In a previous post I wrote about my approach to determining if an investment has merit. In it, I commented on the key areas my due diligence focuses on – Balance sheet, Cash Management, Capital Structure and Management Competence.

Determining if an investment has Merit

But while doing some recent digging on a company, it occurred to me that I wasn’t approaching the research by making a list and checking off boxes. I was asking questions. Kind of haphazardly approaching a potential investment and pestering it, and myself, with questions from all angles. Kind of softening the target up, testing it, seeing if I wanted to do a deeper dive.

Reflecting on this, it occurred to be how many investors are great at learning facts but poor at asking questions. An example. Say a company is light on cash and has a burn rate that suggests it will be required to raise money within 6 months. The logical question most investors will (should) ask is ‘how are they going to raise money?’

But there are so many other questions around something this important.

1. How much money will need to be raised?
2. Will it be raised via equity or debt issuance?
3. How much shareholder dilution (or debt financing costs) will be incurred
4. What would the structure of the financing be?
5. Is this another stop gap financing or a decisive one to eliminate future needs?
6. What is management’s track record with financing? (This is a good one!)
7. In the past, at their current company and previous ones, were they executed in a smart way for shareholders at the right times?
8. Who advises them on capital market activities? What is their track record?
9. Were past financings excessively dilutive or costly?
10. Who is making money on these financings?
11. Did debt levels become unsustainable?

I’m not a pessimist. But many micro cap stocks have less than ‘mature’ or experienced (or frankly incompetent or immoral) corporate governance structures, so you have to keep your eyes open and ask a lot of questions.

Say, for example, a few key company shareholders (who may also be management or directors) have a pile of founders shares at 5 cents. And their stock is trading at 55 cents. An objective that creeps into managements mind may be simply keeping the company solvent…..so they can maintain liquidity and exit their share position before the runway ends. ie, They are telling shareholders who bought in at the last financing at 75 cents they are going to grow that share price! Success is just around the corner! They are gonna pump that stock – but the financing being completed suggests its more of a survival play to exit their share positions – and pay themselves big salaries – as opposed to funding operational growth. This is one reason why watching insider selling reports on micro caps is so important.

Now here is the tough part about asking questions. No one is going to be able to answer most of them. If you can get access to management, they are going to give you the corporate pitch, not the behind the scenes reality. If you talk to other investors, many will be fanboys and have drunk the cool aid, or won’t have enough knowledge or competence to assist. Analyst reports can help, but they are also predicated on their own assumptions and biases.

Basically, to really dig deep you have to get a bit of an investigative journalist thing going, and try to put the pieces of the puzzle together to determine what is going on. Listen to, but don’t rely too much on others opinions.

Ask questions, then try to figure out the answer to them. You’ll learn a lot along the way. And maybe even make better investments as a result.