The irrational selling of rising microcaps and small caps

Some years ago, I had a relation of mine tell me he was selling some shares in a Microcap company he bought only six months earlier. I asked him what the reason for him selling was, and he responded that he made a 50% gain and was taking profits because he didn’t want to be greedy. I think this must be one of the silliest concepts out there and can be very detrimental to anyone’s long-term wealth creation, particularly in the high growth asset class of Microcaps and Small Caps. Over the years I’ve come across many irrational concepts from a multitude of sources that have over time crept into investing, including psychology, religion, science, astrology and possibly even voodoo. Concepts such as “What goes up, must come down” or “I don’t want to be greedy, I will leave some upside for the next guy” are founded in irrational behavioural psychology.

When buying shares, many people are disconnected from the fact that they are buying a fractional ownership in a business. Businesses are not static. They are dynamic in nature and constantly evolve, and small companies in particular grow and evolve quickly. Imagine you bought into Domino’s Pizza Enterprises (ASX:DMP) when it was a Microcap in the 2005 IPO, when they had 333 stores in the network and revenue of around $140m and Net Profit of less than $6m (EPS of 9.7c). Assuming you were not scared by the whopping 22.6X PE at listing and believed in the expansion strategy that management was pursuing over the coming years, you would have most likely stayed with them on their journey to where they are now, at around 2,000 stores in Australia, New Zealand, Europe and Japan, with revenue at circa $930m, NPAT $92m and EPS at $1.05 per share. Meanwhile the share price has gone from $2.20 to the $65 range and has been as high as $80+. At every price increment you would have been tempted to sell to “lock in profits”, assuming you were greedy.

When investing in shares, it is important to work out the value of the business. What is the company worth, i.e. what multiple of earnings or future free cash flow am I prepared to pay for this business based on factors including, but not limited to; growth dynamics quality of earnings, risk of execution and track record of the management team. It is important to also note that earnings growth is not linear and there can be volatility and bumps along the road. When the Microequities Deep Value Microcap Fund first invested in Microcap telco BigAir (ASX: BGL) in 2009 we initially paid around 6c a share. We could have easily sold those shares at 9c or at 12c for a 50% or 100% gain. The shares are now in the $1-1.10 range with a takeover bid on them by Superloop Limited (ASX: SLC). Additionally, over the period we would have collected 5.6c per share in franked dividends. Over the years we have bought more shares in the 20c-85c range. Why did we do this? BigAir managed to grow earnings quickly both organically and by acquisition during this period. Visibility into future earnings growth means we could pay a higher price given the same multiple. So, when is the right time to sell? If the business is a great business, ideally never, but that is probably a topic best covered in another post.

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