Rules to trading small-cap non-fundamental stocks and are you too late to the Triplc party(Part 1)

Since I wrote an article on Triplc, its share price had performed well, going up by more than 30% in the past 2 months. So naturally I am getting some new questions, the most common one being “Can I still buy?” “Is it too expensive now to enter?”

For those who read my previous article, you should know by now that I tend to be long-winded (or detailed, depending on your view) and not for those impatient readers. Second, I don’t like to just say this will happen, you should take this action but rather explain why this might happen, why you should consider this action instead of the alternative.

So in this article we shall explore some interesting ideas in trading small-cap non-fundamental stocks and in between, Triplc and other stocks may be used as an example.

What are small-cap non-fundamental stocks (SCNF)?

If you google the term, most likely you can’t find it. This is because I just coined it, like now.

Small cap

Small-cap is relative, for me, it’s anything below RM300m in market cap, RM300-500m may also be considered as one.

Non-fundamental

Again for me, I limit this to stocks to those without strong fundamentals. What are considered strong fundamentals? I would include strong capable management who are known for creating value and rewarding shareholders and business that has strong moats or competitive advantages over competitors. So general characteristics would be increasing revenue/profit/margins/dividend over the years, famous brands, well known by the investing community and count reputable institutional investors as their shareholders.

Are undervalued stocks considered stocks with strong fundamentals? For the purpose of this article, no. For example, BJCorp. Just a quick glance of their net assets, market value of their holdings in other listed companies, you would know that the company is grossly undervalued. However, the name of Vincent Tan alone would scare away most seasoned investors, not to mention its convoluted corporate structure and erratic profits.

For me, I would still prefer companies that has stable business, infrequent loss making records and hopefully some measly dividends. This would at least help to filter out a lot of stocks that are essentially garbage.

So Triplc fits the bill. It is small cap (RM100+m) and its management has just been relying on government contracts and their actual capability is unknown should the contract flow stop. However, it is in a construction business and constantly making profit. Of course, if you have read my previous article, it is also mainly due to what I think, lack of appreciation by the market on its contracts value and lack of understanding on its accounting.

Why these stocks?

Of course these are not the safest stocks to invest in and it shouldn’t be a large chuck of your portfolio, especially as you age. However, these stocks are the most illiquid and could easily run-up and deliver high % to multiple times returns. Compare these to your KLCI stocks. You would be lucky if it gets you 10% return every year. Public Bank was one of the rare exceptions but it’s also in the past now.

There can also be small caps with good fundamentals. But most likely, it will not fly completely under the radar, or it won't fly under for long. Besides, while these stocks could also deliver multiple times return over the years, it happens more gradually like 15-20% a year as the management is not interested in just pushing up the price.

So what are the rules with these stocks?

I know my title call it rules, but it’s more like guidance or a summary of my prior years’ experience. For simplicity, I will summarise as below.

Rule 1: Hope for the best, expect the worst

Rule 2: Analyse like an investor, execute like a trader

Rule 3: You can distrust the market, but you must respect it

Rule 4: Do not go against the big players

Rule 5: Control your greed

Do these rules apply to other type of stocks? In general, yes but not so relevant. For example Rule 1-3, you can afford to give a little bit of leeway for good fundamental stocks. And for big caps, Rule 4 often not so relevant. But if you understand the concepts, you can always pick the relevant ones to apply for the relevant stock.

Rule 1: Hope for the best, expect the worst

This type of stocks lack moats or capable management, meaning track records are often hard to come by. Their past results often could be poor indicators of the future. I am aware of the big debate around the forum on past vs future but I won’t be touching on it.

For these stocks, you may think that it is going to get better, profits are getting stronger and outlook is good. But after a few consecutive good trending up quarters, don’t be surprised if suddenly it decline or make losses again, not due to one-off reasons. This happens more often than not. You may think that it is all set to explode, but then comes the dampener. This is the difference between stocks like Inari and Ifcamsc (Inari was once small-cap and its owner is not the most popular guy). Everyone thought Ifcamsc profit will go ballistic and it did, at least for a few quarters. Then people were busy annualizing EPS, extrapolating growth rates. All is good until profit turns out weaker, and weaker again then boom losses. In that case, what should you do? Please read on Rule 2.

Rule 2: Analyse like an investor, execute like a trader

Before you invest in these stocks, you should have analysed them (in fact, you should do that for every stock you plan to purchase). So now you have an idea about the company and you think that there’s a mismatch between the market price and its underlying value.

Good, don’t buy.

Yes it’s not a typo, don’t buy. Keep it in your watchlist first. One big difference between investors and traders is investors will buy stocks when they think it’s being undervalued, exit when they think it’s overvalued. Trader will only buy when there’s a signal for them to buy, exit when there’s a signal to run. I prefer the hybrid.

Now you know it may be good, wait until there’s a sign. Maybe it’s a surge in profit, realization of undervalued assets (land, investments etc.) or a surge in price and volume (technical signal). Exit when the previous signals reversed or your criterias set are no longer met.

Why do we do this? Because we don’t want to wait indefinitely. So what if it has a huge piece of undervalued land? It has stayed idle there for 20 years, what makes you think that the company is going to do something on it soon? Consider this, if you only enter when it is selling its land, maybe you earn 10% in 6 months. If you entered earlier, maybe you earn 50% in 5 years. If you have unlimited capital, by all means go for the latter but I think most aren’t. Without catalyst, the stock could just lie there like a pool of dead water for years. And this kind of stocks generally pay little to no dividend, so holding long term is really not to your advantage.

Not to mention profit targets and stop loss. Most investors and traders set profit targets but investors often overlook the importance of stop loss. It is ok to give more leeway for drop in price if you are buying strong bigger-cap fundamentally good stocks as it is often just a blip in the long run (you can hold these stocks for long term) and they have strong fund support (not to mention decent dividend).

But if you are buying SCNF stocks, you are more like investor cum trader. So you need to put on your trader hat as well. Set a stop loss point, if exceed, cut. Be ruthless, move on. Why? Because it’s linked to Rule 3.

Rule 3: You can distrust the market, but you must respect it

Investing is fundamentally about buying low selling high. In order to do that, you are essentially betting that the market is not 100% efficient so the price does not equal to value. In other words, you don’t trust the market and you believe you can beat it.

But for SCNF stocks, disclosures are usually scant and track record is limited. So essentially, you think you understand the company very well when in actual fact, you don’t.

There is a saying “Market is always right”. Ask any successful trader, most will trade based on flow/momentum. Investors on the other hand, fundamentally think “Market is often wrong” because that’s where they fit in. For me, when dealing with SCNF stocks you should think that “Market is often right”. That’s why if it exceeds your stop loss point, just cut. Why? Because it’s linked to Rule 4.

Rule 4: Do not go against the big players

Big players control the price of these stocks. When number of shares and liquidity are low, big player’s movement is equal to the price movement. So big players are the market. Let’s accept it, unless you are investing/trading multi-millions, our transaction is unlikely to move the market price. Imagine this, a tug of war between a big strong guy and another soft skinny guy. Which side do you take? When the big strong guy pull, you just happily pull and follow. Just follow until when the big guy had enough, let go off the rope and left, then you better run. If not, then it’s you against the soft skinny guy.

So how do you follow? There are always signs. One common one is a price surge coupled with volume surge. Here, the volume has to be compared against the stock’s usual volume. When this happens, this means the big player are in. Don’t go in immediately. Big players can be fickle and the price could just run for a few weeks/days before they rush out again. So wait for consolidation and the next price volume surge (typically smaller than the first one), then yes, you are good to go. Same thing when price drop drastically with surge in volume, meaning big players are exiting. Here don’t wait, just get out. Remember the rule, so don’t go catch the falling knife when it drops.

But how many of us can follow up till Rule 4? That depends on how good you are with Rule 5.

Rule 5: Control your greed

This is the one rule to rule them all (ignore this pun if you are not a LOTR fans).

Even till today, I still struggle to really master this rule. Greed is good, to a certain extent. Controlled greed is more like hunger, you want more. But uncontrolled greed is like playing with fire. It burns big and bright until one day it burns on you.

When you practice Rule 1-4, especially Rule 4, you need to be aware of your situation. You are not a big shark trying to swallow the others, but you are more like scalpers trying to nick something here and there. So if big sharks want to earn 200%, be realistic, aim for maybe 50%. If they want to earn 50%, you better take 10-20%.

Unless you are one of them, you will never know exactly how and when big sharks move. So to buy at the lowest point and sell at the highest point is simply unrealistic or plain impossible. So be content of buying somewhere at the start of the rally or midpoint and sell at somewhere off the peak.

I will illustrate how a person who fails Rule 5 would argue against and most likely will fail Rule 1-4.

Rule 1: What if the situation is temporary and it could reverse?

Know the stocks you buy. If it’s small cap with good strong fundamentals, you may be right, for SCNF, more likely you are not.

Rule 2: What if I don’t buy and I miss out?

Yes you won’t be there when the price starts to rally. But to think another way round, you are also not there when price just lie stagnant there for a few years or worse, decline. If you master Rule 5, you will be happy to join the ride later, forgoing some of the early gains while avoiding potential pitfalls.

Rule 3: What if the market is wrong? I could have profited.

Here, give the market the benefit of doubt. Take it as right until proven wrong. Again, you could miss some parts of the gain but it is better to control your greed and be content with what you could earn.

Rule 4: This is where big money is earned isn’t it? Especially when betting on a rebound

Yes if you are skillful enough. But then do you know when will there be a second round or more? Or even if there is going to be one? If you don’t know then it’s pure betting isn’t it? Remember the tug of war example? If you are not sure the big guy is coming back to be on your side, why stress yourself by fighting it yourself?

Many liken stock market to casino. I would like to think that to certain extent it is true. Both you need a bit of luck but at least in stock market, with a bit of homework, you can increase your odds slightly. But if in stock market, you go against the big player/banker, you reduced your odds to no different than those in the casino. 

(to be continued)

# As this article is going longer than I first thought, I split it into Part 1&2. However, due to poor response, I am suspending Part 2 for now. Sorry if you are expecting Part 2.