Right There with You |
What to look for before investing in small caps
by Fabrice Taylor
Since the stock market crash that bottomed out exactly one year ago, defensive and value stocks have both come into favour, but now investors are beginning to think about growth again. That includes small-capitalization stocks, which carry both the biggest upside and the greatest risk of failure.
One of the best things to look for when shopping for small caps is a heavy dose of aligned interest. What that means is you want a management team and/or board of directors that has the same goal as you: to build a profitable business and make themselves (and you) money. You want them lying awake at night thinking hard about the next move. You want to know their wives are checking the stock price occasionally and looking forward to the day they can spend some of their paper riches on a nice vacation or a new car or home. You want, in short, to know that they live and breathe their work and that when they spend a dollar you’ve given them, they’re also spending a lot of their own money.
Sadly, that’s rare, even in small caps. Although they tend to have higher levels of inside ownership than big companies, some small caps have relatively little. I’d say that anything under 15% is worthy of skepticism. Anything over 30% is a good sign.
Another promising sign, which is fairly easy to figure out, is that the people in charge have a history of making money for people (other than themselves). There’s a healthy pool of recyclables in the small-cap arena, people who start something, make themselves a little money with financial engineering and then move on quickly to the next big idea.
With that said, have a look at Calgary-based Diaz Resources Ltd. (TSX:DZR). It’s a small oil and gas producer, with a market capitalization of $10 million. As such, it’s had a rocky time of it lately. But it’s a promising story. First, insiders own more than 40% of the shares, a good sign as discussed above. Second, CEO Bob Lamond has made investors and himself lots of money over the years in the oilpatch. He made millions selling Czar Resources Ltd. in 1995 and Orbit Oil and Gas Ltd. in 1998. With Diaz, he bet on natural gas again in 2002, going against the grain, taking the stock up to $1.20 in mid-2006 before it came crashing down.
In my view, Lamond stands out among the new breed of Calgary oilmen who tend to be either engineers or accountants. He’s a Scottish-born geologist, a student of military history and a big fan of fellow Scot and economic philosopher Adam Smith, whose derelict final resting place he paid to have spruced up a few years ago. He came to Canada more than 40 years ago and has carved out a reputation in the industry since then.
Lamond recently made the decision to move Diaz toward oil. Gas assets will be sold off when prices recover, which the company expects will be this year, and more oil and heavy oil assets acquired, particularly in Canada.
To that end, it has been acquiring land in Alberta and Saskatchewan – 14,000 net acres in 2009 – and cleaned up the balance sheet with asset sales and a private placement, more than a third of which was taken up by Lamond or his publicly traded investment company. The company believes, based on the seismic and drilling production data available to date, that it’s sitting on up to 3.5 million barrels of oil.
So here’s the upshot: you’ll never know more about the inner workings and prospects of a company than the people running it, no matter how smart or experienced you are. You can improve your odds by first getting a handle on the general direction of the company and thinking about whether or not you agree with it.
Then you look at management and insiders: Are they quality people? Do they have a track record of creating value? What are their incentives and how are they attending to them?
In this case, the company is transitioning from gas to heavier oils. Personally, I like that as I think oil prices will rebound strongly. Demand will grow briskly as economies improve and finding the stuff is getting harder. That hasn’t changed.
So benchmark oil prices will rise and the big leverage – the big moves – go to the marginal reserves, the heavier hydro-carbons like those Diaz is getting into.
As for the questions, the answer to the first and second questions is yes. Lamond has been around for a long time. He has good instincts and plays them well. He’s made himself and his investors a lot of money.
And what is he doing? He’s buying more with (in large part) his own money, suggesting that he believes what he’s telling people.
There’s another way of playing Diaz too. Lamond’s investment vehicle, Humboldt Capital Corporation (TSXV:HMB), owns a substantial stake in the firm. But it also owns stakes in other companies and is controlled by Lamond. What’s interesting about Humboldt is that it looks cheap, with a net asset value per share north of $3 and a share price of just over $2. The company earned a lot of money last year and paid a special dividend of 24 cents. The qualities I’ve outlined for Diaz also apply for Humboldt.
There’s no guarantee in small caps, but a few rules, like ensuring your interests and the company leadership’s are aligned, tend to serve investors well.
Fabrice Taylor is the Prairie Trader. He is an award-winning journalist and equity analyst.
Prairie Trader is an independent overview and assessment of investments available to Albertans. Alberta Venture assumes no responsibility for the accuracy of any stock recommendations. You can send letters about this column to feedback.
