Sunday, February 19, 2006

My Investing Journey: A conservative approach towards small caps 0 comments

(P.S: Sorry for any disturbances the advertisements above may have caused you)
Is conservative small-caps an oxymoron? Traditionally small caps are associated with high risks and hence high potential rewards --- they are the favourites of retail investors who do not have the money or the patience to play the blue chips; occasionally one will be picked out from the masses, by virtue of consistent growth or promising business model, by institutional managers who will accummulate and soon other fund managers will herd and bring about an upward re-rating of the stock --- this is the holy grail for all small cap investors. On the other hand, without the necessary critical mass and support, many other small caps tend to fade into obscurity and illiquidity, removing any exit strategies for the unfortunate holder: that is the bane of small cap investing.

There sure were. At the start of 2001, as I considered the stocks I had been investing in the past, it became clear that I might have been buying the wrong stocks. Why was I buying stocks that were making losses, and then hope to reap the (presumably) huge rewards that would come when the red ink turned blue? The problem with this approach was that firstly, earnings momentum once established was hard to break; secondly, stock price could have gone down so substantially while waiting for earnings to recover that even if it did a two- or three-bagger after the latter actually recovered the investor might not even have got back his original investment; thirdly, I was still a relative rookie investor and did not have the feel of fundamental industry trends, nor the ready access to resources to find these out, in order to establish whether the company's earnings turning point had been reached. In short, I was bottom-fishing without knowing the technical details: was my line long enough, was the bait suitable for the fish etc.

Indeed, I should be investing in recognised small-caps with a history of steady if not growing earnings --- that indicated a stable and profitable industry niche (my business vocabulary was improving) and good management. Stable and growing earnings tended to follow its steady upward trend in the absence of major disturbances. If there were major disturbances in the Force, then the stock had to go down with the falling tide --- however, its strong underlying fundamentals, as outlined by the hitherto steady earnings, should ensure a strong spring (or bungee, they call it) effect when things cleared. Hence associated to this approach was holding power, something I had believed in from the start and still hold true to this day. A good dividend payout had also become important in my new approach --- I had come across the DCF (discounted cash flow) method of valuing stocks and felt that if cash flow to the investor was how they valued stocks theoretically, then obviously (1) the free cash flow should increase proportionately with declared profit, and (2) the company had to show me the money through dividends in order to justify the stock valuation.

I would have liked to be able to ally my approach with an understanding of the intrinsics of business trends. However, it was impossible for a newbie investor to figure out the dynamics of each industry --- it probably takes both work experience and investing experience to integrate over time for one to form a consistent world view of the business world. As it was, I parlayed my training in Accounting (an option taken in university) into reading accounting statements to sieve out small cap stocks with the above parameters --- consistent and growing earnings, good dividend yield, steady cash flow. This formed my conservative approach to picking small cap stocks, a very simple approach indeed.




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