Digging around at the small-cap end of the market can be a dangerous activity, especially if you’re investing like a loose cannon by buying without a plan or strategy.
Despite these dangers, value investors do love their small-caps and so it’s worth spending some time drawing up a repeatable and systematic plan for uncovering value.
This is the critical first step in becoming a successful investor because study after study shows that investors are generally very bad indeed at stock picking.
Most recently, Professor Greenblatt outlined how individual investors have wiped out the magic formula advantage by making poor stock picks.
So let’s start by picking Psion (makers of the iconic Psion Organiser II back in the 1980s) which is a company that I know scores highly on the 21st century net-net screen, and see how it fares. Here’s the 5-year chart:
Look for companies with little debt and lots of cash
The reason for wanting little debt and lots of cash is that the future is uncertain. In fact it’s so uncertain that there are no meaningful ways to work out the probability that any particular economic event will happen.
If the future is uncertain then the earnings of any company are uncertain and so it’s probably better to have the adaptability that being debt-free and cash-rich brings.
Looking for net cash is a simple way to find companies with a good balance of debt and cash. Psion has net cash with around £27m cash in the bank and only around £2m in debt, compared to £6m operating profit last year.
The current and quick ratios are also favourites of many value investors and for Psion the current ratio is 1.6 and the quick ratio is 1.3. Both of these are reasonably healthy figures, especially the quick ratio of more than one.
Buy companies that are cheap (this is value investing after all)
This is a ‘deep value’ strategy, based on Ben Graham’s net-net strategy, so value is measured against assets. Psion’s price to book ratio is 0.35 which is way down in the bottom 10% of companies by price to book.
The price to tangible book ratio is 1.2 because the company has £118m of intangible assets which might scare off some hardcore ‘asset’ value investors, but for this strategy intangibles are not…
