How the dice rolls

Let me start off by saying that I'm part investor, part speculator with speculator being defined as one who trades based upon price action.  I try taking the best of both worlds, however, I'm a investor first, speculator second. I invest using a value foundation because in the end the value approach wins the most. After all, a stock is simply an ownership claim to a business and if you buy that business cheap, or any other asset cheap for that matter, time is on your side and you'll come out a winner in the end whereas if you buy high to sell higher time is your enemy. This is why Buffett and Templeton  are the  legends that they are. They bought stocks that traded at a "bargain" to what they believed their true value was and held for years and sometimes decades. While, it's arguable as to what a company is truly worth, there are situations when little argument can made that a company is being valued a lot less than what it should be and those are the situations smart value investors look for. For instance who's hotter Jessica Alba or Scarlett Johansson? That's arguable, but there's clearly no argument that Jessica Alba is hotter than Rosie O'Donnell. So, a smart investor will look for those situations where the stock trades like Rosie O'Donnell but has Jessica Alba features.

It's important however to avoid value traps. That's a situation when you buy a stock of a struggling company which appears cheap on a book value basis. The trap is that the book value is an illusion because it will likely end up deteriorating a lot more in the months/years ahead if the company continues struggling racking up the losses and possibly writing down their inventories and LT assets. The best example of this was bank stocks in March 2008. Many "value investors" got crushed thinking they were getting good deals buying banks near book but those book values were tainted by toxic MBS and ended up getting substantially written down.

To be a successful value investor what you need to look for are "turn around" situations where a company may have been struggling for some time and thus trades at cheap valuations, but has recently (1 year or less) turned things around and are are making money again or have at least stabilized. I like to look for such opportunities in the small/micro cap space where analyst coverage is minimal.  Mind you, there's a lot of junk in this space, but if you search hard enough and yes, get a little lucky, you can really score some massive gains. Small companies are often overlooked by analysts and big fund managers...until they start delivering solid results and then finally get the attention they deserve and when that happens look out above! You can get  multi-baggers in rather short period of time and it's such a treat to see your stock "graduate" to the next level....but be careful not to fall in love with your stocks!

As I just mentioned above, I look for turnaround stocks....stocks that for whatever reason fell out of favor but are showing early signs of turning the corner or have turned the corner for some time but are not not getting the respect they deserve. Fundamentally speaking,  I look for stocks trading at 1.5 times tangible bv or less, have low debt  AND have just recently turned the corner in their business going from struggling i.e. a string of negative quarterly EPS to positive EPS or at least break even. It's important you see evidence of the turnaround otherwise you risk falling into a value trap.

Secondly, I want to see favorable price action. I want to either see a multi-month bottoming process or a new, non-parabolic uptrend. This would help to confirm that the turnaround in the company is indeed taking place and the market is just starting to realize it.

Third, I want the company to have 100 Million shares o/s or less. The less shares out there the quicker the stock can move higher. I'm flexible with this parameter though.  I also don't want to see any insider selling. Insider buying and stock buybacks are a big plus but not a pre-requisite,

These types of turnaround plays I discussed above are what I call "sweet spot" opportunities. You're getting in early when both the fundamentals and technicals are in your favor...you're getting in when the stock is about to transition from a value stock to a growth stock and in such cases the returns are huge if you get it right.

Caveats to this strategy are as follows.

1. You need to use a buy and hold approach and be able to withstand a lot of noise volatility that is present in the small/micro cap space. Trading volumes tend to be quite thin when you are trying to buy early into a potential turn around situation and so you can see the stock drop 5-10% on just a few thousand shares. If you're one to use tight stops then you can't play these stocks.

2. When you are buying early, often times it will be as exciting as watching grass grow. You may have to wait several months to see any material results, but let me tell you, it's well worth the wait. When the move comes it tends to be out of nowhere and it's explosive. You have to fight the temptation to take profits too early. However, if you crave day to day action and feel pressured to beat the market day in day out (which I think is a bad way to play the game) this strategy is not for you.

3. You need favorable macro conditions i.e. bull market conditions for the sector of the stock and that in turn often means a bull market for equities in general. The mistake I see a lot of stock pickers make is that they think their stocks exist in a vacuum. They don't. Unless the company did something extremely positive like a drug company finding the cure for some disease, you need to have the macro winds at your back.

4. Speaking of drug companies, stay away from small cap pharma stocks. They are far too much like lottery tickets.

So, how do I find these turnaround plays? The main way I find them is to look at every chart of every stock that trades from $.50-$5 on the TSX and from $.30-$2 on the TSXV. I look for interesting price action (charts that fit the "favorable price action" criteria I outlined above). When I see a chart I like, I'll check out the fundies of the company to see if it meets my standards. If that checks out, I'll get familiar the company's "story" reading historical news releases and company presentations. If after all this I like what I see and I'm ready to buy, I'll start by committing 1/3-1/2 of my intended position. As per my rules, no more than 15% of my capital can be allocated to any one idea. This "starter" position will have no stops...the fact that I typically only commit part of my intended position is  in effect like a stop. Once I'm in,  I can only add more when the stock is behaving favorably and I'm showing a profit. No averaging down allowed. Of course there are exceptions but they should be just that.....exceptions and not the rule. By never averaging down only adding to winning positions it incorporates a method of discipline to counter act reckless conviction.  If you want to make big money you gotta have balls but at the same time you can't be reckless and stubborn when you may be wrong otherwise you'll get wiped out. Discipline vs Conviction....it's a delicate balance but one that MUST be there.

Another exception I have is buying a stock that has all the investment criteria I want to see but is not yet showing favorable technical action (multi-month bottom or emerging uptrend). In such cases, there will be a high risk of a V shaped rebound and so waiting for things to settle down before buying could mean missing out on big gains. In that case, the risk/reward is worth "catching the falling knife"  but again, I will only commit a portion of my intend position and will not add to it unless it shows a profit.

When I buy these small/micro cap stock I'm looking for at least a 100% gain within 2 years. So far my big winners have taken about 6 months to do so. As I said earlier, I don't use stops with my initial buys although I will sell for a loss if for whatever reason  I no longer believe the company will preform as I expect it to.  Once I'm fully committed in a position, which means I'm showing a profit, I'll take more protective action with my add-ons. I may designate a portion of a my position as "trading" while keeping the core in tact at all times.

Stocks that I recently purchased are gdc.to, isc.vn, hwo.to, fmc.to, prt.to. I've been quite busy  reviewing a few more candidates and so on that note, I'm going to go dark for a while with the blog. Feel free to leave comments/question. Happy hunting!