Analysis

While investors may be focused on FAANG, this investor shows there’s a far superior place where the largest returns live

July 17, 2020

Investors love to look at and think about large-cap stocks because they are a proven force in their respective market

However, only investing in large-cap stocks means missing out on the largest potential returns. One specific group of tiny stocks, while risky if not analyzed correctly, have the largest potential for serious upside. Today’s fund understands how to screen for these companies through the noise of as-reported accounting.

In addition to examining the portfolio, we’re including a deeper look into the fund’s largest current holding, providing you with the current Uniform Accounting Performance and Valuation Tearsheet for that company.

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“It’s not the size of the dog in the fight, it’s the size of the fight in the dog”

                         –   Mark Twain

If you ask people on the street what they think would be a good investment, you would most likely hear one of the FAANG stocks, such as Netflix or Apple.

It is easy to default to large companies when thinking about potential investments. We always hear how Apple has created an unbeatable ecosystem of devices, or Netflix has created a content generating machine.

These large stocks can generate significant returns if you pick the right one. Over the past five years, Apple has seen a 191% return. Meanwhile, Netflix realized gains of 335% over the same time period.

However, this is after they had already become large-cap names.

If you had bought Netflix just 3 years after its IPO in 2005, today you’d be sitting on a 31,000% return. If you had bought Apple at the same time in 2005, you would have realized a 7,000% return over the past 15 years.

Many investors today are battling over the next marginal dollar by investing in large-cap names. However, investors who are comfortable hunting in a larger but significantly less-covered space can yield significantly higher returns. Returns like the ones Netflix and Apple have generated the last decade and a half.

Of course the investing opportunity we’re talking about is the world of microcaps.

Big institutional investors can’t even invest in these companies. They’re often too small and too illiquid for big investors to build up positions that would be at all meaningful to their portfolio.

Also, there’s limited Wall Street analyst coverage down here. With no institutional investors to pay for research, and investment banking fees being tiny, there’s no incentive to cover these names. Many investors shy away because of the dearth of information.

Lastly, these names are so small, and so plentiful, the SEC doesn’t even really regulate them. There are just too many to regulate and the SEC has a finite amount of time, so it spends its time focusing on the bigger companies that fetch headlines and that big institutional investors are worried about.

All these factors mean many investors are afraid to invest in the microcap space. They view it as higher risk, less clear, and less liquid.

And of course, without the oversight that SEC regulation and big institutional investors provide, there are questionable companies in microcap land. There are hucksters and snakeoil salesmen looking to make a quick buck. You need to be able to identify the companies that are at risk of running off with your money before investing.

Fortunately, we’ve spent over a decade building a process to identify which companies investors need to avoid in the microcap space. Focusing on management, auditors, board members, and other stakeholders, we can pick out the companies who look like their focus is on enriching insiders, not creating value.

If you can avoid those companies, which our process lets us do, the reward for choosing the right name can mean returns that are multiples of your investment or more, significantly more easily than you can for a bigger name.

Of course, not every micro-cap will be the next Apple or Netflix. Yet, if you’re buying a $250 million market cap name, you don’t need it to become Apple or Netflix to make heaps of money. If that company reaches $1 billion you can make 3x your initial investment.

We’ve built a process and a service to help identify these tiny names that are primed for massive upside. Companies where have massive market opportunities, sound management, good fundamentals, and are primed to take off because no one realizes it yet, since no one is paying attention to the microcap world!

We just launched this service, and because we want to start to shine the light on the world of microcaps, and help people finally unlock the value in this market of MASSIVE upside, we’re making a special offer.

For a limited time, charter members of the service can buy it for half off its normal price. But this won’t last.

This service is called Microcap Confidential. While we’re biased (we did take the time to create the product and shoot this video afterall…) we highly recommend you take the time to learn about the service.

We have put together a video discussing the power of identifying microcaps that have significant upside when we pull together all the tools we have in our framework that you read about every day here, including:

–   Uniform Accounting
–   Credit analysis
–   Management compensation and communication analysis
–   And deep fundamental research

Click here to take your first step in the microcap world.

By the way, if you listened to the full video…we tell you our favorite stock to buy in the microcap world right now, and we also tell you one company that is aggressively and regularly promoting itself in the news and through press releases to try to take advantage of speculators in the midst of the pandemic, that we think it is essential you do not buy.

It’s not just Valens who has identified the potential of the microcap space. Today’s fund, Wasatch Microcap, has excelled in investing in small companies.

And we can take a look at Wasatch Microcap’s equity portfolio, using its most recent 13-F, to provide a window into the firm’s investment mindset when it comes to microcap investing. We’re showing a summarized and abbreviated analysis of how we work with institutional investors to analyze their portfolios.

While these names may appear to be mediocre investments using as-reported metrics, these securities are in truth stronger names once Uniform Accounting metrics are reviewed.

See for yourself below.

Using as-reported accounting, investors would think the Wasatch Microcap was buying anything other than high quality businesses that could have sustainable upside.

On an as-reported basis, many of these companies are poor performers with returns at 0% or below, and the average as-reported return on assets (ROA) is right around 4%.

In reality, the average company in the portfolio displays an impressive average Uniform ROA at 35%.

Once we make Uniform Accounting (UAFRS) adjustments to accurately calculate earning power, we can see these are the kind of high-quality microcap names that earn Wasatch Microcap a sizable return.

Once the distortions from as-reported accounting are removed, we can see that Upland Software (UPLD) doesn’t have a below cost-of-capital return of 1%, but a sizable ROA of 159%.

Similarly, CyberArk Software (CYBR) ROA is really 54%, not at 5%. While as-reported metrics are portraying the company as a business below cost-of-capital, Uniform Accounting shows the company’s true robust operations.

Mastercraft (MCFT) is another great example of as-reported metrics mis-representing the company’s profitability. Mastercraft doesn’t have a 19% ROA, it is actually at 124%.

The list goes on from there, for names ranging from Freshpet (FRPT) and Simulations Plus (SLP), to Kadant (KAI), Nova Measuring Instruments (NVMI), and Purple Innovation (PRPL).

If Wasatch Microcap were focused on as-reported metrics, it would never pick most of these companies because they look like anything but successful companies in the microcap space.

Wasatch Capital focuses on firms with strong underlying returns, but they also pay attention to firms with compelling EPS to compound on their returns.

This chart shows three interesting data points:

  1. The 2-year Uniform EPS growth represents what Uniform earnings growth is forecast to be over the next two years. The EPS number used is the value of when we take consensus Wall Street estimates and we convert them to the Uniform Accounting framework.
  2. The market expected Uniform EPS growth is what the market thinks Uniform earnings growth is going to be for the next two years. Here, we show by how much the company needs to grow Uniform earnings in the next 2 years to justify the current stock price of the company. If you’ve been reading our daily analyses and reports for a while, you’ll be familiar with the term embedded expectations. This is the market’s embedded expectations for uniform earnings growth.
  3. The Uniform EPS growth spread is the spread between how much the company’s Uniform earnings could grow if the Uniform earnings estimates are right, and what the market expects Uniform earnings growth to be.

The average company in the US is forecast to have 5% annual Uniform Accounting earnings growth over the next 2 years. Wasatch Micro’s holdings are forecast by analysts to grow four times that number, at 20% a year the next 2 years, on average.

That is the power of microcaps. It is easier for them to grow a lot faster than big companies. The power of the law of large numbers in reverse!

The fund is clearly choosing stocks with strong underlying fundamentals and growth potential, in the search for the next successful microcap stock.

On average, the market is pricing these companies to grow earnings by 40% a year. The market is pricing these companies for growth to be much higher than what analysts are forecasting, but Wasatch Microcap is betting that analysts may even be underappreciating how much these companies can grow.

After all, there aren’t that many analysts covering these companies anyways, so Wasatch likely has better information than Wall Street anyways.

One example of a high growth company in Wasatch Microcap’s portfolio is Freshpet (FRPT). While the market expects Freshpet to have a sizable 135% Uniform earnings growth over the next 2 years, Freshpet is forecasted by analysts to have 169% growth over the same period.

Another company with similar dislocations is Nova Measuring Instruments (NVMI). The company is forecast for Uniform EPS to grow by 25% a year, and the market is expecting the company to only grow by 4%.

Yet another example is UFP Technologies (UFPT). The company is cheap, as it is priced for only 3% growth in Uniform earnings, but the company is forecast to grow earnings well above market averages by 15% a year.

That being said, there are some companies that are forecast to have strong earnings growth, but the market is paying a higher premium. For these companies, like Five9 (FIVN), Medallia (MDLA), and Kornit (KRNT), the market has growth expectations in excess of analysts’ predictions.

In conclusion, Wasatch Microcap has focused on firms with strong underlying fundamentals, not ones that simply appear strong due to as-reported distortions. To be successful in the microcap space requires extensive research, and with the power of UAFRS, we can see how much Wasatch has done to position themselves for success.

SUMMARY and Kornit Digital Ltd. Tearsheet

As the Wasatch Microcap’s largest individual stock holding, we’re highlighting Kornit Digital Ltd.’s tearsheet today.

As our Uniform Accounting tearsheet for Kornit Digital Ltd. (KRNT:USA) highlights, Kornit’s Uniform P/E trades at -476.8x, which is below average valuation levels and historical average levels.

Negative P/Es require low EPS growth to sustain them. In the case of Kornit, the company has recently shown a 13% Uniform EPS growth.

Wall Street analysts provide stock and valuation recommendations that in general provide very poor guidance or insight. However, Wall Street analysts’ near-term earnings forecasts tend to have relevant information.

We take Wall Street forecasts for GAAP earnings and convert them to Uniform earnings forecasts. When we do this, Kornit’s Wall Street analyst-driven forecast is a 125% and a 683% Uniform EPS shrinkage in 2020 and 2021.

Based on current stock market valuations, we can use earnings growth valuation metrics to back into the required growth rate to justify Kornit’s $51 stock price. These are often referred to as market embedded expectations.

The company needs to have Uniform earnings grow by 49% each year over the next three years in order to justify current price levels. What Wall Street analysts expect for Kornit’s earnings growth is below what the current stock market valuation requires in 2020 and 2021.

Furthermore, the company’s earning power is 1x the corporate average. Also, cash flows are also 4x higher than its total obligations—including debt maturities, capex maintenance, and dividends. Together, this signals low credit and dividend risk.

To conclude, Kornit’s Uniform earnings growth is below peer averages in 2020. Therefore, as is warranted, the company is trading below average peer valuations.

Best regards,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research