Finding Your Next Investment

 

Like anything done well, being successful at active investing takes considerable effort. And for the majority of investors, this becomes apparent at Step 1—having a strategy to find companies in the first place.

This is exactly what we do at Smallcap Discoveries. We use our extensive investing experience to identify trends and market opportunities. We dig through financials for every listed smallcap to ensure it meets our essential criteria. And then, if everything aligns, we consider it.

So far, so good. Our strategy has brought market-beating returns and some exceptional wins over the last several years. Over the past year, we saw great gains with POSaBIT Systems (CSE: PBIT), Inventronics (TSX.V: IVX), Fab-Form Industries (TSX.V: FBF), and Vigil Health Solutions (TSX.V: VGL).

We share our process with our members, who have access to a wide range of companies run through our criteria. But for those who are interested in simply understanding more about how to come up with investment ideas in the first place, we are happy to share the following steps.

1 – Ideas Process

There’s no shortage of places to get investment ideas. And by all means, the plethora of investment information and opinions available online is a big advantage for retail investors. Discord, Reddit, Twitter, newsletters, news and investment websites, forums, random blogs—the list goes on.

But there’s a catch. Without a process for finding companies, you’ll just swing with the herd and find yourself following someone else’s trade. This sadly seems to happen to the majority of amateur retail investors, who get their ideas from someone else.

They don’t have a process to come up with their own investment ideas, and this is like cooking without a recipe. The truth is, the best investors have a process that helps them find investment ideas—and you need one too.

For instance, this could be following the 52-week high or low list. Your approach could consist of using filtering software with specific criteria. Or maybe going to conferences to generate ideas.

There is no perfect process for identifying potential investments. But without one, you will be rudderless, letting yourself get swept along without proper conviction.

2 – Due Diligence

Creating an idea-generator is definitely half the battle, but what comes next is crucial: running each investment idea through a due diligence process.

This is where you dive in and decide whether the investment gets a pass, fail, or wait-and-see. Talking to management is generally a good idea. They will give you a general idea of where the company is at and where they could be going.

And if you are financially savvy, looking under the hood at the financials is always a good idea. But make sure you know what to look for and ask yourself if this aligns with proper criteria for understanding if a company is a good investment. For instance, are you seeing consistent revenue and profit growth? Or is it just increasing debt?

A big thing to consider is if the company is actually cheap or not. In essence, you have to build a mechanism for valuation and you need to be willing to step in if an investment has been mispriced. Essentially, be somewhat of a contrarian. Well-known contrarian investor Howard Marks espouses this approach, having built a successful investing track-record by buying unloved companies with good financials.

We will explore valuation more in a future post, but if there’s one takeaway it’s that once you’ve figured out a process to generate investment ideas, you then need to run it through a due diligence step to understand which ideas to pursue.

3 – Execution

Execution can often feel hard, but if execution feels like the hardest step it’s because you haven’t done proper due diligence. The feeling of hesitancy, while rational, can also be a sign of a flawed idea and approach.

Even if you have done extensive research and have strong conviction, it’s best to have a plan because there are many variables.

For instance, are you a short- or long-term trader? We generally take a longer-term view as it allows our thesis to play out, rather than hoping to get lucky with a swing. This is the zoom-out mentality, which allows you to stomach not just the large swings that are common in smallcaps, but also the liquidity constraints. It also helps to avoid the often large tax consequences of short-term trading.

And when it comes to buying, starting with a small position and adding on dips is a good approach. Either way, find an execution strategy that works for you and stick to it. And if you are having a hard time executing or if you find you are tempted to yolo your cash all at once (only to most likely get shaken out) then your due diligence and/or idea-generation is flawed.

4 – Maintenance

If you get to the maintenance stage, you’ve already passed all the major hurdles. That said, you do need to establish a routine for keeping up-to-date with your investment. You want to make sure that it continues to meet your investment criteria because, let’s face it, life and business are both unpredictable. Market trends and economics can alter your investment thesis, so can bad management practices like over dilution.

We recommend developing a process that makes you regularly check in on your investment. This could be listening to quarterly calls, checking on competitors, talking to customers or management from time to time, and, of course, following financials. As the saying goes, it’s not about buy and hold—it’s buy and validate.

Then there’s selling. Have a plan for when or why you sell. This could be if your investing criteria is no longer being met, or if the investment has met a specific return target. Or maybe you sell when you find a more compelling investment. Take this analogy: coaches are always thinking of succession planning for their star athletes, taking a risk by investing in up-and-coming stars rather than over relying on those who have had their run. The same can be said for replacing stocks that have met the majority of their performance potential with those that have more room to grow.

You can also use valuation metrics to gauge the best time to sell. For instance, the price/earnings-to-growth (PEG) ratio is a company’s stock price to earnings ratio divided by the growth rate of its earnings. It’s a common metric for valuing smallcaps and often comes in handy when understanding if something is cheap or not.

But note that a common mistake is relying too much on rationality when a stock starts to move, which leads to missing out on larger gains. This is because, being humans, we feel compelled to validate our process by having a winner. So like with the other steps, maintenance demands you have a process to follow.

5 – Stick to it

This whole process—from generating ideas to due diligence, execution and maintenance—comes down to having a well thought-out approach. But at the same time, you have to be willing to refine and improve this approach as you learn. It’s not easy by any means, but nobody with any integrity ever said that making great returns on stocks is easy.

It is, however, very possible and we encourage you to try these steps as they will make you a more well-rounded investor. And hopefully, they will help you make more money! Alternatively, if you want to get a head-start by joining us and reaping the benefits of our established process, we recommend you sign up to learn more about a number of great companies we believe have huge potential.

In the meantime, best of luck in your investment hunt.

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