Explosive Stock Price Moves – Understanding the Discovery Process
We have all heard the statement that beating the market is difficult as future expectations are largely priced in. But this presupposes that a stock is known in the first place.
The efficient market theory simply doesn’t apply to most smallcaps, let alone microcaps. There are several reasons why, but the most important is visibility. The institutional players, with the funds to move stock prices and create huge momentum and attention, are almost non-existent in anything with a sub $100 million market cap.
This is where we look for opportunity. Our approach is to understand how “discovered” a stock is, and the less the better. We find unknown stocks that we believe have a significant chance of appreciation, and we get in before true value is recognized.
This is a successful approach we have used for many years. And as the video below from 2016 demonstrates, we have stuck with it because it works.
Patience and criteria
This approach requires patience and having conviction because you can never be completely certain at what point you are at in the discovery process.
However, if a company meets most or all of the criteria we look for, then it’s likely just a matter of time. This includes:
- At least 25% year-over-year revenue growth
- At least two consecutive quarters of profit growth
- A small share float of 30 million or less
- Illiquidity, or a tight share structure, with high insider ownership
- And little or no institutional investors.
The ride is often bumpy, shaking out most who have jumped in without a solid approach and strategy to back up their purchase decisions. But eventually, a company that meets most of the criteria will be discovered. Sometimes it can become self-fulfilling, with early investors like us causing the initial stir that gets others onboard. But often, it’s when institutional players with deep pockets get onboard.
This is why we suggest paying particular attention to smallcaps that are cruising along 52-week highs. This advice works against common investor psychology, which tells us that companies at their highs are now “expensive.” In the smallcap space, this often means they are in the process of being discovered, and if they are growing at a healthy rate there is more value to come.
The key thing to remember when this happens is that the fundamentals haven’t caused the sudden increase in the stock price. It’s the discovery that has changed the perceived value of the business. That’s why its price is higher—because it’s easier to forecast the stock moving based on discovery than based on fundamentals.
Where we come in
How do you know what companies to follow?
You must find companies that are growing. This is why we constantly hammer on revenue and profit growth. Small companies essentially get orphaned if they are just too small without enough growth momentum. Nobody pays attention, even if the company is trading at a $5 million market cap but worth $50 million.
Companies that present strong growth will essentially pull through. And even if they continue to grow and the stock price doesn’t, they have options: they can be taken private, they can buy back stock, or they can use capital to grow further. All of these can lead to an increase in value down the road.
Overall, we have never seen a company whose stock doesn’t increase in price if profits per share are increasing. At a certain point, something triggers attention—whether it’s an analyst, a significant press release, or a newsletter piece—and the tide turns.
For instance, we have seen a couple of our picks perform exactly along these lines in the last year.
We recently covered Total Telecom (TSX.V: TTZ), a leading developer and provider of remote monitoring, asset management and control products and services throughout North America. TTZ is a great example of the price discovery journey. They had two years of flat trading, with spikes in November and December. They then began a strong climb from 15 cents early this year, with upwards momentum as they are slowly becoming discovered.
Atlas Engineered Products (TSX.V: AEP) is another good example of a company going through institutional price discovery. They have continued to deliver over the last year, and their growth has finally gained notice, moving the stock up more than 50% since the start of the year. In this time, they have gone from having a $50 million market cap towards $100—the point at which everyone can participate.
There’s also IBEX Technologies (TSX.V: IBT)….
And Canadabis Capital (TSXV: CANB)….
And the list goes on….
Staying the course
Investing in an undiscovered company with strong growth that meets solid criteria is one of the most calculated bets you can make.
It’s a strategy that requires considerable patience and strong conviction. After all, it can be frustrating seeing large companies trading at 25 times earnings for no reason other than that they are known, while your profitable smallcap is barely hitting 5. But if you stick to buying undiscovered companies with strong fundamentals you will be working with a better margin of safety than just chasing hot stocks.
Fundamentals are the essential foundation that creates the opportunity for discovery to happen—and be sustained. When we understand the price discovery journey as one that is about generating interest from larger players as much as it is about going on a solid growth trajectory, the bet makes sense.
In the end, price discovery is what happens when interest walks in the door. As Howard Marks says, “Buying at a discount from intrinsic value and having the asset’s price move toward its value doesn’t require serendipity; it just requires that market participants wake up to reality.”