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Oct
30
Do not throw the baby out with the bathwater (you may miss out on a big winner)
Posted by: Gerry Wimmer
10/30/2022
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Key fundamentals that should give investors comfort to own a small cap tech stock for the long term.

This year has been the worst in a decade for small and micro cap investors in non-resource industry stocks. To date technology stocks were the hardest hit in the broad market sell-off in 2022. While some tech high-flyers deserved their fate this year with a deep cut in their market valuation there are some small tech companies that did not and still don’t based on their current fundamentals and long-term prospects.

The purpose of this Investorfile blog post is not to select which small cap tech stock is a sell, hold or buy in the current market environment but, rather, provide our viewpoint on some key fundamentals to consider for the stability of a growth company operating in an uncertain economic climate. This information can be used by small cap investors to better formulate investment decisions going forward.

Investorfile’s three key fundamentals for long-term ownership in growth stocks:

Balance sheet strength. At all times the maintenance of a strong balance sheet is a must for a small company so it can best weather economic uncertainty and equity market volatility. While cash-rich and debt-free status is advantageous, it is perfectly acceptable for a small company to have some debt. But, with debt, a company must have predictable revenue and earnings to support that debt service. With that said, the debt leverage should amount to less than three times the next 12 months (NTM) of adjusted EBITDA that is expected. It is important that a company with debt be able generate free cash flow too.

Durability of earnings. An economic slowdown can impact growth stocks; to what extent is largely dependent on the individual company’s business model. Businesses that already generate strong gross margins (40%+) and operate with EBITDA margins greater than 10% are more likely to remain profitable even when revenue growth slows. The durability of earnings of a company during a period of economic uncertainty is a key fundamental to consider for long-term stock ownership.

Predictability of revenues. What makes revenue more predictable are two main components. If the nature of the business relationship with a Company’s customer is ongoing (a continuous service), revenue will be "recurring” and most likely tied to longer-term contracts (and therefore more predictable). Also, if a company provides a type of service that is essential for its customer, it is more likely to continue during periods of cost rationalization. The second component to revenue predictability is based on the customer mix. A company with a highly distributed customer base operating in many sectors reduces concentration risk, which is the financial impact of losing any one customer.

No doubt 2022 has been a difficult one for investors in small tech companies, as share prices have retreated significantly and no stock has been spared. But, our point is that there are small tech stocks that are fundamentally strong despite their stock price decline. It is these companies that will lead the charge in a market recovery.

As the saying goes, don’t throw the baby out with the bathwater. Despite its current share price woes, that tech stock baby could end up being a big winner for years to come.


Read Disclaimer:

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.
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Hi Gerry, Your philosophy is focused on principles that have been shown to produce above average results over time and your record has clearly proven that. Congratulations on a great blog and thank you for the hard work that you do in sharing and updating your ideas; it is much appreciated.