Great Balance Sheets

Because small and micro-cap companies tend to be underfollowed, it is easier to find companies with great balance sheets at attractive prices.  We measure balance sheet strength by net cash as a percentage of market capitalization, and we define a strong cash position as at least 10% net cash as measured as a percentage of market cap.  A strong net cash position provides flexibility, opportunity, and downside protection.  We also look for hidden assets, such as understated real estate, ownership of stock in another public company, or ownership stake in private companies.  Hidden assets provide downside protection as the market is potentially valuing a variable asset for nothing.

Summary

Less Risk of Permanent Capital Loss

A stockpile of cash reduces the risk of permanent loss of capital.  As a whole, the small and micro-cap sector has returned 14.6% since 1927.  This performance has been a mix of huge winners, such as Microsoft, which grew 100 times between 1989 and 1999, and big losers that have gone bankrupt.  Companies with strong cash positions, net of debt and operating leases, don't have bankruptcy risk.

Downside Protection

Having a strong net cash position provides a very tangible downside protection for share price. The share price will not dip below net cash.  For instance, if you purchase a company for $8 per share that includes $2 per share in cash, your downside, in the worst case, is $2 per share. 

Dividends and Stock Repurchases

As a stockholder, the cash on the balance sheet belongs to you.  If management is shareholder friendly, and they should be, then the stockpile of cash will be passed along to you in the form of a special dividend or Dutch tender to buy back stocks. For companies with extremely undervalued stock, buy backs are the norm, while special dividends are more appropriate for companies with fairly value stock.

Growth and Acquisitions

Compared to larger companies, small and micro-cap companies tend to have better opportunities to reinvest cash.  Smaller companies have room to grow.  Could GE, Wal-Mart, or AT&T realistically double?  Just by the law of the large numbers, it is unlikely.  To fund growth, small companies need cash.  They also need cash to make acquisitions. Frequently, a small company, in a fragmented industry, will have the opportunity to acquire rivals at discount prices. In order to take advantage of these opportunities, the small companies need to have cash available.

Easier to Understand

An often ignored benefit of investing in small, cash-rich companies is increasing the chances of staying “within your circle of competence.”  Companies with net cash balances are more likely to be operating businesses, as opposed to more complex financial businesses that earn money by borrowing and lending at different rates (“spread businesses”).  Cash on the balance sheet is more likely amassed through operating activities or stock issuance.  The balance sheet should be not be very complex -- no currency hedges, credit default swaps or special purpose entities

Beware of Too Much Cash

Beware of companies that have too much cash (i.e. 50-90% of market cap).  Too much cash can be a temptation for managers to make bad decisions.  For instance, managers may use the cash to build an empire through ill-considered acquisitions, or worse, managers and the board may consider the cash hoard to pay themselves generous salaries for doing little work.  Too much cash may indicate that the business has little earnings power as an operating business.  The company's earnings may be dependent on the interest generated by cash savings.  That is not a very efficient use of capital, and it is not looked upon favorably by the market. Ideally, we like to see 10% to 30% of market cap in net cash. 

-balance between too much / too little cash. 

Capital Allocation

Lots of net cash is often a signal of competent, or at least conservative, board or management.  The good thing about small companies is that often the founder or key insiders own a significant portion of the company.  As such, management will probably do a good job managing capital.  However, it is still vitally important to understand management's history of raising and allocating capital.  Some management teams are very smart, or lucky, in dealing with capital markets.  When valuations are unrealistically high, they will raise equity through secondary stock offerings.  When valuations are unrealistically low, they will reduce the share count via buy-backs.

Hidden Assets

Investors should look for potential hidden assets, such as understated real estate, ownership of stock in another public company, or partial ownership of a private company.  These assets are usually carried on the company's books at the price the company originally paid.  This may understate the value, particularly if the assets were purchased many years ago.  For instance, suppose that in 1975 a company spent $250,000 on a new headquarters ($100,000 on land and $150,000 on construction of the building).  Accounting rules generally require holding land at cost while depreciating the value of the building.  Therefore, in our example, the headquarters real estate would be carried on the balance sheet at about $100,000, whereas in realty, the headquarters might be worth more like $2 million today.

Conclusion

A strong balance sheet is an important factor for investing in small companies, but we are not just buying the balance sheet.  We are also buying the earnings power of the business, and we are dependent on having the right incentives for management to return excess cash to shareholders.

Buybacks

Buybacks are an especially valuable tool in the small and micro-cap segment since the pricing of small and micro-cap stocks is less efficient than large caps.  As a result, small, publicly-traded businesses frequently sell at low multiples of cash flow, which creates significant opportunities for patient investors.  When this happens, management can grow earnings per share by materially shrinking the shares outstanding. 

Summary

Repurchases and Cash Flow per Share

At the most basic level, stocks appreciate for two reasons: cash flow per share increases or investors become willing to pay a higher multiple of cash flow to own the stock.  Buying back stock is a tool to increase cash flow per share.  With fewer shares outstanding, the company's total cash flow is divided among fewer shares.  Therefore,

cash flow per share is higher, and the stock price will also be higher.

Management Conviction

In small and micro-cap stocks, it is not unusual for management to own 10% to 40% of the outstanding shares. In this case, it takes great discipline and confidence in the company's prospects to use the company's cash to buyback shares on the open market.

Motivation for Buybacks

If a growing business hits a snag, the stock price, and underlying business value, might sink significantly.  If the problem is short-term and fixable, the company may become significantly undervalued.  For instance, perhaps the company is selling at half the price of a recently sold private competitor. This may motivate the board to authorize a share repurchase.  In October and November of 2002, at the market bottom, small and micro cap companies announced 120-130 buybacks in each month.  The five year average remains around 30 a month.

Share Count Reduction

In small and micro-cap companies, shares are usually repurchased for the right reason: to materially reduce the share count.  However, big companies like Dell, Intel, and Microsoft have bought back billions of dollars worth of stock, yet the outstanding share counts have not materially declined.  This is because the companies simultaneously reissue shares to employees in the form of option grants.  With smaller companies, that are undervalued and well-managed, you will find the exact opposite.  Companies aggressively shrink the share count year in and year out.  Ideally, they are trading cash for stock that is worth twice as much. If the stock truly is undervalued, this creates significant value for the remaining shareholders. 

Announcements vs. Repurchases

Beware of the false announcement.  Frequently, companies announce "authorization" for a major buyback, but never follow through for the full amount.  You need to read beyond the press releases and ensure the company is actually repurchasing a significant volume of shares.  It is also important to watch management's history of share repurchases over multiple quarters and even years.  If you find a small company that is actually buying the shares, then it is probably worth a deeper look. The board is telling investors that the business is materially undervalued; now it's your job to try to figure out what they see. 

Dutch Tenders

A Dutch Tender is a more aggressive method of repurchasing shares.   The company will set a price range, usually slightly above the current share price, for example $9.00 to $9.75.  Then the company will repurchase a set dollar amount of shares, perhaps $10 million, in the preset range.  Investors that want to sell their shares back to the company choose a price somewhere in the range. The company will begin purchasing shares, from the lowest to highest price of tendered shares.  Preferably, management and key insiders will agree not to tender their own shares.

Conclusion
Buybacks in small and micro-cap stocks mean more than any other market segment.  When management owns a significant share, it demonstrates conviction in the company. It demonstrates that the board is focused on returning shareholder capital, and the shares are likely undervalued.  

Of course, this is no guaranteed formula for success.  This is starting point for many multi-baggers over time.  A great free site for daily buybacks: www.investhelp.com