Historical stock market data reveal two things about small-cap stocks. First, they're capable of generating significantly higher returns than the broader stock market over long periods of time. Second, they're capable of losing significantly more value than the broader stock market, as the stock market adjustment at the end of 2018 demonstrated.
In other words, smal-cap stocks are accompanied by a healthy dose of volatility. That makes sense considering smaller and less proven businesses are generally capable of growing (and wiping out) more quickly than larger and more mature businesses. It also creates a dilemma for investors: How do you tap into the above-average growth offered by small-cap stocks while still protecting yourself against the above-average risk? Well, by using the same strategy for all of your equity investments: Buy great businesses, and hold on for the long haul.
Diversification worked, so where's the love?
Fertilizer markets have been reeling for years from a glut of supply, which has created hurricane-force headwinds for producers large and small. That put Intrepid Potash in a precarious situation about two years ago, but management made several difficult decisions to position the business for long-term success.
A heavy dose of dilution in 2017 paid off most of the company's debt. The business pivoted to a low-cost potash production method that relies on sunlight and air humidity to evaporate water. The company even found ways to sell excess water reserves to oil and gas drillers in the nearby Permian Basin. It all worked.
In the first nine months of 2018 Intrepid Potash grew revenue 10% compared to the year-ago period. Operating income and net income swung sharply into positive territory. Interest expense declined by over 75%, while operating cash flow jumped 402%. Yet despite all the progress, shares ended the year down 45%.
Why is no one talking about Intrepid Potash? Well, there might be some legitimate concern over the amount of water sales pending delivery. That total swelled to $9.1 million at the end of September, up from $5.4 million at the end of June. Is that a sign of slowing demand from oil and gas drillers, or much ado about nothing? Investors will soon find out, although it's worth noting that $14 million worth of water was actually delivered in the first nine months of 2018.
While water sales are an important area to watch, especially considering they are incredibly high-margin, Intrepid Potash does have minimum volumes of water written into its contracts with customers. That should provide a floor against downside risk that, when coupled with slowly rising fertilizer selling prices, hints at another strong year of operations in 2019.
An industrial biotech/biopharma/software company
After operating under-the-radar for years, Codexis may have finally broken out in 2018. Shares gained exactly 100% on the year after Wall Street noticed the increasing market traction displayed by the company's technology platform.
It all centers on an enzyme engineering platform that combines software and wetware to design biological catalysts for a wide range of applications. Enzymes increase the efficiency of manufacturing processes for active pharmaceutical ingredients (APIs), food ingredients, textiles, and many other products. They make healthcare diagnostic tests possible. And, as the company is in the process of proving, enzymes can even serve as an active therapeutic product themselves.
Codexis is doing it all: licensing its enzyme engineering platform to partners for upfront payments of at least $10 million, designing custom enzymes for the manufacturing processes of customers in different industries, and now developing its own drug pipeline, led by CDXS-6114. The drug candidate is being developed as a potential treatment for the rare metabolic disorder phenylketonuria (PKU), and just wrapped up a successful phase 1a trial.
The drug pipeline seems to be both exciting and confusing Wall Street analysts. It's exciting because the two best treatments for PKU on the market aren't very effective, but still generate $400 million in annual revenue for BioMarin Pharmaceutical. It's confusing because, well, should Codexis be valued as a drug developer or for its high-margin enzyme supply business?
Depending on the pace of product sales in 2019, which will see a healthy bump thanks to the ramp-up of a supply agreement supporting the production of a novel zero-calorie sweetener ingredient, Codexis could begin generating quarterly operating profits this year. That would make it the first profitable and publicly traded synthetic biology company. It would also significantly de-risk drug development efforts -- something most early stage biopharmas can only dream of. At a market cap of only $900 million, it's a small-cap stock that, years from now, you may wish you'd bought.
Look out for market volatility in 2019
As the end of 2018 reminded investors, Mr. Market tends to dish out more pain to riskier stocks during periods of market volatility. That generally tends to include small-cap stocks, many of which are less proven than mid- and large-cap stocks representing more mature businesses. Therefore, while I think the progress at Intrepid Potash is being overlooked, and that Codexis is building a solid long-term business, both stocks could be in line for near-term punishment if the stock market slide resumes in 2019.
For investors with a long-term time horizon, that may not matter -- just don't go overboard allocating capital to the small-cap stocks in your portfolio.