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In Part I, I detailed my entry into the value investing discipline with a focus on dividends, free cash flow generators, and CROIC.

Here is the next (although likely not the final) chapter in my investment philosophy.

Special Situations or Workouts

Influenced again by Fwallstreet, along with Joel Greenblatt’s book You Can Be A Stock Market Genius (one of the best investing books out there), I began looking for workouts and special situation investments.

These are event-driven events, such as merger arbitrage, going private transactions, self-tender offers, spin-offs, and liquidations that are often overlooked by the broader market because of their unique characteristics.

They are a nice supplement to a traditional value investing portfolio, and can provide nice returns, especially on an annualized basis.

I completed my first successful merger transaction, picked up free money as an odd-lot investor in several tender offers, and saw through a microcap going private transaction.

I continue to keep an eye out for new transactions in this space, but have gradually put less emphasis on these plays.

In many cases, upside is limited due to the nature of the event (such as a fixed price for a tender offer), and the downside can be extremely painful.

Also, when the stock market is on a big upswing, I’d rather put workouts on the back burner and try to find undervalued stocks with much higher upside on an absolute basis.

NNWC – Getting the Business for Free

In addition to DCF, EPV, and other valuation methodologies, one of the simplest involves finding businesses that are trading at a discount to their Net Current Asset Value (NCAV).

This is an investing philosophy that goes directly back to Benjamin Graham’s teachings.

According to Graham, picking up businesses that are selling at a significant discount to their net current assets (once all liabilities have been subtracted out), will provide a basis for solid returns.

Even better, some stocks even trade for less than their Net-Net Working Capital (NNWC), an even more conservative estimate of liquidation value.

In the depths of the recession, many solid if unspectacular businesses were trading for less than the net cash on their balance sheet – basically, you were able to buy the cash at a discount and get an entire business for free!

My most successful investment on ValueUncovered, CHBU, was a microcap that was trading at a large discount to net cash.

This is one of my favorite investing methods, but suffers from a lack of qualifying companies during a booming market.

Venturing into the OTCBB and PinkSheets

My new favorite!

As the market continues to heat up, fewer and fewer businesses in the broader market have a large enough margin of safety to satisfy my requirements. I’ve started delving into the world of nanocap stocks trading off the major exchanges, the tiny of the tiny.

One of the core tenants of value investing is finding situations that are being missed by the rest of the market.

Logically, the tiniest stocks – the ones that are too small for Wall Street and the major fund managers – are often the ones trading at the largest mispricings.

While there are many scams, other stocks in this category are hard-working family-owned businesses that have been around for generations. Many of them moved off the major exchanges due to the high costs of compliance, and yet continue to published audited financial statements and communicate with shareholders.

Along with this transition, I’ve also found that I’ve greatly simplified my valuation methodology.

Rather than get caught up in analyzing growth projections or worrying about discount rates, I look for businesses trading at a low multiple of free cash flow or operating income. A solid (and simple!) balance sheet certainly helps to provide downside protection.

More importantly, I search for catalysts – an event, announcement, or influence that catapults these small unknown stocks towards reaching their true intrinsic value.

The importance of catalysts cannot be understated in the microcap world. Otherwise, many can languish for years, still trading at a discount but slowly eroding any margin of safety.

In my view, the thrill of finding a situation that is being missed by the rest of the world is unparalleled!

Conclusion

The good news is that many of these investing principles are not mutually exclusive.

  • I still calculate CROIC for the microcap .PK stock I’m doing due diligence on
  • I still stumble on liquidations and small workouts with substantial margins of safety on the OTCBB
  • I still keep an eye out for chances to invest in profitable net-net’s
  • I still find stocks that are one catalyst away from multi-bagger territory

Traditionally, I used stock screeners to find stocks that matched my criteria.

However, I haven’t found an accurate screener for stocks trading on the Pink Sheets (if you do, please let me know!).

So investing in this space requires more legwork and discipline, but I believe it has the potential for the most rewards – there is a reason that Buffett guaranteed he could make 50% per year with a small portfolio.

With that in mind

I’m going through every Pink Sheets stock one-by-one.

I’m through several thousand so far with a few hundred left to go.

Gotta be some value in there right? :)

Disclosure

No positions.

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13 Responses so far

  1. Jae Jun says:

    just make sure that you share those values with us!

    • asues says:

      Jae,

      I’m finding it increasingly difficult to write about some of these more obscure names, as many have such sharp swings in stock price & are extremely illiquid.

      It’s also making me rethink my model portfolio, as it probably isn’t the most effective method to track buys and sells in this space.

      I’ll certainly share what I can though!

  2. Paul says:

    I started going through AMEX companies, you know, the old “start with the A’s” Buffett’s famous for.

    I highlighted the companies with high balance sheet cash and cash equivalents with little to no debt, or companies experiencing high growth in revenue.

    How did you pare down your list of .PK companies?

    • asues says:

      Paul,

      I think Buffett’s ‘Start with the A’s’ method is a great one for finding the truly undiscovered bargains. Plus I’ve learned so much more than if I ever had by going through screeners.

      As you might imagine, the Pink Sheets have quite a few more development stage companies, high shares O/S, shell companies, scams, etc. that you don’t tend to find on the broader exchanges. The good news is that you can quickly cycle through these companies and move on.

      I’m planning a followup post that details my methodology, as well as breaking down the stats I’ve found so far, so keep an eye out for the details.

  3. Dean says:

    Have you ever looked into the Canadian Venture exchange?

    • asues says:

      Dean,

      I haven’t. My current broker (Zecco) does not allow the purchase of international stocks and it has been tough for me to break away from the commission-free trades.

      I’ve read some of Geoff Gannon’s posts about investing internationally, and believe it is could definitely provide some amazing opportunities, but until I establish at another broker, my investing universe is limited to the U.S.

  4. tim says:

    Hey Adam,

    I was wondering what your tolerance is for related party transactions. I haven’t looked at too many OTC/Pink Sheet stocks so far but of the ones I have, this is a recurring theme. For instance, check out Greystone Logistics (GLGI). I can stomach one or two of these types of transactions, especially if they aren’t too egregious, but the sheer number of related party transactions in Greystone was too much for me. Just wanted to see what your take was/how much weight you put on these.

    thanks

    • asues says:

      Tim,

      Took a quick look at the SEC filings for GLGI. Not really my kind of company (large negative equity position), although it looks like most of the financing is actually provided by the directors. The technology license agreement looks complicated to me, and would probably take some time to unravel what is really going on. For me, it would probably go into the “too hard” pile.

      Some related party transactions are particularly bad, but I’m willing to overlook many others as long as they are well-spelled out. For example, I’ve seen many companies who rent out their office location from an entity owned by one of the directors. As long as the rent is reasonable and within market boundaries, I’m usually okay with it.

      Short answer: Definitely depends on the circumstances, but clear disclosure is a key requirement for me.

      • tim says:

        Thanks Adam,
        I agree that there is a lot going on, particularly with the PIPER 6000. Add that to the related party trans and it was a pass for me as well.

  5. michael says:

    hello i have ben tradeing for about 4 month now and have most of my money in (RCMH)entell I can put some more in. could you tell me what you think about. reach messiging holdings inc.

    • asues says:

      Michael,

      RCMH is definitely not my kind of company (negative equity, losing money, hundreds of millions of shares outstanding, selling for less than $0.01…) Drop me a line via the contact form and I’m happy to learn and discuss your investment thesis around the company.

  6. Luis says:

    When you start with the A’s in the Pink Sheets and/or Over the Counter – how are you doing it?

    Are you using a book like the old Moody’s Manual? Getting the SEC data is easy once you have a ticker, but where are you looking for the names?

    • asues says:

      Otcmarkets.com publishes a list of all the stocks trading on the pink sheets and over the counter market. You should be able to download a spreadsheet file with all of the ticker symbols, including info about their latest closing price, volume, etc. Then just start at the beginning!

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