The Perils and Pitfalls of Microcap Investing
Lessons from a mistake
There is nothing like discovering a small stock no one else has heard of, investing and then watching it double, triple or more.
I will never forget a microcap stock I bought in 1998 when I first started managing money called SonoSite. It was spun-off from a large ultrasound company (ATL Ultrasound) and started trading during the Long-Term Capital Management crisis in 1998. Hidden in the SEC filings, it was revealed that no other entity could buy SonoSite without paying ATL Ultrasound $250 million for a period of five years. To me this made no sense unless SonoSite was sitting on very valuable technology.
SonoSite at one point was trading at a market cap of $50 million or the amount of cash it had in the bank, valuing their technology at nothing. In the next few years, SonoSite, which was developing a portable ultrasound device, went up five times in price. This is why microcap investing is so alluring.
But I don’t want to focus on past successes right now, because that isn’t really how you learn and become better at investing. You learn from your mistakes. And for that I want to talk about what can go wrong when you invest in microcap stocks. So, I want to talk about Scheid Vineyards (OTC: SVIN).
In January 2018, I shared a report on Scheid Vineyards, which is a Monterrey, CA winery that owns a large amount of land and a large winery facility. When I added up the value of the assets, the company had over $200 per share in Net Asset Value but was trading at $67 per share.
Here is my original report: 2018 Scheid Vineyards Report.
The stock subsequently rose as high as $100 per share, but now is languishing at $18 per share. Ouch.
What went wrong? Plenty.
First and foremost, asset plays can be dangerous. How do you unlock the value? What happens if the company loses money and that destroys value? What if the value is trapped? More than a few value investors besides me have invested in “value traps.” The assets matter only if they can be monetized or the business can earn attractive returns from those assets.
Second, Scheid Vineyards is a family run company, which means that their incentives may or may not align with those of the shareholders. Based upon conversations with company management, their approach is to build a wine company with the family in charge. There are dual classes of stock and the family retains voting control that keeps them in charge. This is all fine and dandy when things are going well, but when they are not, it hurts.
And unfortunately for shareholders, management expanded their wine business right into a dramatic glut of wine at the same time there was a sudden drop in demand. This drop was probably related to the sudden surge in legal cannabis. This led to some large operating losses and inventory write-downs in 2019 and 2020. Book value has declined almost $20 million since I wrote the report due to these losses.
Finally, Scheid doesn’t even trade on the NASDAQ, but over the counter, on the pink sheets, and its liquidity is awful. So, when things go south, the stock can trade lower, very, very quickly.
So, where does that leave Scheid? They still hold valuable land assets and the company despite losing money is probably worth more than $100 per share. But now I’m worried that the value may never be realized, as it all depends on the vagaries of the wine business and the family in control.
What did I learn from this mistake?
1. Asset investments are tough, especially if the underlying business has a boom/bust feature like the wine business.
2. Pay attention to the history of the underlying business. Is this actually a good business long term? In the case of wine, there are so many people that want to be in the wine business for the glamor and prestige, it can ruin the economics.
3. There has to be catalysts for realizing value and an aligned management team, otherwise the stock can languish for much longer than you desire.
4. Family businesses are tough and should require substantial discounts to valuation.
5. Be careful of the liquidity of over the counter traded stocks, no matter how attractive.
So does this mean I’ve sworn off investing in microcaps? Absolutely not.
Thanks to our current big cap obsessed markets, I think there is more opportunity in microcaps than there has been in a long time. And that will be fodder for a future column…
P.S. Remember I wrote my opinions on the opportunity in small cap value here: Opportunity in Small Cap Value and I wrote up one interesting microcap opportunity, Lincoln Educational Systems (NASDAQ: LINC): Lincoln Educational Systems Report.