Big Opportunities in Small Companies

 

Big Opportunities in Small Companies

Charles Allmon has been analyzing small, fast-growing companies for over two decades. What he looks for in a young, growing company:
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Balance sheet

The current ratio (current assets matched to current liabilities) should be at least two to one. The company should have no long-term debt. Preferably: No short-term debt, either. The return on shareholders’ equity should run at least 22% and, ideally, 30%.

Ideal

As few shares are outstanding as possible. (This is where the real leverage comes in.) If a company has only 250,000 shares, a fast-growing rate will have a real impact on the equity position. Try to stick with companies that have less than one million shares outstanding, and preferably less than 500,000 shares.

Income statement

Look for a company with very high-profit margins. An after-tax profit margin that is over 10% is excellent. (By the same token, avoid those companies that have after-tax margins that are 1 less.) 1½ % to 2% or

Pay attention to the company’s tax rate

Many investors buy the stock of a company with very high after-tax profit margins only to realize a year or so later that the tax rate was artificially low. Then, when the tax rate returns to normal, the margins shrink dramatically. Thus, if a company pays a full tax rate, give it more points in your rating system than a company with a low tax rate and a higher profit margin.

Management

This is the hardest to evaluate, but the most important. Prime management ingredient: Integrity. The best way to check on honesty is to get hold of the annual reports for the last five to ten years. Read the president’s letter to the stockholders.
How many of his predictions came true? Did he consistently make outlandish statements that never came to pass? Did everything that he forecast happen?

Try to find out what motivates the chief executive now

What might motivate him in five years? All too frequently, a company president suddenly decides to sell out, and the company loses its momentum.
Focus only on companies in which management holds a very large interest (50% to 70% of the stock). That way, you can be sure they will do everything in their power to get the stock up. That’s your goal, too.

Geographical location

Concentrate on companies located in the Sun Belt, preferably in Texas. That part of the country is growing much faster than any other region. It has a pro-business economic and political environment. The Northeast, on the other hand, is losing population, and it is not so positive toward business. Also, after the 1982 elections, the southern and western states will elect half or more of the representatives to Congress, so the political influence of the Sun Belt will grow as well.

Best-situated industries

For the rest of the 1980s, concentrate on energy (North American oil and gas producers), communications (radio, TV, and cable TV), data processing and data communications, and food (convenience stores are booming due to the need to conserve gasoline).

When to sell

Many entrepreneurs don’t have the ability to take their company beyond a certain annual sales level. The first major hurdle is $10 million in sales; the second is $50 million. Be sure to watch the company closely as its sales volume approaches these points. If the company gives signs of languishing there, it’s probably time to sell.
 
Don’t forget that It Really Pays to Ask Questions,

 

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