How to Find Small-Cap Investing Opportunities

In this podcast, Bill Mann, director of small-cap research at The Motley Fool, and Motley Fool producer Ricky Mulvey continue their series on small-cap investing, one area where individual investors have a shot at beating the market. They look at the stories behind some companies you know (and ones you probably don’t), and discuss:

• How to discover new small-cap opportunities.
• Metrics that can tell you a lot about a company’s future.
• Small caps for chicken wing lovers and fans of workers’ comp insurance.

To catch full episodes of all The Motley Fool’s free podcasts, check out our podcast center. To get started investing, check out our quick-start guide to investing in stocks. A full transcript follows the video.

This video was recorded on August 20, 2022.

Bill Mann: One of the best pieces of advice I’ve ever gotten from someone is that you should be jealous of your equity. There are small-cap managers out there who have come public without selling any shares into the public markets.

Chris Hill: I’m Chris Hill, and that’s Bill Mann, Director of Small Cap Research at The Motley Fool. Ricky Mulvey caught up with him for part two of their series on small-cap investing. They talk about how to discover new opportunities among small-cap stocks and some key metrics that can tell you a lot about a company’s future.

Ricky Mulvey: Last week, we laid out a framework for small-cap investing. This week we’re diving a little deeper. Joining us again is Bill Mann. He accepted the calendar invite and he’s also the small-cap investing director at the Motley Fool. Thanks for joining us again.

Bill Mann: Thanks for letting people know that my presence on this show is just due to my availability.

Ricky Mulvey: That is correct. I think there’s you can’t have one without the other. First, I want to start off with some framing questions a little bit different than last time. We talked about the benefits of holding onto small caps for a long period of time. But it’s also like investing is a game. If small-cap investing is a game then who is this game for?

Bill Mann: When you think about small-cap investing, you’re talking about companies that generally speaking have less available information, they are less liquid. Frankly, a lot of people just haven’t really heard of these companies, which means that your ability just to come across them is somewhat reduced. You need to be willing to be an active participant in the markets in order to be a small-cap investor in order to do it well. Now by active participant in the market, I don’t mean that you need to be a trader. What I mean is that you need to be willing to do the work to learn about companies that are going to have a lower level of information about them than you might be used to with some of the larger companies.

Ricky Mulvey: Then on the flip side of that, who are the types of investors, the types of folks you would recommend, turn off the podcast, go home, stay away from the small-cap game?

Bill Mann: Well, I mean, one of the things that we talked about last week that is true on an individual level is that small caps tend to be much more volatile than larger-cap companies. That has to do with a lack of information, a lower market cap, and simply little more obscurity and a little less liquidity. I happen to think that small-cap investing is one of the areas where individual investors have an absolute advantage over institutional investors. It is one of the areas in which if you are willing to do your homework, you are able to get into companies both earlier and in some cases ones that institutions cannot buy.

Ricky Mulvey: I think it’s worth it, but I know we mentioned that last week, but I think it’s worth diving that idea a little bit deeper. If you’re a Charles Schwab and TD Ameritrade, if you’re a major mutual fund company like you, it straight up, isn’t worth your time to look at the small-cap companies because often you’re investing more money than the market caps of some of these companies?

Bill Mann: That’s exactly it. To be a diversified mutual fund in the United States, you cannot put more than five percent of your money into any one company. You immediately start to think about just the mechanics of a mutual fund that’s got several billion dollars in assets under management, what good is it to them to go and find a $100 million company if they are limited by how much of the company that they can buy, also, how much of the fund they can commit to that company. There are all sorts of limitations that really make it. It’s not worth their while to play in this pool, which is why it’s great for us as individual investors. I mean, people get excited about IPOs because of the pops and things like that. That’s not really truly where the advantages for investors. The advantage for individual investors is investing in places where institutions cannot go.

Ricky Mulvey: Well, I think there’s a couple of exceptions like you can buy. There are small-cap index funds like VB, the Vanguard Small-Cap fund is a very popular ETF with very low expense fees. I guess the only, I shouldn’t say issue, but the cost of that it’s literally thousands of companies within that one ETF, which in itself has an advantage, you have the diversification. But to your earlier point if you do the homework, they are drastic differences in the qualities of these companies.

Bill Mann: I think that’s absolutely right, and research has actually borne this out. There is a much higher prevalence of companies that fail or underperform within small caps. The other reason why I think that small-cap investing from an institutional standpoint is not necessarily the way that you want to go is that the definition of small caps at the institutional level is fixed. For example, a company like Activision, which is now a massive company. When it first came public, it was a small cap company. But at some point, if it is a successful small-cap company, it moves into the mid-cap space and it moves into the large-cap space. You can’t continue to hold it as an institution, which we as individual investors can. I mean, very famously here at The Motley Fool, David Gardner did that with Amazon having held it since 1998 when it actually was a small cap, so we do have that advantage.

Ricky Mulvey: Since these are less talked about, less followed, how do you look for interesting small-caps?

Bill Mann: I mean, Ricky, this is going to sound a little diminutive, but just open your eyes. The fact that companies aren’t talked about that much means that one of the things that you can do is you can just start to pay attention whenever you go to the store and you choose one product over another, there’s a point in time where you can say, well, who makes this or when you hear someone talking about being excited that a chain is coming to your area or when you hear your kids talking about a website that they use. All of these things they don’t feel like research, but particularly in the small-cap realm, they are. Most of the companies that I own that I bought when were small caps really came from some form of personal experience.

This goes back a long way. It’s perhaps, maybe the most famous story of someone doing this was Peter Lynch, who was the longtime portfolio manager for Fidelity Magellan went to go have lunch one day and he noticed a line going out the door at Taco Bell. He went back and this was before Taco Bell became part of Pepsi and then part of Yom and Taco Bell had its own ticker. With not that much more research, he bought part of it. That turned out fantastically well for them. The great news with small-cap companies is that if you see something small that’s well-run, that’s public, that’s really a big part of your research.

Ricky Mulvey: In many cases though, you’re looking for younger companies. Within the past couple of years, a lot of the younger companies have SPAC’d or IPO’d at extraordinarily high levels. Now they’re, they’re down. I guess there’s two parts of this question, or I guess there’s one part of this question. Market timing tends to be a losing game, but it seems like now might be a richer environment to look for small caps now that a lot of those valuations have been brought back down to earth.

Bill Mann: I like the way that you put it that way, and again, because small caps are actually defined by the market as by the size of market cap, there were a lot of companies that were actually very small companies that had mid-cap and even large cap valuations and have now come way back down to earth. For example, there’s a Korean company that came public in 2021 called Coupang, and it is a combination of Amazon and eBay, and it’s a wonderfully run company. It’s now much lower in price, and so, therefore, it is a small cap. In some ways, there is a level of risk that comes with smaller companies with higher share prices or higher valuations. When they come back to earth, you get to see that risk turned on its head where the expectations that are being put into these companies now are much lower. Ricky, they’re really the same companies. Obviously, the environment has changed from 2020 and 2021. Let’s hope we never go back to that again, but at the same time, these companies are not that far away from that same part of their development curve, as they were then at 60, 70, even 80 percent lower price than they were even a year ago.

Ricky Mulvey: Last week we talked about some of the metrics to watch, sales, trading volume, minimum share price, all that good stuff. Let’s look at some more. One of which we didn’t talk about on last week’s show, but I think is worth bringing up is Insider Holdings. What are you watching for in terms of management owning the company that they’re managing?

Bill Mann: I think with small-cap companies, you want someone who is lashed to the mast of the company. We talk a lot here at The Motley Fool about companies being founder-led. That’s a bit of a shortcut to saying that you want a CEO who is absolutely positively dedicated to making sure that this company succeeds. One way that you can see that their interests are aligned with yours as shareholders is straight, insider ownership. What percentage company does the insider own? This gets to be somewhat absurd with larger cap companies because you’re talking about companies that are billions and billions of dollars, but in the smaller cap companies, if you see a company that is valued at a billion dollars and the founder owns less than a million dollars in shares you know that this founder has in some ways traded away whatever interest he or she has in the business for some upfront payment. It doesn’t mean that this isn’t a talented founder, this isn’t a talented CEO, but it is a way that you can determine whether they are going to be really motivated to see that share price go up over time.

Ricky Mulvey: They’re not exactly playing in a contract year.

Bill Mann: They’re not playing into contract year, that’s right. When you own 10 percent of the company, every day is a contract year.

Ricky Mulvey: I think it’s also worth talking about how these companies manage share count a little bit. Younger companies have more opportunities to widen them, is getting diluted out of a younger company. Is that something you watch is how they manage that share dilution? We had a conversation earlier before recording about Rent the Runway a little bit.

Bill Mann: Rent the Runway, I believe that their share count went up about six times between last year and this year. It’s an extraordinary amount. Now, that in and of itself is not 100 percent concerning, because they did go public, and when a company goes public, they are in fact selling shares to the public. But it is a tremendous amount of dilution, and it does tell you in some ways that the insiders are more interested in selling than they are making sure that they retain as much equity as possible. One of the best pieces of advice I’ve ever gotten from someone is that you should be jealous of your equity. There are small cap managers out there who have come public without selling any shares into the public markets. It’s all secondary and pre-public shareholders who want to sell. Again, it’s not a sure thing that a company that you see a big share dilution is a bad company and a company that doesn’t dilute shares is a good company, but it’s a pretty good way to vote.

Ricky Mulvey: When you’re looking at profitability, cash flow from operations, free cash flow, is that something that you’re keeping a close eye on or are you giving a lot of these companies the benefit of the doubt, hey, these are younger, they might need some time to reach profitability?

Bill Mann: It really depends. For younger companies, you absolutely do. You have to keep in mind, when companies go bankrupt, and in smaller caps, they really do actually go bankrupt more often than large caps do. I think that the reasons why probably makes sense. They are much more on a razor’s edge. It’s not a lack of profits that causes a company to go bankrupt, it’s a lack of cash. You really do see situations where companies aren’t showing much profitability, but at the same time, they are either generating cash flows or they’re not burning that much. Now, with a younger company, that’s something that I’m pretty comfortable with, just so you can see the path, even though you have to keep in the back of your mind the knowledge that you are doing something that is a little bit higher risk anytime that you own a company that is not currently profitable. But yeah, cash is king. What you need to do with smaller cap companies that are not generating profits or are not generating free cash flow is tests the thesis. Make sure that you understand what the path is. Are they in a heavy development stage? Keep yourself honest. If you see a new excuse for why they’re not free cash-flow positive or they’re no closer to profitability, that’s a company that you probably want to get out of pretty.

Ricky Mulvey: Off the cash flow statement, off the balance sheet, are there any metrics or data points that you like to look at it as a small cap investor?

Bill Mann: One of the things that I think is really important with small cap companies, and this might sound funny, but I really want to see a rising number of customers. You have small cap companies and sometimes they’ll have customers where you see the biggest customer is 60 percent of their revenues. That means that this company is in some ways captive or hostage to that big company. If you see a company with a rapidly growing number of customers, and this is something that they all disclose in their 10Ks, if you know where to look for it, there’s a management discussion of the business, and they will describe how many and what types of customers they have. One thing I love to see is a breadth and growing number of customers for these small cap companies.

Ricky Mulvey: We’ve done the academic portion. Let’s look at some real life companies. Get some real-life fish on the line [OVERLAPPING]. Last week, we talked about how every company has good dysfunction. It’s the question you have as an investor is, is what do you look past and then what puts up a red flag. Let’s go off that point. Are there companies that you see with some good dysfunctions and then are there any dysfunctions that you’re happy to watch on the sidelines?

Bill Mann: One company that I really do admire is Wingstop. The ticker is, as you might guess, W-I-N-G. It is a franchisor of the Wingstop brand. It sells chicken wings and boneless wings and all sorts of deliciousness in about 1,600 franchised restaurants all around the United States. One of the things that I look for with restaurant companies in particular is low food costs and low cost of production. A very well-known CEO by the name of Selim Bassoul, who was the CEO of Middleby, was a kitchen supply company, talked about companies that were in the restaurant space that treated their kitchen like a factory. Now that sounds terrible. As a purchaser and as a customer, you don’t want to think of your restaurants as being a factory, but what he means by that is where the steps are all standardized and it takes as much cost as possible out of the process. Wingstop, as a small-cap company, is one of the best in the business.

Ricky Mulvey: At a little bit of a pivot, did they do the Thighstop during the chicken wing shortage?

Bill Mann: They did; that’s right. That’s one of the areas of dysfunction. Obviously, if you were to talk about the risks to Wingstop, maybe the best one is that people will stop eating chicken wings, but I mean, come on. But chicken wings by themselves are a singular supply risk that they have, and wings like a lot of other things this last year, the price went parabolic. They shifted, I think, in a very funny, clever way, and people embraced it.

Ricky Mulvey: Speaking of restaurants, there’s one that I’ve been happy to watch on the sidelines, and that has been Red Robin, where their dysfunctions as a company seems a little bit more difficult to surmount.

Bill Mann: It’s so disappointing, isn’t it? They’ve got a huge number of franchises. They sell wine milkshakes. How is it possible that this hasn’t worked?

Ricky Mulvey: Looking through some of their financials, they’ve had about, this is last year, not this year, 1.2 billion in sales and a price to sales ratio of 0.22, which is that of a grocery store, not a restaurant.

Bill Mann: Yeah.

Ricky Mulvey: I think there’s questions for me about essentially, how are you not profitable selling hamburgers to Americans at a beloved chain? Then number 2, for me, has been management, particularly the way that they’ve been handling the balance sheet. As of 2021, Red Robin had 23 million in net cash, 51 million in short-term debt, and $620 million in long-term debt. Right now, [inaudible 00:20:12] , of a market cap of about a 130 million.

Bill Mann: It’s really incredible, isn’t it? Now they’ve got about 600 restaurants, 500 of which they own, and then they have about another hundred of them that are franchised. You can’t understand why a company that has franchises would have cash dynamics like that. Now, this is a company that has been pretty good at selling but has been absolutely positively lousy over time at managing its costs. It’s very different from something like Wingstop where it’s easy to say, their costs are higher now because of one input or two or three inputs. This is a case of a company that has never gotten its cost structure under control. I don’t care how many hamburgers you sell, the point of a company is not to sell as many hamburgers as possible, it’s not to sell as many wine milkshakes as possible; it’s to make money. They have not figured out how to do it, and their stock is down 70 percent since 2015. You’re not talking about a company that has seen its stock drop sharply over the last year. That is seven years’ worth of the market telling the company that it needs to change its ways.

Ricky Mulvey: CEO Paul Murphy is retiring, and just as an observer, I do enjoy watching how he handles conference calls. In the latest one, this is just how he opened the presentation to investors, “As the headlines have become increasingly negative as it relates to consumer confidence, general inflation, and the likelihood of a recession, casual dine-in traffic has been trending downward, still when we evaluate our sales and traffic trends relative to our peers in the same markets, we are outperforming the casual dine-in segment.” That to me is an absolute heater telling investors like, to start this off, listen folks, the economy is bad, it is really bad.

Bill Mann: I don’t know if you’ve heard, I know I’m going to get asked about this, the economy’s bad.

Ricky Mulvey: I feel bad beating up on Red Robin. I like the restaurant, I like going there, and I want it to be profitable. That’s why I follow it, but it’s been difficult. Let’s speak a little bit more positively. I don’t need to keep beating up on hamburgers. But one thing you brought up in the last show was a way to frame companies as an investor. As you say, if this company disappeared, it would be extremely painful to its customers.

Bill Mann: This isn’t exciting at all. Prepare yourself. We’re about to talk about workers compensation insurance.

Ricky Mulvey: I’m buckled in.

Bill Mann: We’re talking about a company called Employers Holdings Incorporated. The ticker is EIG. It’s based in Reno. It provides insurance to companies, specifically for workers’ compensation, which is an area for companies that is an enormous, almost open-ended risk if their insurers do not handle it properly. Employers Holdings, this is essentially their only line of business, and they are really good at it. We’d like not to think much about insurance, but it really bears remembering how many things would cease to happen in this country if companies were unable to have insurance that protected them against specific types of claims, and maybe at the top of the list is workers compensation.

Ricky Mulvey: Bill, it is incredibly difficult for me to tell if you’re pausing for comedic timing or if your screen is simply frozen. These are the joys of remote recording.

Bill Mann: Maybe both. How about both?

Ricky Mulvey: It could be, sure, why not? Last thing, one quality we talked about in last week’s episode is, hey, it’s OK to look at products that customers just really seem to like. Going back to the Peter Lynch idea. When you think of smaller companies with the products that customers really seem to like, that’s the fill-in-the-blank. What do you think of?

Bill Mann: Well, there’s a company that’s based actually in the UK, but almost all of its business is here in the United States, about 80 percent of it, called Naked Wines. Naked Wines, you’re going to like this, they’ll send wine to your door on a subscription basis and their customers love it, and the vineyards love it because the vineyards get to lock in an entire vintage of wine, and it’s pre-sold to Naked Wines who then sells it out to their customers, an absolutely wonderful model. It’s a really small company. Obviously as we have come out from the pandemic, people are leaving their houses again, maybe we don’t need as much wine mailed to our house as we did in late 2020, but it’s a company that has a tremendous amount of what’s called customer retention, which means that very few of the people who actually try Naked Wines end up leaving it.

Ricky Mulvey: Supply side, that seems nice that you don’t have to deal with the entire complex distribution process of all the wine shops that seem to be independently owned, multiple wine distributors, I clearly see the problem that it’s solving.

Bill Mann: Also vineyards, basically all of their investment is upfront. There’s this strange pressure because they know the optimal day to pick their grapes. These are basically very, very high-end chemistry experiments. But they also know that if they pick them just a few days sooner, they start to get their cash sooner. If their cash is fronted to them, they can actually optimize on the quality of the grapes, the end quality of the wine. From beginning to end, it is a better process for really everyone involved.

Ricky Mulvey: The other thing is companies don’t just start out as small caps, they can also go back to being small caps. In this past, let’s call it bearish market, you’ve seen a lot of companies that went to the mid cap land and then turned out to be small caps like sure, there’s Lemonade, there’s Upstart, but also if you look in the, we call it the dredges of the S&P 500, there’s a flooring manufacturer called Mohawk Industries. You got your sin stocks, Penn Gaming, Wynn Resorts, and you also got an IT outfit called DXC Technology. Let’s call some of these companies that mid cap graveyard. It doesn’t have to be from an investability perspective, but are there any of these companies that went to mid cap land and came back that are interesting to you?

Bill Mann: Well, we already talked about Coupang earlier, but Penn National, PENN Entertainment is absolutely one of those and yes, it is a sin stock. They’ve got casinos in 20 states, 44 properties. They are a management company of casinos. I don’t know about you, Ricky, but I really do believe that 20, 30, even 50 years from now, we Americans will still gamble.

Ricky Mulvey: Yes, I’m pretty confident in that. It’s like this is the thing I struggle with, which is it’s invest in the best vision of the future. But also I think part of the future might look a little bit like that movie Idiocracy, and if I can sit on my couch and gamble on the baseball game, UFC fight, NFL game that’s on TV, am I going to deny that that makes the game somewhat more exciting?

Bill Mann: My best vision of the future is not in a casino outside of Saint Louis on a Thursday night, it just isn’t.

Ricky Mulvey: I think that’s pretty fair.

Bill Mann: But Idiocracy is exactly right. We should embrace the fact that we as human beings do like to have fun, and we like us a good gamble. We really do. There’s absolutely, positively, nothing wrong with that, and Penn National is a company that’s been incredibly intelligent about how they go about deploying places for people to do this all around the United States of America.

Ricky Mulvey: We are moving into the wrap-up as we’re completing these two episodes on small cap investing. Is there anything you think that we didn’t talk about for the small-cap curious that you would want to make sure they know before they entered this investing space?

Bill Mann: The best thing that you can do with any small cap is go and get their annual report and read the letter to shareholders, which will, generally speaking, be written by the CEO or the chairman, whoever the most important person at the company is. In those words, you can get a sense of what this company is about and what this leader is about. Because these companies, they are so specifically dependent upon good management, you really want to know what this management is. One thing that I like to do actually is just go onto YouTube and see if there’s an interview with the person who is running the company. In almost all situations, you’ll be able to find something and you will get a sense of whether this is a person that you would like to put your money with or if this is a person who you would like to wish good luck.

Ricky Mulvey: It’s not so fun to gamble outside of Saint Louis on a Thursday night, but it is a lot of fun to read a company’s annual report and its management discussion for shareholders. Bill Mann, thanks for being a part of this series. Thanks for guiding us through the small cap investing landscape.

Bill Mann: Hey, thanks so much, Ricky.

Chris Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don’t buy or sell stocks based solely on what you hear. I’m Chris Hill. Thanks for listening. We’ll see you tomorrow.