The first big discovery move in a microcap is always the easiest. Why? No one owns it to sell it. There is the least amount of friction. Just a few people with low expectations. The catalyst could be a large contract win or series of small wins, legislation change, competitor leaving the market, or any number of reasons that create a quick 20-100% growth spurt in the business over 2-6 quarters. The first breakout quarter is like a siren going off to the thousands of retail and small institutions looking for such things. The revenue growth flows through the income statement with relative ease producing operating leverage on the bottom line. The crowd gets excited. The stock moves up 100-500% in 12 months. The issue with discovery moves is expectations become too high. Everyone projects out 50% annual revenue growth and 200% net income growth for the next 10 years. Smart retail buys first, small institutions second, and finally dumb retail pay the highest price at the top. The stock trades for perfection. You've reached the height of the discovery move. What most investors don’t realize is the company is over earning. Management is learning as they go and is late in making the necessary investments to support a larger enterprise. Then management realizes they are behind the curve. They need more infrastructure and redundancies. C players must be replaced with B or A players. They must spend $3 million on a new Sales Force CRM implementation. At the same time growth gets harder. Last year’s 50% growth turns into this year’s 30%. 200% earnings growth turns into flat earnings YoY due to the increased investment in labor, technology and infrastructure. Investors are shocked because they’ve never run a business before. Expectations fall. The stock/rollercoaster made an elegant and graceful rise over a few quarters and now it plunges 50%+ in a few days. This is why selling is necessary and perhaps the most important skill in microcap investing. Those that sell the first wave of discovery are correct for doing so. The base rates are low for management teams proving they are more than a one hit wonder. The valuation compresses. 50x forward earnings turns into 15x trailing earnings. Growth investors leave, and value investors start circling the company again. microcapclub.com/small-stocks-a…
