Why expecting the unexpected helps sustain our Top Ideas

Beyond any stock recommendation the Investorfile blog has made over the last several years, there is still one piece of advice that we do our utmost to get across to investors. That is: To expect the unexpected when owning small cap stocks.

We first wrote about our thesis three years ago from a case study from our own investing experience during the economic downturn of 2008 (See: Expect the unexpected from small cap companies with debt). Our conclusion in that blog post was that small cap companies are very vulnerable to the unexpected. But survival from the unexpected is a better bet from investments in small cap companies that remain largely debt-free.

Continuing with that theme, in another blog post we cited numerous factors an investor should consider when buying a small cap stock. The most important factor was a strong balance sheet; preferably a company that has lots of cash and little or no debt. We concluded that a small cap company with a strong balance sheet can better withstand unexpected changes in its marketplace. This provides investors peace of mind, knowing that a company is in no immediate need of financing, which would be very dilutive to its current shareholders (See: Your small cap stock is down: Is it time to sell?).

Last year in our blog post (See: 5 principals that have guided Investorfile) we advocated that investors should avoid small cap companies with meaningful amounts debt as these stocks are very vulnerable to unforeseeable events. Such events can lead to debt covenant breach (from companies with debt) that can spiral into insolvency and big losses for small cap shareholders. We concluded that investors can’t avoid what they don’t expect, but they can dodge big losses from the unexpected by investing in debt-free small cap companies.

This year we put our thesis to the test with our Top Ideas Titan Logix Corp. (TSXV: TLA) and Questor Technology Inc. (TSXV: QST). Both are companies that serve the Oil & Gas industry. For these two small caps the unexpected has happened: The rapid decline of world oil prices and, hence (at least in the short-term), a decrease in demand for their products and services. But these small cap companies (from years of profitable operations) have very strong balance sheets with lots of cash and no debt to withstand the unforeseen changes in the Oil & Gas marketplace. Yes their stock prices are down from their three-year highs, but their value still remain significantly higher than their trading lows during this same period.

For Titan Logix and Questor Technology there could even be a silver lining to this story. During this downturn both companies have the financial flexibility (cash) to make strategic acquisitions, create new products or hire available marketing, sales and engineering talent, all which could make them bigger, better and stronger operations going forward.

The unforeseen is here for small caps in the Oil & Gas industry and only the financially sound will survive. Better yet over the longer-term the stronger companies (and their shareholders) may even prosper by being in a position today to take advantage of the current market conditions.

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This article is for informational purposes only. This article is based on the author's independent analysis and judgment and does not guarantee the information's accuracy or completeness. The information contained in this article is subject to change without notice, and the author assumes no responsibility to update the information contained in this article. The information contained within this article should not be construed as offering of investment advice. Those seeking direct investment advice, should consult a qualified, registered, investment professional. This is not a direct or implied solicitation to buy or sell securities. Readers are advised to conduct their own due diligence prior to considering buying or selling any stock.