17 red flags to watch with small caps

After numerous recent small cap explosions, investors are now treading fearfully in the sector. But as Buffett famously said: “…be greedy when others are fearful”. So is it now a good time to take a look? This  sector can usually provide outstanding opportunities – if you know how to navigate the minefield. With this in mind, we approached four nimble small cap managers to ask them what ‘red flags’ they use to identify, and avoid, the potential dusters when assessing an opportunity.  

Avoid high PE’s, promotional management and concept stocks

NIGEL LITTLEWOOD, Harness AM 

As I get older, and greyer, and accumulate ever more market experience, the list of red flags to watch out for in the stockmarket grows. It is a dangerous place for the inexperienced. The list is almost inexhaustible, but six things I avoid are below.

1. High multiples. Paying high earnings multiples is risky by putting a high probability on a rosy future. I hate losing money and paying a high price for a security is a good way to lose money.
2. Very promotional management. If there is one thing I have learned is that managers who are good promoters (salesmen) of their stock usually end up failing and leaving shareholders carrying the bag. This goes for managers who spend a large amount of their time and energy focussing on the share price.
3. Concept stocks have great ideas that seem to make a lot of sense when promoted well but more often than not, fail to deliver at the profit line.
4. Fashionable sectors, by their very nature being popular are almost never cheap. One is far more likely to buy cheap in an unfashionable sector or stock.
5. Management with a poor track record should be avoided.
6. Most of the time, companies operating in an industry that is in structural decline should be avoided, having said that, I have made great money owning shares in catalogue printer PMP, which is in a declining industry but I bought it too cheap and it has been well run.  

Four key filters we use when assessing companies

MICHAEL GOLDBERG, Collins St Value Fund 

A lot of pain and suffering can be avoided at all market cap levels with just a few considerations – most of which are magnified when dealing at the smaller end of the market.

1. Ensure that the balance sheet of the company is strong: Companies with strong balance sheets can survive short-term volatility and will still be there when the market turns around.
2. Ensure that Management is engaged, and preferably have a remuneration plan closely aligned with a performing business (and share price). Human nature dictates that people can always be relied upon to act in their own self-interest. We want a management who share our interests.
3. Ensure that the price paid is attractive enough to ensure that mild disappointment won’t overly negatively affect intrinsic value. Too often investors allow their emotions to make decisions for them and end up investing in the current fad at any price. If a share price has risen substantially without a parallel improvement in earnings, avoid.
4. We seek businesses that have a diversification of product, and customer base. Too often, a share will soar on the back of a single promising product, or the promise of a large new customer relationship. Companies with all their eggs in one basket tend to go hungry when they trip and fall. 

It’s all about fundamentals

ROGER COLLISON, DMX AM 

We are long-term investors so we aim to look through all market noise and to only focus upon the fundamentals. As a result, we only have two main red flags we look out for.

Firstly, a change in business fundamentals such as a change in management or the loss of a previously sustainable competitive advantage are red flags for us which may lead us to change our view on a stock.

Secondly, as value investors, a company’s valuation will always factor into our view on a stock. When market valuations and expectations are high the greater is the prospect of a de-rating if a company fails to meet these lofty expectations. DMX Capital Partners’ portfolio generally comprises stocks trading at only 8 to 12 times FY17 earnings, so stock expectations are generally low across the fund. If one of our stocks were to trade on a significantly higher valuation which left no margin for error, we may change our view. Across the broader ASX smaller companies’ universe we are currently seeing many stocks on valuations which are unsustainably high in our opinion, and we’ll be avoiding these stocks as a result. 

Watch for insider selling 

RON SHAMGAR, TBF Boat Fund 

We monitor “red flags” on a continuous basis for our portfolio holdings. Here are five to consider:

1. Investors should keep an eye out for any insider selling shares in a company, especially by key management personnel, directors or company founders.
2. A change of outlook commentary from previous management announcements or earnings forecasts no longer reiterated.
3. Companies relying on large second half earnings skews to meet previous profit forecasts.
4. Industry regulatory risk that is currently playing out in the media but is yet to be reflected in a stock’s share price.
5. When the share price of a stock falls materially without any company-specific news flow (insiders know something we don’t). 

To read our panel's thoughts on the road ahead for small caps, please  click here.