How to earn 34% in 3.5 months

12 May 2024

Long-time readers know that I prefer companies with high returns on capital over simply cheap stocks. The benefit of such an investment strategy is that it requires little activity (not much buying and selling). Hence, it does not generate high commissions and tax liabilities on realised capital gains. There is no pressure to constantly look for a new idea as your money stays invested with a great company that reinvests capital for you.

The downside of such a strategy is the moderate returns, which are usually around 15% in the best case, matching the long-term return on capital for successful companies. While this level of return will put you well above most other market participants, it will not make you super rich. You will preserve your capital and increase your purchasing power at a good rate with this strategy, but it will not increase your wealth exponentially. You can still retire rich if you start early and save a lot every month, regularly adding to your pension accounts, tax-free and general investment accounts.

Today, however, I would like to discuss another investment strategy that could potentially lead to faster wealth creation, as long as you have time and are ready to put a lot of effort into one activity.

This famous quote is backed up by Buffett’s early investment track record. Back in the 1950s, when Warren Buffett started his professional investment career, you would need to request a paper copy of the annual report to learn about the company’s last year’s performance. In hindsight, it was easy to get an edge over your competitors.

What is, perhaps, more intriguing is that Buffett insisted on his (and Charlie Munger’s) skill to generate such high returns even today. With the use of computers, availability of various analytical software tools, higher transparency and other factors, including stronger competition, it is natural to struggle to find obvious ‘no-brainer’ opportunities in today’s markets.

However, Buffett still confirmed his belief in 2019 and during the most recent shareholder meeting in 2024.

In 2019, he said the following:

This year, a young gentleman from New Zealand asked Buffett about his method of generating 50% today, and more specifically, whether Buffett would still go through 20,000 pages of Moody’s Manual to find cigar butts or would be a hunt for a great business at a fair price. This was Buffett’s answer:

I agree that the rewards for someone who is willing to dedicate all his time to studying smaller companies could be well above average, even today.

I have not been focusing on this method until recently as I had a full-time job. So naturally, I drifted towards the so-called compounders. I am still happy to keep most of my savings in such relatively safe businesses, but as I have more time and I am not investing billions, I am interested in exploring higher return opportunities.

It is crucial, though, to maximise return on your time by eliminating areas where you should not look for new opportunities. Given how large traditional asset managers have become, I think companies with over $20-30bn market cap in the US (and $3-5bn internationally) are well covered and generally trade 10-20% around their fair value.

It is hard to believe that a US large cap that is covered by 40 sell-side analysts, hundreds of bloggers on Seeking Alpha and other platforms, and dozens, if not hundreds, of professional investors meeting with such a company at least once a year, will be trading at an extreme price relative to its intrinsic value. Of course, there are exceptions, like the case of Meta in 2022. Dislocations generally happen with huge changes in market sentiment and if you are fully invested, your portfolio goes down with the market. So, to take advantage of new cheap stocks you have first to sell down your own ‘cheap’ stock, possibly taking a loss.

I am sure there are many interesting opportunities in the small-cap space in the US, but with limited information and not being able to physically ‘test’ the product or meet with management, these opportunities are not easily accessible to me.

I am excited about the UK small- and mid-cap stocks, however.

I would like to share a case of one company where I earned 34% returns in just three and a half months (well over 100% on an annualised basis). I think it illustrates very well what Buffett meant. I shared this case earlier with my Premium Subscribers as I bought the shares in SEED.

On 25 January 2024, I attended the Proactive Investors conference in London, where a few UK-listed companies made 20-minute presentations to investors. One company in particular caught my attention. It was SEED Innovations, an investment company with several investments in public and private companies, mostly in the healthcare and well-being space.

I do not know this sector well. However, what looked peculiar was that the company’s market cap was just £4.6mn, while its net cash was £7mn. On top of this, it had investments in businesses with a combined fair value of £7.5mn.

I did not have to make a call on the right valuation of investments, their growth prospects and future profit margins (or the discount rate to calculate their NPV). All I had to do was decide whether management could be trusted and whether they would do anything about the situation.

It was encouraging to see a few important shareholders on the register, including the original backer, a UK financer, Jim Mellon. Also, the company’s CEO, Ed McDermott, had a small interest in the company, which he purchased on the open market.

I was also pleased to learn about the company’s ongoing buyback programme.

All this gave me more confidence that the management was trustworthy.

I opened a small position in the company at an average cost of 2.28p. The price I had to pay was above the quoted spread, which often happens in microcaps. Not much was happening for a while. The stock drifted towards 2p and below, taking my position to a paper loss of more than 10%. That was when most markets were making new highs, with the US S&P 500 closing +10% in Q1 2024.

I had a chance to meet the company again at the Master Investor conference in London on 9 March 2024. I was reassured that management shared concerns over valuation and poor stock performance. So, I decided to wait for a little longer.

Then, on the morning of April 16th, I received the news about the company’s decision to pay a special dividend of 1p (c. 50% of the market price of 2p). The special dividend was a way to return cash to shareholders and reduce the discount to NAV.

This is not the end of the story, though. I was busy at 8 a.m. when the market opened, but when I checked the share price 20 minutes or so later, I realised that it was up just 15-20%, not matching the size of the announced dividend. So, I bought more shares at 2.49p. My average cost increased to 2.32p.

The record date was set on 26 April, and the payment date on 13 May 2024. Even more interesting is that after the ex-dividend date, the share price did not drop as much. So, I sold a third of my position at 2.12p, booking a net gain of 34% [(2.12p + 1p)/2.32p -1].

The stock closed at 2.25p this Friday (10 May).

While not exactly a 50% return, it is still quite a good result. 34% in 3.5 months translates into more than 100% on an annualised basis. An additional advantage was that I purchased SEED through my ISA account (which allows you to contribute £20k annually to a tax-free investment account).

Of course, there is no guarantee that this can be consistently replicated. To stay with the spirit of full disclosure, I could also lose money on the remaining position in SEED or my other investments.

The point of this article is not so much about my results but rather about the opportunities that lie below the radar.

With the number of sell-side analysts declining and the focus of professional investors shifting increasingly towards multi-billion companies, hundreds of stocks are being left to be priced by novice retail investors or just some automatic systems. Those brave private investors who have not lost faith in the market prefer to speculate about elections and geopolitics or identify the AI winners.

While it's not a straightforward task, I believe it's possible to identify potential opportunities among the many small-caps listed in the UK (and possibly Europe). This process may be more manual and less glamorous than identifying a great business and analysing its long-term potential, but the potential rewards can be significant (especially if you're managing modest amounts of money). In most cases, returns from bargain small-caps are uncorrelated with the broader market, which is an additional bonus.

Thank you for reading this piece. I hope it was useful. Please consider sharing it with your friends who may also benefit from this.