Why Less Than $10 Million Market Cap is Too Small

I’ve been looking for stocks to buy: not blue chip compounders with 10% annual earnings growth

I’m talking about the good stuff

Overlooked and undervalued small cap companies worth several times more than their price

Investors managing large sums don’t buy these securities, because they are too small for a <10% position to have an impact on their portfolios. Analysts don’t cover them. They are overlooked

I’ve found about $1B to generally be the cutoff, below which institutional managers and analysts seldom tread

I ran a screen for the smallest companies in the market (less than $300M market cap), filtered out the companies that I knew were outside my circle of competence leaving me with about 2,000 stocks, and started working my way from the smallest companies to the largest

Given that I have 2,000 stocks to go through, I can’t be completely thorough in investigating companies further which appear at first undesirable. Nonetheless, a pattern started to emerge among the very smallest companies: especially those below $10M in Market Cap

Accumulated deficits (negative retained earnings), little shareholder’s equity if any after discounting inventories and PP&E (Buffett talks about this in his partnership letters. Companies tend to overstate what they could get for these assets if they ever became forced sellers), negative earnings, negative operating profits, and sometimes even negative gross margins

Company after company looked like this

Not only that, but above $10M other types of businesses started to appear: businesses that looked more like a typical slow-growth small businesses

What was going on?

Here’s my running theory:

Companies go public to raise money

And they do so for a few reasons:

a. To raise more money than they could from private investors and possibly get their big exit

b. To raise more liquid capital in the hopes that either management or the company will be able to buy more shares in the future

c. Investors aren’t interested, so they can’t raise private capital

My best guess is that these companies with below $10M market caps often go public for reason c. They’ve already exhausted the funds that they could raise from private investors in the form of equity and then raised all they could in the form of debt. Then, with the business still operating below profitability, they turn to the best remaining option

To take the company public

That would explain the large debt burdens, cash flows primarily from financing activities, large cash positions being whittled down, and why the managements decide to take these companies public in the first place

These companies have effectively fast-forwarded the lifecycle of a growth business from idea to IPO, by injecting too much capital before building a competitive advantage and a moat, or in some cases, before finding product-market fit

IPOs are expensive

A company with profits in an ordinary range for a <$10M valuation (say $3M or less) should probably be re-investing in its growth rather than spending a big portion of those earnings on fees to go public. It wouldn’t make much sense if your company was funding itself from its profits. It would make sense though if your company raised a lot of money from private investors that it was quickly burning through

For that reason, I am going to use $10M market cap as my floor when searching for investments. It’s possible I might miss something great. It’s possible that I’ve misjudged some of the businesses I was looking at. It’s possible that some of the businesses I looked at will succeed in spite of their challenges, and I hope that they do

As an investor, I have limited time with which to analyze securities, so I must maximize the value that I find for the time that I spend to find it. For that reason, I am making $10M my floor, and I may even raise it depending on what I find as I continue on