Dividend growth investing hasn’t always been my investment strategy; I tried different approaches of value investing to eventually reach my goal of financial independence. In my previous article I wrote about how I got to investing in the first place and my personal experiences with magic formula investing as thought up by Joel Greenblatt. After two years of disappointing investment returns and the awareness that I wasn’t on the right track I decided to do things differently.
Making Big Money Under The Radar… I Thought
As I wrote in my previous article I read hours and hours about investing. I regularly had read about micro and small cap stocks outperforming stocks of mid and large cap companies. This has many causes of which I’ll highlight two here. The outperformance of the stocks of micro and small cap businesses is primarily driven by their lack of visibility within the investment community, which leads to a disconnect between their stock prices and fundamentals. Investors can take advantage of this discrepancy. Another reason for their outperformance is stocks of micro caps and small caps are thinly traded. This presents a great opportunity. If the company survives the imminent struggle of being small in terms of market capitalization (like cashburn, loans with high interest, customer concentration) and becomes larger and profitable, analysts will start coverage which will attract more investors. The paper of O’Shaughnessy Asset Management Microcap as an Alternative to Private Equity highlights that 2.1 analysts only cover the typical micro cap stock on average. Some stocks aren’t even covered at all. If future growth prospects of these under the radar businesses remain solid, then demand for the stock inevitably perks up. But there’s only a very limited amount of stock which gives micro and small cap stocks the potential to rise substantially.
Partly based on the above mentioned reasons I decided to allocate more capital in micro and small cap stocks. I sold many positions with a net loss, but I told myself this was necessary. “Things will only get better from now.” Based on paid newsletters and analyses of authors on public websites who had made significant amounts of money (according to themselves) I invested more and more money in these companies. The investment pitches were more or less identical. Most often it was a very small company of which the CEO was the original founder who owned large piles of stocks. So the shareholder interests were aligned with the interests of the CEO. The business was cashflow negative but this would certainly change within 4 or 5 quarters. However, revenues and earnings were rising with growth numbers in the 30-50% range. The companies were one-trick ponies or sold lots of stuff but couldn’t manage the costs of growing this fast in such a short period of time. Hey, but that didn’t matter, because if they could get their gross margins under control, earnings would skyrocket. And if we just extrapolate those earnings to the future, then the company traded at very, very low multiples right now. So you better be quick…
Unnoticed Cognitive Bias
Source: Better Humans
I went on a buying spree and ended up with stocks of companies like Crossroads Systems, Digirad, Glu Mobile, Inuvo, Musclepharm, Noble Roman’s, On Track Innovations, Perion Network, Spark Networks and SuperCom to name a few. My decision to buy stocks of these kind of companies was often based on analyses of two or three authors. In a couple of cases they wrote follow-up articles about events related to the companies such as quarter reports, winning or losing clients, tender offers and renewed bank credit facilities. The perspective was mostly biased; the quarter report was not as expected, but the bigger picture still looked great; although the company lost a client, the focus of management has shifted to the higher margin products/services; share dilution was significant due to issuing shares, but this created the opportunity to accelerate investing in business opportunities; the interest rate on the new credit facility agreement was in the high single digits, but working capital has improved for the better. My confirmation bias made me average down like crazy. “Wasn’t that going against the herd?” I told myself. During the first year I added to my positions vigorously when prices went down more than 20%. I had read extreme price swings were typical for investing in stocks of micro and small cap businesses. So this was all part of the game, it seemed. Besides, the beauty of averaging down is your loss in terms of percentage points drops. So that looks good. If prices increase, well, that makes up that annoying red-coloured amount of money in the column next to my loss in percentage points.
It wasn’t all drama. Some stocks were up 30%, others 80% or even 700%. Companies like IEH, Marathon Patent Group, Pacific Healthcare Organization for example, This investment strategy certainly works if you pick the right companies, but that’s always the case with hindsight bias; these are backward-looking figures. Regarding my positions in green, I got greedy… Some positions were down 40-50% and my big winners masked that loss on a total portfolio basis. It’s nice if that number isn’t down too much. And, if it’s up 700%, why couldn’t it double again or maybe triple if I’m lucky? I read multiple times you only have to find one or two homeruns to really make a lot of cash with investing in micro and small cap companies. So, I didn’t sell my golden eggs. But I didn’t buy more of them either on their way up as it was emotionally hard for me to add to my positions at higher prices. I just loved the profits of 100% and 700% up in price and I didn’t want to screw that charming sight. So anchoring bias certainly kicked in. At some moment I had invested my savings in 25 of these companies. I fortunately acknowledged that diversification is a good thing when buying these high risk, high reward stocks. At least, I was that smart.
But I found out soon that investing is not easy and certainly not the way I practiced it. The stock prices of micro caps and small caps tend to move independent of what the Dow Jones Index or NASDAQ does. I didn’t feel comfortable when stock markets were up and at the same time the prices of stocks I owned were down. On those days I browsed Internet and all kind of forums for explanations. “What causes this price decline? Do these sellers know something what I don’t know?” During my period of investing in small companies I was often searching for more information supporting the long thesis. I didn’t want to read the short thesis as I believed that would only bring doubts and jeopardise my investing success in the long run. To convince myself of the plausibility of being long and the need to standfast I reread the investment case over and over. (I tried so hard to apply some fundamental value investing principles.) But, it was just simple pain-avoiding psychological denial leading to self-deception: denying or rationalizing away the relevance, significance, or importance of opposing evidence and logical argument.
How It Turned Out
As I mentioned earlier I had built big positions in underperfoming stocks by averaging down and small positions in stocks which were up significantly. It took only one thing to let reality set in: major price declines of the stocks that had an incredible run-up. The stock which was up 700% decreased at least 90%, because the business lost a big customer in terms of revenues. Another stock crashed more than 80% due to disappointing growth figures. With time I sold positions of which it was impossible to justify them any longer. Realized losses within the range of 40-50% were normal. I still had confidence in some stocks that were down, but I sold almost all positions except maybe five stocks. These were high-quality companies with a good business model, diversified customer base, growing earnings, low debt and so forth. Now, some stocks I sold were up 20% and 50%. I think my total loss at the end of this period was around $4.000.
After three years of investing I felt pretty depressed. All I had to do was investing in good companies of which the metrics are publicly known and on various websites and buy their stocks at low prices which means only when the estimated value exceeds the stock price. Why is that so hard to do? All the big names are up around 20% a year and I can’t even generate 15% or at least 10% a year. And it has been a damn bull market for years now. LOSERRRRRRR! It looked like financial independence was completely out of reach. No apartment in Newport Beach and condo in San Diego for me, folks. Still, I refused to be a hack until my retirement age…
In the next part of this series I will set out how I came to dividend growth investing, my motivation to adopt this investment stategy and the things it has brought me.