/grow their revenues while maintaining their margins.

4. Capital allocation: “Money is no good if you can’t keep it” - Stink Stonk.

Similar to Mark Twain’s quote, “A person who won’t read has no advantage over one who can’t read,” making money is useless if you waste it, which is it what many companies do.

If the stock is undervalued, I want them to do share buyback (NCIB). If they don’t know what to do with the excess moolah (money) I want them to issue special dividend. The last thing I want them to do is acquire garbage in attempt of “growth” or waste it in some other meaningless way.

Ideally I want a company that can reinvest itself for high returns on investment (ROIC) for a long period of time (economic moat.) No reversion to the mean.

People often think that money a company earns is their own, but the truth is if the company wastes their profits, it’s equivalent to company never making money at all because shareholders won’t get any of it. Look for what they do with their extra cash. This takes me to my last point, high insider ownership.

5. High insider ownership

You want a company with high insider ownership. If they have high insider ownership and skin in the game, they won’t ruin their own equity stake. They will be vigilant in keeping costs low, grow revenues, and most importantly not waste money through bad capital allocation decisions. They won’t sacrifice the long term outlook of the company for short term revenue and income boosts.

Also dig into the management information circular (filing) and look for compensation structure and what their bonus depends on. Whether it’s based on EPS, revenue, or profit targets, or other metrics and make sure it doesn’t involve management taking shortcuts to meet their targets.

Some companies do share buyback even if the company is overvalued to increase EPS metrics. BAD!

This is only a start for investing in stonks, there is a lot more details to look for.

-Stonk out. Share to get your boi some clout.