Why stock investors need to focus on risk

This post has been written by Ian Cassel, microcap investor and founder of MicroCapClub. 

Let me start with an excerpt from Same as Ever.

Harry Houdini used to invite the strongest man in the audience onstage. Then he'd ask the man to punch him in the stomach as hard as he could.

Houdini was an amateur boxer and told crowds he could withstand any man's punch with barely a flinch. The stunt matched what people loved about his famous escapes: The idea that his body could conquer physics.

After a show in 1926 Houdini invited a group of students back-stage to meet him. A guy named Gordon Whitehead walked up and started punching Houdini in the stomach without warning.

Whitehead didn't mean any harm. He thought he was just recreating the same trick he'd just seen Houdini perform. But Houdini wasn't prepared to be punched like he would be on-stage. He wasn't flexing his solar plexus, steadying his stance, and holding his breath like he normally would before the trick. Whitehead caught him off guard. Houdini waved him off, clearly suffering. The next day Houdini woke up doubled over in pain. His appendix ruptured, almost certainly from Whitehead's punches.

And then Harry Houdini died.

He was probably the most talented person in history at surviving big risks. Tie him up in chains and throw him into a river? No problem. Bury him alive in sand? No issue, he could escape in seconds – because he had a plan.

But a jab from a student that he didn’t see coming and wasn’t prepared for?

That was the biggest risk. What you don’t see coming always is.

How does this work in investing?

When you buy a stock, you are betting that the business trajectory will stay the same or get better. No one buys a stock thinking the business will get worse.

What is surprising is how often the business does get worse.

Few investors focus on this risk. They focus on what could go right. They focus on what could accelerate growth. They do not focus on what could go wrong. It’s an obvious risk we like to overlook.

The best question to ask yourself and management- What would cause this business to decline?

Tom Russo said the late Bill Ruane used to always ask management: What are the chances that your business will lose money next year? All the conversations management normally has with Wall Street were about whether they’d make $2.10 or $2.11 per share next year or whatever. At first management would be a little perplexed, then a little disturbed, but at the end, they’d say something like: “Look, for that to happen, the following 3 things would have to happen…” And those are about the only 3 things you should really care about. It tells you a lot about the business.

I like to play golf. The average width of the fairway on a golf course is 40 yards. It isn’t a small landing area.

Why is it so hard to hit the fairway? It’s 40 yards wide right in front of me. If aliens were looking down at the game of golf, they would think players are trying to hit the ball in the rough. Even the average PGA Tour professional only hits the fairway 50% of the time.

Everything in life, business, sports, and investing is easier said than done. Nothing is easy.

The most desirable, "easy" setup for microcap investors is a company with a growing core profitable business that can self-fund some blue sky/green shoot opportunities.

It’s the best of both worlds. You get stability with upside optionality without the risk of dilution. The cherry on top is purchasing a company like this below the intrinsic value of the core business. You get the upside optionality for free. The core business provides an ascending floor of valuation.

Low risk, high reward. Perfection.

This setup should work 100% of the time, right? Not exactly - they work 50% of the time. Why wouldn’t they work out?

The following scenario happens quite often:

1. Microcap companies have limited resources, even if they are profitable.
2. Management starts diverting resources (too much) to the green shoots/science projects.
3. Management stops focusing on the core business.
4. The core business stops growing. The golden goose stops laying eggs.
5. Existing shareholders get startled.
6. A business that looked anti-fragile becomes fragile.
7. The ascending floor of valuation is broken.
8. The stock drops 50%.
9. With a broken core business - management now needs a successful green shoot/science project to work to justify the existing valuation let alone a higher valuation.
10. Management doubles down on the science projects.
11. The balance sheet weakens.
12. Balance sheets don't matter until they are the only thing that matters.
13. Existing shareholders become more startled.
14. The stock drops 30% more.
15. Management raises capital to bridge the gap to commercialization of a green shoot/science project.
16. The stock drops 20% more.
17. An activist shows up.
18. The board and management are replaced.
19. Management cuts out all the science projects to focus on the core business.
20. Rinse repeat.

The obvious risk in stock picking is the business declines. The cause isn’t as obvious. What is the random gut shot Houdini wasn’t ready for?

The business gut shot can come from anywhere - Management loses focus, wrong strategy, competition, losing a large customer, toxic workplace, losing key people, supply chain issues, reimbursement shift, macro black swan event, etc.

The list is endless. Each taken independently, they can be dealt with, but one thing often leads to another which leads to another. It’s like dominos. The compounding of small good things leads to huge results. The compounding of small bad things leads to disastrous results.

It happens slowly and then all at once.

Look for the first domino. Be prepared for a gut shot.

Successful investing isn’t about being right all the time; it’s more about the ability to identify when you are wrong quicker.