We developed our approach on three tenets: 1) strict adherence to our value philosophy in all market environments; 2) in-depth internally generated fundamental research; and 3) integrated trading and portfolio management. We strongly encourage the reader to study the risks and considerations section to get a broader understanding of investing in the stock market and with First Wilshire.
We love finding unknown, undervalued companies in emerging industries that possess excellent growth potential.
Unlike growth investors who pay a fair and often inflated price for companies with high growth potential, value investors buy companies that are undervalued relative to their assets or growth prospects. (Read here for a comparison of value vs. growth investing style) We at First Wilshire strive to find the diamonds in the rough that have strong growth potential and are trading at a low price. While we consider companies of all sizes, our search for the rare combination of high growth and low valuation brings us to the small-cap universe. The small-cap universe is never without intriguing revelations.
Of the many criteria we look for in a company, each investment candidate typically demonstrates many of the following fundamentals:
• Low valuation relative to assets, market indices, peer group and growth rate of the company
• Earnings growth superior to its industry and the general economy
• Relatively low debt; relatively large cash position
• Expanding cash flow
• Strong, credible management
• Sustainable competitive advantage
This requires looking beyond the obvious. Currently, we consider small caps to be publicly traded companies with market capitalizations up to $1.5 billion. Over 80% of all U.S. public companies belong to the small cap equity class. Large Wall Street firms, however, usually focus only on the largest companies, representing a small fraction of the opportunities. That leaves out a staggering number of underfollowed companies among which to find potential winners. Many companies plod along in relative obscurity, waiting to be recognized by Wall Street. We want to be there before this recognition sets in.
The risk of investing in small caps is considered greater than larger cap stocks, but so can be the potential reward. It helps to invest with experienced professionals who know how to juggle risk, return, and capital preservation. Small cap investing requires a team of vigilant and experienced professionals who can spot opportunities and avoid deadly pitfalls. It is certainly not an easy way to invest in the stock market, but we believe our clients eventually see the reward.
Our selection criteria results in stock holdings that don’t fall into neat categories popular with mutual funds. We try to be initiators rather than followers. Our value approach results in three broad categories of stocks.
Growth at a discount
The majority of First Wilshire stocks have fallen into this category. We seek to buy companies growing faster than the S&P 500 and trading at price/earnings ratios below the market average. First Wilshire often invests in emerging industries that are poorly understood by the investment community. Portfolios have often contained more than one company in these industries. First Wilshire might also buy a single company servicing a growing niche market that is not addressed by other products or services. Finally, we may buy an out-of-favor company that is misperceived by the market to be slow-growing, but in fact is a growth company in disguise because of a new distribution channel, a new product introduction, a new emerging business, or a new strategic focus.
Deep value/pricing inefficiencies
These sorts of investments are trading at very low valuations, such as price/earnings ratios in low single digits, discount to tangible book, and market values less than cash. These companies often have certain common characteristics: they operate in mature industries and have been overlooked by investors for long periods of time. They are consistently buying their own shares and may make a bid to take the company private. Stocks with P/E’s of three or four can double in price even with a small amount of recognition by the investment community. Similarly, profitable companies selling for less than cash value usually return to normalized valuations rapidly. Another type of trading situation may occur during a period of extremely negative market sentiment or when a large holder must exit a stock quickly, driving down the price to a temporarily low valuation. To take advantage of such opportunities requires a fast and efficient analytical process.
Good value often occurs after the plight of a company, industry or market segment has driven down the stock price. The company may have missed earnings estimates, stumbled in product quality, or lost a key customer. Analysts have dropped coverage of the company. Disappointed investors, focusing on near-term results instead of long-term potential, sold their stock at depressed prices. Our interest would probably begin with such negative sentiment. We look for signs of a turnaround, such as return of revenue growth and positive earnings, completion of a major restructuring, or a new management team. If our research proves fruitful, we would take an initial position, often at a multi-year low price, and add to it as our confidence in the story increases. In these situations, a catalyst that would help investors recognize the value of the issue is a big plus. Such a catalyst might be a management change, debt reorganization, litigation settlement, regulatory change, new business line, or a renewed investor relations effort by the company.
Risks associated with Growth and Value investing strategies
Both value and growth investing involve risk and can result in a complete loss of principal. Compared to investors in growth stocks, investors in value stocks attempt to limit downside risk by buying companies trading at relatively low price-to-earnings or price-to-book multiples. However, there can be no assurance that any investment strategy will be successful. Value investing typically involves buying stocks at low price-to-earnings or low price-to-book ratios with the expectation that the stocks are undervalued and will eventually return to a fair valuation, resulting in an increase in stock price. However, many companies trade at low valuations because of known negative prospects, such as an expectation of declining earnings, significant risks to the company’s solvency, or a negative outlook for the industry in which the company is in. If such negative prospects materialize, stock prices can drop rapidly, resulting in loss of capital. In other cases, stocks trade at low valuations because they are unrecognized by investors. Even if the company continues to perform, there is no assurance that other investors will become interested in the stock. Stock price can remain stagnant for years and can even decrease despite the good performance of the underlying business. Growth stocks as commonly defined by investors are stocks with high growth prospects trading at high price-to-earnings or price-to-book ratios. We are principally value investors and rarely invest in “growth” stocks with high valuations. If a company has anticipated high growth and this growth does not materialize or the company misses analysts’ estimates, disappointed investors can quickly sell off the stock. This can result in a rapidly decreasing stock price and loss of capital.
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