Putting Some Risk Back in Your Life

Last week, I introduced to you my simple but effective method for cutting the useless fat from your microcap portfolio.

I showed you the simple filtration steps you can take to get rid of companies that add more risk than potential.

But I also mentioned that by cutting big chunks of risk, you’re also cutting out some serious chunks of upside.

It’s just inevitable when you exclude pre-profit stage companies.

However, there is a way to reverse this effect and emphasize upside potential over stability.

Statistical de-risking makes your microcap stocks safe… but now we’re going in the opposite direction. Appropriately enough, I call this statistical re-risking.

It seems counterintuitive, but to seasoned investors, the frustration of untapped potential is sometimes enough to warrant the most speculative swing possible.

And for those who are properly hedged against loss, big swings on reasonably limited chunks of cash can be the most important of all.

Take Reid Hoffman, for example — a famous, now-legendary venture capitalist.

Already a multi-millionaire, he decided to risk a mere $40,000 on a social networking start-up about 10 years ago.

To most people, $40,000 represents a new car or maybe a kitchen renovation. To Reid, it was more like pocket change — but he still kept his investment measured, which is a lesson in itself.

When Facebook had its IPO in 2012, Reid’s paltry investment was worth just shy of half a billion.

This modest investment ended up being what was probably the biggest hit of his career.

And if you look through the history of venture capitalism, it’s risks like these — the true long shots — that gave rise to the biggest fortunes ever.

From Henry Ford to Steve Jobs, it wasn’t de-risked investments that made the giants — it was true, calculated, swing-for-the-fences gambles.

In many ways, that’s what sets the 0.1 percenters apart from everyone else: their ability to effectively manage and exploit risk.

Before I continue, I want to reiterate — just as I did when I wrote about de-risking — that there is no such thing as a system for finding a winning stock.

The only methodology with any scientific validity whatsoever is based on excluding bad candidates in order to increase the chance of success with the remaining pool.

Sounds pretty simple if you ask me: the systematic exclusion of candidates unlikely to achieve the desired results.

So here’s how I adapted the method…

De-risking your microcap stocks involved filtering based on:

• Cash/share ratio
• Profit margin
• Gross margin
• No dividend

To re-risk your microcap stocks so as to maximize profit potential, you need to flip this equation on its head a little bit…

The Logic

Profit means favorable earnings reports. Favorable earnings reports mean appreciating share prices.

So if you want to buy something at the very start of its life cycle — in other words, with the highest degree of remaining potential — you need to exclude profitability.

It’s painful, but it needs to be done.

Applying your filters, you should specify a maximum zero-profit margin…

Companies in this stage need to be spending, and their balance sheets must reflect that. So no net revenue.

This means companies that are developing new products but that have existing product lines keeping them in the black are out.

You want to stick to the no-dividend rule… and you want to stick to the positive cash rule, because taking risks on insolvent companies — regardless of the state of their research and development — is never a good idea.

The Process

So let’s run the algorithm and see what we get:

First step, keep the market capitalization between $4 million and $50 million. No need to go bigger. Bigger companies no longer qualify as development-stage.

Next step, set maximum dividends at 0.

Next step, set maximum gross margins at 0.

Next step, set maximum profit margins at 0.

Then we look at average volume. You want this company to trade, but not too much. Too much trading indicates that it’s too well known among speculators. Too little means too much risk — even for this bracket of microcap companies.

Set the minimum at 10,000 shares a day to cover the pricier stocks and the maximum at 150,000 to cover those true penny stocks.

Finally, set your cash at positive, with the minimum cash-to-share ratio at 0.2.

The Product

You’ve just whittled a field of more than 5,000 companies — with a total market capitalization of between $4 million and $50 million — down to 35.

35 companies that show all the signs of future prospective but have shaken all those symptoms of decline.

It’s not quite as effective at statistical de-risking in terms of exclusion percentage, but you’re also starting with a smaller field — and still yielding better than a 99% exclusion rate.

Now, does that mean these 35 are going to deliver those orbit-changing gains?

Definitely not. You will need to cut this list down even further, and even once that’s done, there are no surefire bets.

And here’s the bad news: Taking that field of 35 down to three or so will take most of the effort and most of the thinking.

You’ll need to look at what they do and, most importantly, the future of what they do — because companies in this segment cannot be anything but forward thinking.

Properly apply those parameters, and you’ll get a handful of stocks with the absolute highest profit potential — by process of elimination.

Of course, your personal methodology for those final 30 or so companies is what’s really going to matter, and yes, I do have my own.

How is the final step of vetting best done? I’ll let you know what I think in the next few weeks.

Fortune favors the bold,

Alex Koyfman

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His flagship service, Microcap Insider, provides market-beating insights into some of the fastest moving, highest profit-potential companies available for public trading on the U.S. and Canadian exchanges. With more than 5 years of track record to back it up, Microcap Insider is the choice for the growth-minded investor. Alex contributes his thoughts and insights regularly to Energy and Capital. To learn more about Alex, click here.