How To Find Great Micro-Cap Stocks

During their recent episode, Taylor, Carlisle, and Ralph Molina discussed How To Find Great Micro-Cap Stocks. Here’s an excerpt from the episode:

[Ralph] Yeah. And I will be a little conscious here because right now I am an outsourced investment analyst for some other hedge funds and other investment firms. So don’t want to talk too specific about active names that we’re looking at just for their own proprietary sake.

But I am really looking for other companies like Armagnino Foods. The thing that really helped me understand, I think Armagnino Foods was a great experience as an investor. Obviously it hasn’t been a mistake at least yet since my initial investment in 2021.

But after also consulting with the company, I realised a few things. One of the most important things is that this relationship between capital allocation and competitive dynamics and the core. And that’s kind of what I’m looking for now.

So Armagnino Foods, when I invested, it had net cash. It had basically no goodwill and it hadn’t issued any equity. And so when I think about a company that does all those three things, typically it’s a very unusual board and management team that has that kind of dynamic.

Usually it’s founder orientated or family still affiliated or something like that. Especially for micro caps and small caps, you don’t see that kind of setup. And usually what that means when you think about it on a quantitative basis, how do they have net cash if they’ve never issued equity?

And what does that mean about the core business if they’ve never acquired another company? This means that this is a profitable core with a long runway. And so something that I’ve done and I encourage others to do is actually filter first through capital allocation.

And strangely enough, if you filter through capital allocation, you can typically find a good quality business because it’s very hard. Like my involvement at Parks American, Armagnino Foods taught me that it’s very hard to have good, stable, predictable, creative capital allocation when you’re in a bad business. Jake and I kind of have affiliation with like the utility from our careers and lives past.

But one thing that always baffled me was that utility company would issue equity while paying dividends and also leveraging. There’s a lot of financial engineering that goes involved in order to create a desired outcome to get the right shoulders that you want. That doesn’t happen if you have a good core business.

And so I’ve actually been able to find several good niche small caps and micro caps simply through that, starting with that screen. And then of course, I’ll use other ways to screen and filter down so that it’s an understandable universe. But really looking for companies with that kind of unique capital allocation profile.

[Tobias] So no good will, net cash on the balance sheet and has never issued shares. Those are your screening criteria?

[Ralph] Yeah, ideally net buybacks, right? 1% growth in shares outstanding isn’t going to kill me. But after a certain point, right, if you get to 2%, it’s going to be hard, right?

And if you’re buying these more quality companies, you start to reverse engineer with the free cash flow plus growth that you would need in order to at least get a sustainable 10% return. And that 2% equity issuances is actually a large hurdle to get over. Because not every company is going to be converting revenue to free cash flow growth in the same way, unless you’re buying at a very particular time where capex is actually going to be much lower in the future than it will be in the past.

But primarily looking at those things. And ideally, the goal is to find near perfect investments, and then make trade offs where it’s necessary for each situation. And, you know, you can make a trade off in goodwill, like you can buy a company that has made acquisitions, you can also make a trade off with the debt or net cash situation.

But it’s really about the context between all the variables, right? How predictable and durable is this company? Trying to think of some, I mean, one slightly larger company that I’ve found is, and I’m not saying it’s good investment, but it just shows you the power of the screen.

If you just use a screen, the company is called Rightmove. It’s traded in the UK, are you guys familiar with it? No.

Jake, you’re nodding your head. It’s a property portal company. And it’s the largest property portal company in the UK.

It’s I think it trades between a billion and $2 billion. But it has net cash, it really hasn’t issued a lot of equity. And it doesn’t have much goodwill, because as you can imagine, with these kinds of marketplaces, you don’t need to acquire something else.

Your business is, you know, highly defensible. And so that came up on the screen, simply just from looking at capital allocation. So I was able to find a good quality business at that.

And it is interesting that Rightmove is trading at a lower price than in years past. Now, I’m not saying for people to go buy now, but it’s just, it’s a good lead, right? Because the relationship between those, you know, a qualitative variable, like capital allocation, and then more quantitative variable, like quality, like, you know, how high is the free cash on?

[Jake] Yeah, you got the AI. It’s kind of considered a loser from AI potentially. And then you got the UK listing, which is also a double whammy on it right now.

[Ralph] Yeah, yeah, totally.