Before I jump into today's column, let me announce that I am extending the small cap investing idea contest I announced back on September 4th to the end of the month -- so you still have time to write to me at ZAshton@Fool.com and tell me all about your favorite small cap stock and why you like it in 500 words or less. I've received some great ideas so far, and I'd like to extend the contest for another week. So send in your best idea, and I'll announce the winners on October 2nd in this column. Thanks to everybody who has sent in an essay.
Today's topic is volatility, and more specifically, a strategy to help you cope with volatility. Without a doubt, the most frustrating thing about small cap investing is finding a great little company, buying that stock at what you think is a great price, and watching it go down 30% within a month on no news.
First of all, I feel your pain. It's happened to me many, many times. Today I'll share with you a strategy that I came up with after one such incident. The strategy is designed to minimize the damage, and even turn this type of volatility in my favor. Before I share it with you, though, let's examine the nature of the beast to get a feel for what we are dealing with.
As a quick sampling, I looked at seven companies that fell off our Foolish 8 screening tool for various reasons in a recent month. I examined the 52-week price ranges for these seven stocks. In virtually every case, the 52-week low is at least half the 52-week high, and in four of the cases, there is a threefold difference in the high than the low. This obviously provides a lot of opportunity for big percentage moves in both directions.
A particularly fun case study in the list is Keith Companies (Nasdaq: TKCI), a small construction consulting company. The stock was at five bucks in November of 2000, when it jumped pretty much on a single day to $8, where it stayed until January, when it caught fire.
If a sports announcer had been calling the play-by-play, it would have sounded like a kickoff return. It went from $10, to $15, to $20, and was finally brought down at $25 in March. By May it was almost back to $15, but rebounded into June, getting to the mid-$20s before starting a slide in August that has dropped the stock all the way back to about $8 as of this writing. This type of volatility is, scarily enough, pretty common for a small-cap growth stock. The stock prices of MTR Gaming (Nasdaq: MNTG), Chico's FAS (NYSE: CHS), Copart (Nasdaq: CPRT), and Clark/Bardes (Nasdaq: CLKB) have shown similar tendencies over the past year.
You'd think that all this volatility in the stock price would imply that good and bad things were happening to the business at a breathtaking pace. I mean, if you owned the business, and you saw it quoted in the paper in November at $36 million, then to $55 million in January, all the way up to $190 million in March, and back down to $60 million today, you'd think that there must be some series of dramatic events to cause this type of price volatility.
That's not been the case at all. The story at The Keith Companies has been pretty much unchanged, with the company growing its business at a nice clip all year. This is just the way it goes in the game of small cap growth investing -- the lack of liquidity means that if anybody has a lot of shares to sell or wants to buy a significant amount, it's going to move the price in a big way.
Now, let me unveil my strategy for making volatility your friend rather than your enemy. First, do what you normally do when you invest in small cap companies -- but when you get to the point where you would ordinarily pull the trigger and buy the shares, don't. First, forget you know the stock price and the market cap. Think about the business for a minute. Do some projections, using what you think is the most likely outcome for future sales and earnings growth. Where does that put you in three years?
Now, come up with what you think those growth estimates will translate into in terms of a stock price, using P/E ratios, Price to Free Cash Flow, or whatever you find to be appropriate for the business you are looking at. Be conservative in your estimates, and try to come up with a stock price that would give you a pretty good chance at doubling your money in three years. Now cut that figure by 25% and then compare it with the currently quoted price for your stock.
If your number is lower than the stock price, we're in good shape. If your number is higher, you should consider waiting. Remember, these stocks are so volatile, you have a pretty decent chance that you will eventually be able to get it at your price at some point. Now cut another 25% off the figure, and write that number down.
My strategy is simple. If you normally put 5% of your portfolio into each stock, buy half of that when the stock reaches your first price. This should provide you with a good chance of a double in three years, with a margin of safety of 25%. If the stock continues to drop (assuming there is no news or at least no nasty surprises) and hits your second number, buy more with the other half of the money.
Using this strategy requires tremendous patience. It may mean that you don't actually get shares in some of the companies you identify. But it does play to your advantage in that you will virtually always have a margin of safety in your purchase price, and it will make you much less concerned about whether the stock drops after your initial purchase. If the stock does drop, you get to buy more shares. If it doesn't, you are making money on your first purchase, so you are happy. Most importantly, you probably won't get frustrated and sell because of a big percentage loss.
If you want to take this strategy to its extreme, only buy when the stock hits that second, lowest figure. If you use this approach, you won't buy many stocks -- depending upon how many "targets" you identify, maybe only two or three each year. On the flipside, you will probably get some great percentage returns on these investments, as you will essentially only be buying when the odds are tipped dramatically in your favor, assuming the assumptions in your valuation work are good.
This is a tough strategy to implement -- but if you find yourself selling your stocks out of frustration after a large percentage move against you, this approach should allow you to make volatility work for you and not against you.