Small-Cap Value Step by Step with Psion

Digging around at the small-cap end of the market can be a dangerous activity, especially if you’re investing like a loose cannon by buying without a plan or strategy.

Despite these dangers, value investors do love their small-caps and so it’s worth spending some time drawing up a repeatable and systematic plan for uncovering value.

This is the critical first step in becoming a successful investor because study after study shows that investors are generally very bad indeed at stock picking.

Most recently, Professor Greenblatt outlined how individual investors have wiped out the magic formula advantage by making poor stock picks.

So let’s start by picking Psion (makers of the iconic Psion Organiser II back in the 1980s) which is a company that I know scores highly on the 21st century net-net screen, and see how it fares.  Here’s the 5-year chart:

Look for companies with little debt and lots of cash

The reason for wanting little debt and lots of cash is that the future is uncertain.  In fact it’s so uncertain that there are no meaningful ways to work out the probability that any particular economic event will happen.

If the future is uncertain then the earnings of any company are uncertain and so it’s probably better to have the adaptability that being debt-free and cash-rich brings.

Looking for net cash is a simple way to find companies with a good balance of debt and cash.  Psion has net cash with around £27m cash in the bank and only around £2m in debt, compared to £6m operating profit last year.

The current and quick ratios are also favourites of many value investors and for Psion the current ratio is 1.6 and the quick ratio is 1.3.  Both of these are reasonably healthy figures, especially the quick ratio of more than one.

Buy companies that are cheap (this is value investing after all)

This is a ‘deep value’ strategy, based on Ben Graham’s net-net strategy, so value is measured against assets.  Psion’s price to book ratio is 0.35 which is way down in the bottom 10% of companies by price to book.

The price to tangible book ratio is 1.2 because the company has £118m of intangible assets which might scare off some hardcore ‘asset’ value investors, but for this strategy intangibles are not automatically a problem.

The company has enough current assets to pay off all its liabilities so it does have a positive net-net ratio.  However, the net-net value is about £32m while the market cap is £59m, so the net-net ratio is over 1 while Ben Graham required it to be below 0.66.

This isn’t a problem though and actually highlights why the 21st Century Net-Net strategy was created, which was to overcome the overly limiting nature of the original formula.

Buy companies that are cheap relative to their economic activity

It’s all well and good buying companies that are cheap relative to assets, and many academic studies have found it to be a successful – if difficult – strategy to follow.  In practice a pure focus on assets can lead a portfolio to hold many companies that don’t really do very much.

For example, pharmaceutical companies that are still testing their new products and don’t actually sell anything in meaningful amounts, or property companies that have a lot of assets (houses) which don’t generate a great deal of money.

A quick and easy way to check for a reasonable amount of economic activity is the price to sales ratio.  For Psion, price to sales is about 0.33, so last year’s sales were about three times the market cap of the company at £180m.

A final sanity check

Despite the wall of evidence which shows that investors are terrible stock pickers, most people aren’t happy to invest purely on the numbers, no matter how compelling they may be.  So it makes sense to have a final sanity check once all the number boxes have been ticked.

The idea is just to see if the company is facing some immediate threat to its survival or that its key economic engine is about to become obsolete or illegal.

In Psion’s case, after reading through the latest reports and searching recent news articles about the company, I cannot find any obvious evidence that it is about to go broke or be taken over at a price significantly below the current price.

Nor can I find any evidence that the company’s products (robust mobile computing devices) are about to become obsolete or un-sellable for any reason.

Diversity – The final defence against the unknown

The future is uncertain and the capitalist system is brutal for the companies within it (unlike banks for example which don’t really exist in the normal capitalist system).

Since the future is so harsh and non-deterministic it makes sense to be honest with yourself and admit that even with the best will in the world you will likely be wrong about most of the things you think will happen.

In that case it’s probably best to keep your eggs in many baskets and hold as many companies as your funds will allow, without harming returns with excessive trading costs.

For the 21st century net-net model portfolio the number of holdings is 60, so only 1.7% of the fund is allocated to each stock.

I’ve added Psion at 45p today so now the model portfolio looks like this:

Cash is still about 92% of the total and filling the portfolio with stocks will take the rest of the year, but this is a long-term project which I hope will generate a lot of practical insights into many aspects of investing.

P.S. One final point to mention is that Psion pays a dividend which, as far as I can see, is sustainable for the moment.  The current yield is just under 10%.

Further reading:

1. Titon – A Classic Ben Graham Net-Net
2. 21st Century Net-Nets
3. The Four Drivers of Long-Term Equity Returns (for large-caps)