Dunn, a senior analyst at KeyStone Financial, says when investor enthusiasm about a company ends the consequences can be catastrophic.
At the recent Vancouver Resource Investment Conference, KeyStone Financial Senior Analyst Aaron Dunn told the Investing News Network that his firm looks for “growing, strong, profitable” businesses with shares that can be purchased at a reasonable price relative to “underlying profitability.”
He said research is particularly important when looking at small-cap stocks because they have a reputation for being “highly speculative companies.”
One example of KeyStone’s past success is its recommendation two years ago of a US software company called Ebix (NASDAQ:EBIX). At the time, it was trading “a little under a billion in market cap. It’s tripled over the last two years.” Dunn said the increase was driven by growth in earnings per share and a “general positive outlook on the business.”
Dunn explained that investors can often make the mistake of buying into hype, and highlighted cannabis, blockchain and the junior mining sector as places where that can happen. He emphasized that KeyStone focuses its research on “companies that we consider real businesses.” According to Dunn, that means companies that have demonstrated that they can generate revenue and be profitable. If a company can’t do those things, it’s “not a real investment. It’s a speculation.”
Continuing, he explained that when investor enthusiasm ends, “it is definitely catastrophic and you see share prices fall off extremely quickly. The vast majority of shareholders that take that strategy with a significant portion of their capital end up losing a lot of money in the long term.”
Dunn concluded, “if you want to invest in companies that are more speculative, that’s great. You just have to understand what you’re doing and you have to limit your exposure to those types of stocks.”
Watch the video above for more insight from Aaron Dunn. The transcript for this interview is available below.
INN: What goes into picking a small cap stock?
AD: Sure. So what we’re doing is we’re looking to maximize the opportunity and minimize the risks. So our focus is always on the fundamentals of the business. We’re looking for good, strong, growing businesses.Businesses that are increasing their revenues, increasing their profitability and are reinvesting that profitability back into the company for future growth. So a growing, strong, profitable business that can be purchased at a reasonable price relative to its underlying profitability. So what we essentially do is we look at everything on the market and we have certain criteria that we focus on right away. Profitability is a key criteria for us. So if a company is not profitable, it’s not something that we would even go to the next stage of research on, and that’s particularly important in the small-cap space because small caps, in particular, have a reputation for being highly speculative companies. In most cases, that’s often true. But there are a lot of smaller companies out there that are growing profitable businesses, good solid stable businesses. They just happen to be small but they’re rapidly growing and they’re under-followed and their opportunities to get in earlier and buy those companies at a very good valuation relative to the underlying profits.
INN: Do you have an example of that for 2018?
AD: Sure. So I’ll give you an example of a US company that we recommended. So in the US, small caps are typically considered anything under a billion dollars. Whereas in Canada, small caps are considered much smaller. But in the US, two years ago, we recommended a company called Ebix Inc. So this is a software company. What they do is they do digital back-end infrastructure for insurance companies and other financial companies as well. So when we first recommended this company, it was trading at a little under a billion in market cap. It’s tripled over the last two years and that tripling of the share price has been driven by growth in the earnings per share and this general positive outlook on the business. So when we first started researching this company, we looked at the historical financial performance and this was a company, for over a decade, had increased year after year, had increased their revenues and increased their earnings per share consistently at a double-digit growth rate. They’re even able to do this through the financial crisis in 2008. So that was something that was very attractive to us.
So at a good strong base of business, a good solid track record. And then, looking forward, they were signing contracts, they were pursuing acquisitions that were profitable and had a track record of doing that well. And then, as well, they traded at an attractive valuation at that time. So two years ago, when we recommended them, they were trading at about 17 times trailing earnings and this was a growing business. So relative to other US companies, we thought that was a very attractive valuation. Today, we still like the company even though it’s trading at a valuation at 26-27 times earnings. But when you look at that business and you look at the growth profile going forward, we think that the value is quite good at the current price, especially when you compare that to other companies in the US.
INN: Right. So definitely, research plays an important part. What are some of the pitfalls that investors often fall into when they’re trying to choose a stock?
AD: Oh, easy question and answer, a buying into the hype. So typically, what you have, at certain points of the cycle, is there’s gonna be certain sectors that have a lot of hype. So right now, in Canada, marijuana sector, there’s blockchain businesses out there. You know junior mining is starting to make a return as well. So what you will need to focus on are companies. For our research, what we focus on are companies that we consider real businesses. So that means companies that actually demonstrated they can generate revenues and that they can generate profitability. If a company doesn’t have that, then odds, it’s not a real business. It’s not a real investment. It’s a speculation and there’s nothing wrong with speculating just like there’s nothing wrong with playing the lotto or going to a casino. But you have to understand what you’re doing. You have to understand that when you’re purchasing a company just because it’s the flavor of the month, you have to understand that if that company is not an actual sustainable business, then what you’re doing is not investing. And even though a lot of other investors may be extremely excited about that sector and pushing the price up week after week, month after month and everything seems like it’s great and the future is rosy, we’ve seen it many times in the past, many many times. When those cycles end, when that investor enthusiasm ends, it can be catastrophic. I mean, it is definitely catastrophic and you see share prices fall off extremely quickly, and the vast majority of investors, that take that strategy with the significant portion of their capital, end up losing a lot of money in the long term. So if you want to invest in companies that are more speculative, that’s great. You just have to understand what you’re doing and you have to limit your exposure to those types of stocks.
INN: Great. Is there anything else that you wanted to add that I maybe haven’t talked about yet?
AD: I just think that when you’re investing in the stock market, you either need to know how to do the research yourself, or you need to know that you’re working with somebody who is doing the research for you. So one of the things that makes KeyStone different from a lot of other firms out there, is that we are completely independent. And what I mean by that is that we only work for our clients. So we don’t sell research to companies. We don’t try and get investment banking deals or financing deals with the companies that we recommend. Our business model is to get subscription fees from our investor clients, and then, we provide high-quality research to those clients. So that removes the conflict of interest. We only work for them, and long-term, we’re only successful if we can make our clients successful.
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Securities Disclosure: I, Melissa Shaw, hold no direct investment interest in any company mentioned in this article.
Editorial Disclosure: The Investing News Network does not guarantee the accuracy or thoroughness of the information reported in the interviews it conducts. The opinions expressed in these interviews do not reflect the opinions of the Investing News Network and do not constitute investment advice. All readers are encouraged to perform their own due diligence.