Screening 100 Microcaps: Two that Missed the Cut

I mentioned in my last post that I recently went through ~100 microcaps. Before I get into the results, I want to briefly summarize some thoughts I have recently had about stock screens.

While many investors do stock screens, I think it is very important to always screen for a purpose. It is not enough to just enter the “perfect” screening criteria for stocks– high revenue growth, high ROE, low PE, etc.. Once you start entering too many criteria, you start generating results that look very cheap quantitatively, but often are cheap for a reason.

I prefer to screen for a purpose. Screen for a particular type of result, then search for something among those results. This allows you to really focus on what you are looking for (again, this comes down to having a clear investment philosophy and sticking to it – see my post on risk and eliminating investing mistakes).

Sometimes I screen for insider buying– often these stocks will look horrible, but if I can find a reason why an insider is buying a significant amount of stock before the market catches on, maybe I can get an edge. For example, in my recent screen for insider buying, I found that after a steep stock decline, nine insiders bought Kemet (KEM) stock in May 2012 for a total of $430 K:

I don’t know much about capacitors (their main product), but a screen like this might make me want to find out more (and if you happen to know anything about them or the stock, please comment on the post!).

Sometimes I screen for beaten down companies with lots of pessimism priced into the stock (crazy cheap valuations). Then I search for something positive. I start asking, “Is the market being overly pessimistic with this company/industry/sector?” Are there emotional sellers? This recently led me into the for profit education space, where I believe some stocks, such as Career Education (CECO), have been punished too hard by the market (this may be the subject of a future post). Lisa Rapuano of Lane Five Capital agrees.

Sometimes, like last weekend, I am screening for high quality companies that may be under the radar or underappreciated by the market. In this particular case, I was looking for microcap companies with greater than 15% ROE and greater than 20% ROC in the last twelve months with reasonable capital structures (I hate debt) that were within my circle of competence. While a plethora of these 100 stocks were really interesting, many of them were outside of my circle of competence, and I ultimately determined that only six of them were worth a deep dive. Of these six, I found that three were particularly interesting to me as an investor.

1) The stock that actually had me most intrigued was called Groupe Athena (OTCPK: GATA). The company claims to be a consulting company that helps Indian medical companies obtain FDA approval for their devices/ pharmaceuticals for sale in the U.S. This seemed like a pretty interesting niche—certainly a simple business model I could understand. Here were my initial notes:

Groupe Athena (OTCPK: GATA)

  • $6.6 mm mkt cap, $3.1 mm EV
  • 0.5X EBITDA, 1.6X P/E, 0.7X TBV
  • Revenues grown 100% yoy the past two years, ttm EBIT is $4.9 mm
  • Higher than I would expect capex has led to negative FCF
  • They provide testing and regulatory consulting services to help Indian and Southeast Asian medical companies obtain regulatory approval and facilitate exports of pharmaceuticals to the U.S.
  • Based in Mumbai, India
  • http://www.ceocfointerviews.com/interviews/GATA-GroupeAthena12.htm

Questions

  • Number of customers?
  • Capex?/machinery?
  • Auditors?
  • Stock Split, dividend, buybacks?, increased IR?

You don’t find too many consulting businesses growing revenue 100% yoy two years in a row at .5X EBITDA and half the market cap in cash. With a $6.6 mm mkt cap, it was definitely worth doing more digging because at this point, I just wanted to find out if it was a fraud. With those metrics, if it wasn’t a fraud, it was likely to be a multi-bagger.

I contacted management of the company and they got back to me rather quickly. I started to ask many questions—about their auditor, their customers, their management, their buyback strategy, increased IR etc. As my questions became more detailed, however, they stopped answering some of my questions. For example, they claimed one of their managers worked at Johnson and Johnson for 12 years. This was a pretty important fact to me—this is something that could be verified and if someone left a reputable job at J&J after a decade, starting a small-time fraud in India seems unlikely.

However, when I followed up and asked who worked at J&J for 12 years, he said, “the name you are looking for is Ms. Pooja Rajpurohit.” However, this person graduated from Rutgers in 2007 and therefore could not have worked at J&J for 12 years.

Other red flags:

  • I could find no information surrounding Allianz Atlantis Partners, their largest and founding investor, who has been selling stock aggressively lately
  • Their website includes generic pictures from around the web
  • The listed website and email address of the accounting firm listed on their financials did not work. They now have a new website with new contact information, but when I contacted them, they refused to answer whether they were the auditor for any other publicly traded companies

I could go on and on as I studied this for a better part of a week, but I was very disappointed with the conclusions from my digging: they are most likely a fraud, and certainly something I am not comfortable investing in. While these are my initial takeaways, I am certainly open to continuing a dialogue with management if they continue to do so and are willing to answer all of my questions with clear responses.

This is just part of microcap investing. You have to do your due diligence and occasionally you will find a gem that is truly under the radar.

2) The second stock I found interesting was  Vapor Corporation– (VPCO). Here were my initial notes:

  • $12 mm mkt cap, EV
  • 0.6X Revenue
  • Vapor Corporation designs, markets, and distributes electronic cigarettes in the United States. The company’s electronic cigarettes are battery-powered products that enable users to inhale nicotine vapor without smoke, tar, ash, or carbon monoxide
    • Very interesting, potentially lucrative market
  • Company has grown revenues tremendously over last few years. In 2008, they had less than $1 mm in revenue, but in ttm, nearly $20 mm
  • Company has never been profitable, but could on the verge of profitability with increased scale. There is also very little volume—would be difficult to establish a meaningful position
  • Insiders own 51% of stock

I liked a lot about this company: extremely high revenue growth, interesting (and addictive) market, and very much under the radar. However, the company has never generated FCF and I see very little long-term competitive advantages. It is unclear to me how the electronic cigarette market will unfold and even if it does take off I am not confident they will capture the economics. Ultimately, this is a company I will keep on my watch list. If they are able to continue to grow top line, but somehow build their brand and improve margins, then maybe it will be worth another look. With no evidence to suggest a competitive advantage, no meaningful FCF, and an uncertain business environment for their products, I’m not sure the stock deserves to trade much higher than its “cheap” revenue multiple. This could change, but it does not quite look like a “no-brainer” to me.

It’s getting late and this post is already getting long. There are two stocks that did make the cut that I will write about hopefully tomorrow, but I feel they deserve their own post. Don’t forget to subscribe to my blog and follow me on Twitter to make sure you don’t miss the next update.

 

Disclaimer: The content contained in this blog represents only the opinions of its author(s). I may hold long or short positions in securities mentioned in the blog. In no way should anything on this website be considered investment advice and should never be relied on in making an investment decision. This blog is not a solicitation of business– the content herein is intended solely for the entertainment of the reader and the author.

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