Aug 29, 2022 9 min read

Small, illiquid, uncertain, unknowable, with operating leverage

I’ve come to view almost everything in investing as a factor. Both conceptually and empirically, factor investing makes sense. The less desirable a stock, the greater the expected return should be. The obvious takeaway is to invest in stocks that are as undesirable in as many ways as possible, as long as the undesirability doesn’t reduce their ability to generate and distribute cash.

The standard list of factors is growth/value, size, momentum and liquidity. I have the greatest exposure to value, and I also try to make sure that my portfolio is tilted in the direction of every factor that works (save for momentum which is not my game).

I could stop there, either buying some factor ETFs or building my own factor-based process and doing no further work on individual stocks. For it to be worth my while doing more — managing actively and applying discretion via fundamental research — I must be adding value over and above the mechanical process. The hope is that I can identify other, squishier characteristics that cannot be captured systematically.

Even when I do identify such squishier characteristics though, there’s no guarantee that things will work out how I expect them to. Additional research can only resolve so many uncertainties and I’m still left making probabilistic bets. Assembling a portfolio still just means identifying stocks that, as a group and in expectation, I expect to perform well, but I never know in advance which ones will work out best.

Those squishier concepts are starting to sound a lot like additional factors, and that is indeed how I think about them. A few of the obviously undesirable characteristics which I look out for are:

Situations where career risk abounds
Highly uncertain investments
Unknowable situations, where further research cannot resolve uncertainty but more importantly, does not even allow investors the illusion of certainty
Businesses where hopes have been dashed

A final additional characteristic which doesn’t capture undesirability, but increases the likelihood of large revisions in expectations and thus prices:

High operating leverage

High career risk positions speak for themselves. Managers are certainly not seeking stocks for which they can possibly look like an idiot, or in which they will not get the recognition for making a good investment. See this great piece by Lyall Taylor for a better explanation.

My quick screen here is to ask, ‘would I look like a dumbass if this turned out badly?’ If the answer is yes, there’s a higher chance that something that superficially looks cheap actually is cheap, because professionals won’t want it in their portfolio even if they think it’s a good bet.

Highly uncertain investments are undesirable for many reasons. They can be heart-wrenching to own. The feedback loop of decision and outcome is more loosely coupled so it’s more difficult to get better at investing in them. And even if they do go right, you suffer from the career risk perspective that you might not get the credit even if it turns out well.

As far as I can tell, the investing zeitgeist has shifted towards higher conviction and more highly concentrated active portfolios over time, likely due in part to these reasons as well as constant admonitions from the likes of Buffett and Munger not to over-diversify. This is one of Munger’s takes:

The whole secret of investment is to find places where it’s safe and wise to non-diversify. It’s just that simple. Diversification is for the know-nothing investor; it’s not for the professional.

But I suspect fewer remember Buffett’s counter point:

Charlie and I by nature are pretty risk-averse. But we are very willing to enter into transactions — we, if we knew it was an honest coin, and someone wanted to give us seven-to-five or something of the sort on one flip, how much of Berkshire’s net worth would we put on that flip? Well we would — it would sound like a big number to you. It would not be a huge percentage of the net worth, but it would be a significant number.

For the managers who espouse high conviction investing and have large minimum position sizes, they flat out would not invest in Buffett’s coin flip above. It stands to reason that with a whole class of professional investors who won’t touch these situations, there are probably some cheap coin flips out there.

Contrary to the view that concentrating in your best ideas should yield the best returns, this concept suggests you can add expected return by adding many low conviction and highly uncertain stocks to a portfolio. I’ve moved towards higher diversification over time for this reason.

Unknowable situations are distinct from uncertain in that the odds cannot be reasonably estimated even with further information. A dice roll is uncertain; you know the odds are one in six but not how the dice will fall. Unknowability is when you don’t even know how many sides the dice has and is sometimes (but not always) even less desirable.

Very few outcomes are truly unknowable but there’s an obvious spectrum and the less knowable, the less likely that investors are able to either gain more certainty, or to research their way into the illusion of certainty which will give them the confidence to bid prices up. When you start thinking ‘too hard pile’, there’s a good chance you’re operating towards the unknowable end of the spectrum.

But uncertainty and unknowability are not always undesirable. Nascent technologies, drug pipelines or new markets all hold the potential for untold riches, and investors daydreaming about them can lead to systematic overpricing rather than underpricing.

It’s not until hopes have been dashed that uncertainty and unknowability are on the friend of the investor. When outcomes are uncertain and unknowable, and the present appears hopeless or boring, that’s when underpricing is likely.

Lastly, there’s little point in holding uncertain and low-hope positions if, even when unanticipated positive events occur, the fundamentals don’t actually move enough to change expectations and sentiment. That’s where operating leverage comes in. (I’m really talking about anything that makes earnings more sensitive to changes in the business and not just operating leverage as it is strictly defined. But it is a good enough descriptor for this characteristic in general, and certainly for the stocks listed below.)

With the framework out of the way, let’s go through a few stocks that meet all of the factor criteria, both the standard list of small, cheap and illiquid, as well as my extended list. While the stocks below are all as small as I could find to maximise my factor tailwind, the idea works just as well for larger stocks as well, including ones I’ve written up like Reckon and Platinum.

Cirrus Networks (ASX: CNW, $0.033) is an Australian IT services business. It has traditionally been in the low value end of the spectrum; mainly reselling hardware and software licences. It has an impressive history of sales growth and has been making strong inroads into government clients in Canberra. But the business of moving boxes is a poor one and they’ve never been able to do much better than break even despite their revenue growth. The price chart tells the story pretty well.

What the business has needed is to couple better economics to their impressive ability to win revenue. They’ve been pursuing a sensible strategy of shifting towards higher margin value-added services. I think they’re a decent shot of making it happen, and the stickier and higher margin services revenue has the potential to transform their profitability. The market isn’t interested though, given the long laundry list of undesirables:

Tiny: Yes, market cap of A$30m.
Illiquid: Highly. Average volume below A$20k/day.
Cheap: Yup. It trades on 0.3x sales and about 10x their H2’22 annualised NPAT. (I’m taking H2 here as it’s more representative of the future; it’s post a restructure and includes some newer ongoing contracts.)
Uncertain: They’ve been breaking even for 10 years and several green shoots all withered.
Unknowable: Their success relies on them doing something they’ve never done; selling services which historically have not been in their wheelhouse, largely to government customers which are a relatively new segment for them.
Hopes dashed: They’ve been talking about their strategy for years and it hasn’t happened yet, and investor excitement has been punished for their entire listed experience.
Operating leverage: It’s not proven but likely. Their services revenue is much higher margin and recurring which hints at the ability to grow gross margin faster than their cost base. They have large deals signed and not yet contributing revenue. Their most recent half is much improved, but it’s hard to tell yet whether they’ve cut costs too far.

Given Cirrus scores high on my uncertain and unknowable factors, I can’t say for sure what will happen. But just a handful more managed services contract wins could transform the company. They’ve added three such contracts in the past 18 months and one would imagine that contracts beget contracts, especially in government. I own it.

IDW publishing (IDW: $1.69) is another Howard Jonas outfit which is the fourth largest comic book publisher in the world. Having seen the success of DC and Marvel, IDW is trying to emulate them by turning itself into a mini Disney.

The comic book business is pretty much breakeven for IDW. Its value is as a free content and intellectual property generation machine. The characters and the stories that it churns out can be tested on mass audiences cheaply. The best content floats to the top and IDW signs deals to turn these stories into TV shows.

They had a go at making TV shows a few years ago which drove the share price increase. But those deals ended up losing tens of millions of dollars as IDW held all the cost and revenue risk and things didn’t turn out as planned. The shows all got cancelled and they had to triple shares on issue to stay alive.

New shows are now being signed with a de-risked revenue and cost model. It’s lower upside but much lower risk and still offers the potential to transform the business. IDW ticks all the boxes:

Tiny: Yes, market cap of USD$23m.
Illiquid: Yes. Average volume around USD$30k/day.
Cheap: Depends. Trades on 1x revenue and 2x gross profit but is usually loss making.
Uncertain: Absolutely. They’ve consistently missed targets for deals signed and their most recent hit, Locke & Key, was cancelled by Netflix.
Unknowable: Their TV deals are few and far between and not forecastable. That’s changing though, with 5 new shows recently signed — up from 5 total lifetime to date.
Hopes dashed: The share price shows it all. Investors thought they’d succeeded when their original shows were created, only to find out that the deals were hugely unprofitable.
Operating leverage: Lots. Their new TV deals are structured like licensing deals, with very high margin and zero-risk revenue paid to create TV shows from their IP.

As usual, I have no idea whether this will work. IDW have enough cash to make it a couple of years which will give them time for a few shots on goal. The recent signing of five new TV deals both hugely increases the chance that they could succeed and also reduces the risk of dilution while you wait. If this works out, IDW could be a multi-hundred million dollar business — as it was a couple of years ago.

Connexion Telematics is the smallest and crappiest business of the bunch. It’s a profitable software business with a market cap of just A$10m with $5m of cash, but it’s a one-trick pony, with one large contract with GM for fleet management software contributing almost all their revenue.

Most of that revenue in turn is linked to dealer car inventory levels which, given the global car shortage post Covid, has caused big problems. Connexion are a scrappy little team though and within months they rolled out an entirely new product to manage rental fleets. It halted the decline in their subscription revenue but wasn’t enough to turn it around (see the left-most component of revenue below: Subscription-based SaaS Revenue).

I don’t love the business given the key customer risk and narrow focus, but I do love how management talks about the company, their strategy and capital management (see page 6 of their annual report). They even reference Benjamin Graham in a recent quarterly.

Going through the checklist:

Tiny: Yes, market cap of A$10m.
Illiquid: Yes. Average volume less than A$20k/day.
Cheap: Not on historicals but yes on potential future profitability. Trades on 3x revenue.
Uncertain: Yes. One contract contributes almost all of their revenue.
Unknowable: Yes. They want to sign more OEMs but it’s completely binary and relies on one or two individuals. If they do it, today’s price may turn out to be 3x future earnings.
Hopes dashed: This business was once full of potential, but they had to reign in their ambitions as the cash dried up.
Operating leverage: It’s a software business. One more customer and revenues could double with very little additional cost.

They’re breakeven because they’re spending on growth and have at least five years of runway with the GE contract. There is also a near-guaranteed turnaround baked into their financials because revenue will spring back as inventories in the US are replenished.

The bet is that something exciting happens in those five years, and that illiquidity and ambivalence is replaced with a rush of investors trying to get into the stock.

So that’s the framework. Thinking about these stocks in terms of factor exposure has helped to relieve me of the key hangup from my earlier years in investing — that only deeper analysis and insight could yield better investing outcomes. I no longer think that’s the case, and by straddling the border between fundamental research and factor investing (at least for part of my portfolio), I think I’m giving myself a chance of outperformance by doing something that few others are.