Osmium Capital has an uncanny knack for finding small-cap stocks with explosive potential. The skillful stock-picking of founder and managing partner John Lewis and analyst Oliver Richner has earned the firm's long/short flagship fund 22.7% net annualized returns since its inception nearly five years ago. Meanwhile, its long-only fund has posted 31% annualized net returns since its 2005 inception. I recently visited Osmium's San Francisco office to see what my fellow Fools could learn from its success.
Zero to hero
Like that awkward girl in every teen movie who's destined to end up as a stunning prom queen, I think Lewis' portfolio is full of overlooked companies waiting to shine. Eventually, I think his picks will be recognized as strong performers worthy of superior multiples and higher stock prices.
However, when delving into the world of beaten-up, misunderstood small-cap stocks, the ability to avoid "value traps" (companies that look cheap, but deserve to be even cheaper) becomes critical.
Here are a few principles Osmium employs to avoid such traps:
- Invest in companies that lead their industries, generating sustainable high returns on capital.
- Invest at low multiples of operating and free cash flow.
- Avoid cyclical stocks.
- Invest in easily understandable companies with a high percentage of recurring revenue.
- Invest in companies with great balance sheets, with net cash representing a significant percentage of the market cap.
- Invest alongside management teams with aligned interests.
- If you deviate from these guidelines, look to buy at a sharp discount to replacement value and/or tangible book value...
- ... And only if there's a clearly identifiable catalyst that's likely to change the depressed valuation.
- Finally, be patient, and have a long-term time horizon.
Margin of safety
Osmium uses strict criteria to minimize its downside risk; its biggest losing position year to date in 2007 has cost the fund less than 2%. The typical Osmium position holds around 15% of its market cap in net cash, and it trades at enterprise multiples around mid-single digits of operating income, or at discounts to tangible book value -- a bargain by almost any measure.
Stalking the multibagger
Investor education and online brokerage firm Investools
In order to get comfortable with the company, Osmium attended more than 40 of Investools' events and three of its annual user conferences. Osmium met with or talked to over 200 Investools customers and contacted the Better Business Bureau to verify the company's user satisfaction ratings. In addition, Osmium put hundreds of man-hours into other due diligence tasks, scrutinizing management's performance and strategic moves.
The hard work has paid off so far. Osmium's position in Investools has turned into a multibagger over the past four years, and Lewis believes that the story isn't over yet. According to a recent sell-side research report, Investools is on pace for 40% revenue growth, with free cash flow estimated to increase from $0.68 a share in 2006 to $1.24 in 2007, rising to $1.80 per share in 2008. (The stock currently trades at $12 per share). At 6.6 times 2008 estimates of free cash flow per share, Investools could be a steal if all goes as planned.
If you've read a recent Berkshire Hathaway
According to Lewis, Investools isn't too different. He estimates that the company spent $86 million in customer acquisition costs in 2006, a huge portion of its $170 million in total sales. In addition, Investools' investor-education business converts 60% of its students into customers at its thinkorswim online brokerage site, which Barron's rated as the top online option brokerage.
This high conversion rate, coupled with reduced pricing in the investor education business, has prompted a 90% jump in unit volumes at introductory courses. In turn, that growth has helped Investools grow five times faster than its industry peers. In addition, like competitors optionsXpress
All in all, Investools exhibits many of the hallmarks of a winning Osmium position: a cash-rich balance sheet, understated income from a deferred revenue model, explosive potential, and a misunderstood business model.
Rinse and repeat
Other Osmium holdings, such as Franklin Covey
I believe that Fools would do well to employ Osmium's strict investing criteria to avoid value traps, and follow Lewis' willingness to look under the hood of misunderstood small-caps. Such techniques might just help turn up companies with multibagger potential.
Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy follows the yellow brick road.