Start with the A’s

One of my favourite Buffett quotes comes from a 1993 interview with Supermoney author Adam Smith:

Adam Smith: If a younger Warren Buffett were coming into the investment field today, what areas would you tell him to point himself in?

Warren Buffett: Well, if he were doing – if he were coming in and working with small sums of capital I’d tell him to do exactly what I did 40-odd years ago, which is to learn about every company in the United States that has publicly traded securities and that bank of knowledge will do him or her terrific good over time.

Smith: But there’s 27,000 public companies.

Buffett: Well, start with the A’s.

This isn’t hyperbole from the Sage of Omaha.  Warren Buffett would literally read through the financials of tens of thousands of stocks to understand the entire market.  Forget genetics, this is the stuff that genius is really made out of: focused  passionate, back-breaking repetition (for a brilliant book on the topic check out ‘The Talent Code‘ by Daniel Coyle).

Inspired by this I set out to do the same for the Australian small cap market.  This is a much easier task since the market is that much smaller.  The process was straightforward, my investment partner and I would review the entire small cap market (Sub AUD250m) one at a time.  From this list we would cull those with a history of under-performance, or in an industry outside our circle of competence, to arrive at a list of ‘potentials’ for further analysis.  These ‘potentials’ would also be classified into 3 tiers.

We undertook this review in mid 2012 and will be updating the task again shortly (with a little time saving by removing a couple of industries that we don’t look at)

Methodology:

We followed a very similar methodology to that Adam over at Value Uncovered posted in 2011: http://www.valueuncovered.com/a-journey-through-the-pink-sheets-3698-stocks-later. (Actually, we started this in the middle of 2012, long after reading Adam’s post. It was now only after going back to find the link to Adam’s article to reference it that I realised just how similar our method was)

We started with a list of 1,537 <250m market cap companies listed on the ASX.

We classified the companies as follows:

Exploration & Mining: Outside our circle of competence, so an immediate pass.

Finance Industry: Likewise, not within our circle of competence, so pass.

Property Trust: We are looking for operating businesses, so excluded these property investment vehicles

No business: No listed business to be found at the ticker e.g. due to bankruptcy etc.

Governance risk: This was a little subjective – this group was intended to include those companies where we believed we could not trust management due to news from recent filings, corporate structure, or the region where they based their business.

Dilutionary: Businesses with substantial repeated dilution. Doing this review again we may remove this category as most of these companies were also repeatedly loss making as you would expect.

Low returns: We actually killed this category shortly after starting, but I have left it in this summary. It was intended to seperate out companies making profits but which were marginal when compared with the level of capital employed. However we found that: A) these businesses could typically be cut through one of the other filters and B) the level of analysis needed to properly measure ROIC was more than we wanted to do in a first run through.

Loss making: If the company has had a history of losing money consistently for the last 3-5 years we ruled it out. We could always come back to this list if we needed to. There is no doubt that by filtering these out we would have missed some turnarounds. But as we soon found, there were so many terrible businesses that we had to find a way to filter them out. Also it is easy for turnarounds to not turn, and start-ups that have been losing money to continue, regardless of the narrative of success that management are pitching.

The above was mostly ruling companies out, now for the interesting part.

Value Potential: Companies which appeared compelling as value investments in the traditional sense.

Growth Potential: Companies which had the potential for high growth and which appeared at first glance to possibly be within a moat. These ratings were less focused on valuation. The idea being that we keep the best on our watchlist for when they may be undervalued in future. We were basically trying to find a classic ‘Buffett’ company with a strong competitive advantage but which was still a small cap.

Further review: Ok some of these small companies were just too damn interesting. This group was for those companies we couldn’t justify considering as investments but where we just had to read more about them later. A small-cap that wants to launch a satellite and a weapons manufacturer that developed a gun which fires a hail of 500 rounds from a battery 50 barrels simultaneously.

Within Value and Growth we had three tiers of quality as outlined below. We also made some notes on the company’s earnings, share count development, and finally anything else we found interesting.

Value Potential Potential for further analysis as a value investment. Although there was no hard and fast rules here, these companies typically had low PEs, low P/B and high NTA as a % of share price – aka the standard symptoms of undervaluation
Tier 1 Star – a consistent performer that is undervalued or with an intrinsic valuation clearly above market
Tier 2 Stable value – without significant financial distress that appears underpriced
Tier 3 Deep value – may just be beginning to turnaround or which otherwise warrants further analysis
Growth Potential Potential for further analysis as a ‘growth’ style investment
Tier 1 Star – a fast growing company with high potential that should be analysed further
Tier 2 Stable growth – reliable quick growing company which appears fair to moderately undervalued
Tier 3 ‘Dirty growth’ – strong growth potential but may have a current or historical reason for low valuation – warrants further analysis
Earnings Current earnings status
Growing Steadily growing earnings past 3-5 years
Stable Stable earnings
Turnaround Recently returned to profit after making losses
Decline Declining profits
Share count Has this been stable last 5 years or has there been dilution?
Other Other notes or thoughts on the company in order to prompt the further analysis

The Results

First off wow – there are a lot of tiny exploration companies in Australia with nothing but a drilling rig and a dream. This survey was undertaken in mid-2012 when the mining boom was just starting to tail off. So it is possible that some of these companies have now died off. But I wouldn’t be surprised if most are still limping on. We also saw some bizarre (and terrible) businesses that had used mining as some kind of last gamble. You would find a failed company with a business description of fish farming, and which was now prospecting for uranium in West Africa.

There were also as you would expect a heap of just plain bad businesses. The tail end of the small cap space is largely just a graveyard of failed small and mid-caps. The walking dead, just one more dilutionary equity raise away from oblivion. Some others had never really recovered from the weaknesses that the financial crisis exposed.

We did however find a fair chunk of companies, approx. 11% that were interesting from either a pure value standpoint, or which appeared to have the potential for significant growth within a franchise.

The breakdown:

Classification pie chart

Classification Percent
Exploration 49%
Loss Making 21%
Finance Industry 8%
Value potential 6%
No business 5%
Growth potential 5%
Dilutionary 2%
Governance concern 2%
Property Trust 1%
Further review 1%
Low return 0%

Follow up

These quick reviews were just the starting point for more diligent analysis, but were a great screen. By looking at all companies, rather than just those that show up on an automatic stock screen you gain a much better understanding of your market. You begin to quickly appreciate good companies and learn what to steer clear from in others. I highly recommend it.

All of the companies we purchased in the past year were from the value or growth potential groups. We recently purchased one Tier 2 company where a special circumstance drove down the price. Because we had down our homework ahead of time this company was already on our watchlist and we were able to buy a great little company at a discount.

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