Account for Share Structure in Your Microcap Investment Strategizing
Which would you rather own: one share of Apple Inc. (NASDAQ: APPL) or one share of Lindt & Sprungli AG (SW: LISN; OTC: LDSVF)? Now, off the top of your head, you’re probably thinking Apple, given that in August it became the world’s most valuable publicly traded company. As for Lindt & Whatever, heck, you’ve probably never even heard of it.
Well, the US$112 value of that Apple share you chose might take you and a date out for dinner at Appleby’s and a movie. The value of that one share of Lindt & Sprungli AG, on the other hand, would let you take your date to a Michelin-rated restaurant and Broadway production in your brand new BMW X4 M. That’s right, one share of LISN is worth about US$85,000, making it the second most expensive stock in the world after Berkshire Hathaway Inc. (NYSE: BRK-A), which was trading at a recent $US 327,115 per share.
LISN, it should be noted, makes fine chocolate, but it’s not the high quality of the candy that makes the share price so dear, but the fact that there are only 1.03 million shares outstanding. APPL, on the other hand, sports 17.1 billion shares outstanding. The difference between the two is so massive that LISN’s share count number could almost be used as a rounding error if applied to the APPL count.
The number of shares outstanding is just one component of share structure that you should pay close attention to when assessing the value of equities. And understanding and evaluating share structure is especially important when assessing microcap companies.
Considering Shares Outstanding with Microcaps
Share structure begins with shares outstanding, which is simply defined as the number of authorized and issued company shares held by investors. The outstanding shares are used to calculate market capitalization (share price times shares outstanding) and are used to calculate the earnings per share metric. With regard to the latter metric, understand that the measurement basically represents the number of slices that have been made out of the whole pie—you could get a similar pie-piece measurement by dividing earnings by market capitalization. While greater numbers of outstanding shares make it more difficult for a company to boost its profitability on a per share basis, the profits themselves are the ultimate key.
Note also that shares outstanding are often a moving target as young companies typically raise capital and fund growth by issuing and authorizing new shares. Generally speaking, the less such dilution, the better, but it needs to be considered in the context of the young company’s need to raise cash. While a relative lack of historic and ongoing periodic dilution can be taken as a positive, not all dilution is distinctly negative. For example, many growth-oriented microcap companies, such as mining exploration firms, need to continuously raise money to fund their exploration efforts. In the early going, such companies are not focused so much on generating cash flow as they are on proving the value of their yet-to-be-discovered assets.
Along with shares outstanding, you need to understand the concept of available float, which refers to the total number of shares that are readily available for trading. While a company may have 30 million shares outstanding, 10 million of those may be locked up by management or institutional investors and unavailable for sale on the open market. Available float can affect trading liquidity, which can be a boon or a bust depending on the circumstances. Understanding available float can help you determine whether trading activity is normal and liquidity is an essential factor in assessing a company’s risk/reward potential.
In most cases, microcap companies with low available floats and large portions of their shares locked up by insiders and institutions are considered positive. In fact, the available float in many microcaps is artificially kept low during the first 6 to 12 months of trading due to lock-ups on early-stage financing and insider ownership positions. This can serve as a share price booster in the early stages of a microcap company’s rise, but can also stall the price when locked-up shares are released into the available float. Of course, if you have faith in the company’s future, this could represent another buying opportunity.
Pay Attention to Potential Dilution Factors
On a related matter, fully diluted shares outstanding is another share structure metric worth understanding, as many small-cap and micro-cap companies fund growth by issuing options and warrants, which represent future dilution. While a company might have a low number of shares outstanding, if it has issued a large number of options and warrants, its future shares outstanding could climb dramatically in the years to come. Not only will this materially impact the market cap and the forecast of future earnings per share growth, but the exercise prices of warrants and options can serve as a brake on the share price.
As with other share structure metrics related to dilution, fully diluted shares outstanding are a double-edged sword. If you believe in the company’s promise, any brakes on the share price can be seen as an invitation to buy more shares. Additionally, the presence of locked-up shares can be viewed positively, as the company and its backers have locked them up to incentivize and benefit early shareholders. Keeping the shares out of the available float gives company management time to execute its business strategy with the goal of proving results and moving the share price higher before the locked-up shares are released. Of course, if the company has struggled with plan execution and suffered resultant share price depreciation, the only people happy with new shares entering the available float are short sellers.
Are Owners and Managers Investing in Their Own Company?
The last, though certainly not least, important factor to assess in relation to share structure is insider ownership. Company insiders are often compensated in part through regular distributions of shares, options, and/or warrants, and may also receive them as bonuses for successfully meeting specific company goals. Likewise, inside ownership moves driven by the exercise or conversion of options and warrants are noteworthy but may not be particularly positive or negative unless they result in significant additions or disposals of shares.
What should really capture your attention about insider ownership is when you see company owners and managers purchasing shares in their company hand over fist on the open market. This shows that they believe in their company’s future success and may know something positive about it that isn’t yet public knowledge. Naturally, should company insiders start dumping shares en masse on the open market, it’s time to get nervous and reappraise your own holdings in the company. In general, a lack of insider ownership in a microcap company should make you wary.
How to Use Your New Understanding of Share Structure
OK, now that you understand share structure basics, you probably want to know how to use it to find a 10-bagger-or-greater microcap stock. After all, it is time to upgrade your 2016 Bimmer, right?
We suggest you consider the share price both as a backward-looking litmus test and as a forward-looking assessment of volatility. Share structure analysis provides the most benefits from the former and represents a relatively quick and easy means of gauging company strengths and weaknesses that can otherwise be assessed by more comprehensive analysis. If a microcap company’s share structure is tight and shows no red flags, it provides reasonable support (a Bayesian indication) that company management is aligned with shareholder interests. In short, a tight share structure is highly indicative that the company and/or management:
- Are operating with some measure of fiscal conservancy.
- Are avoiding excessive and/or unnecessary dilution.
- Have not conducted any unnecessary financing.
- Remain incentivized to perform based on their own sizeable equity position.
Looking forward, a tight share structure now provides a greater likelihood that the company will continue to avoid dilution and unnecessary financing in the execution of its business strategy, compared with a company already lacking in such. More importantly, though, share structure can help you gauge the potential volatility of the company’s share price. Keen investors know that volatility can be their best friend, especially when combined with due diligence research and close attention to risk management. The lower the float, the higher the potential volatility; and the more volatility to the upside, the higher the likely share price rise. The fewer shares for sale (or available on loan for shorting), the more the price gets bid up when a large buyer starts accumulating a position. And such volatile-related moves to the upside are further compounded and self-sustaining as other investors buy into the volatility incentive and existing investors hold on to the scarce shares of what is turning out to be a solid company. Such volatility rides from the undervalued to overvalued status tend to be especially swift—an unexpected type of speed, kind of like what it feels like the first time you try to go pedal down with a BMW M5. OK, maybe not that swift, but metaphorically, few rides on the stock market are like it.
We’ll close by noting that share structure isn’t the only thing you should assess when deciding whether to invest in a microcap company, but shares outstanding, available float, dilution factors, and insider ownership are all valuable clues in determining the relative strength, future growth prospects, and potential volatility quotient of a young company. Thus, make sure you pay close attention to share structure dynamics with your microcap investments. And, you never know, but by doing so, you might end up one day owning a share in a company that could become worth as much as a brand-new BMW!