Why I sold one of my small cap stocks this week

This week I sold out of one of my small cap stocks, a small Australian manufacturer. I bought into them in December 2005, attracted by strong dividends – a yield of 10%, fully franked – that were fairly well covered by earnings, and my assessment the shares were worth perhaps 95 cents instead of the 76 cents I paid. This assessment was made using an EBIT multiple relative to similar companies. In hindsight I think it was flawed and I should have used DCF (see an earlier post for more info.

Growth prospects were reasonably good in their sector and in adjacent markets; the company possessed some new technology that customers were in the process of adopting.

Of course, high yield generally reflects higher risk and this case was no different. Two customers – notorious hard cases for their suppliers – represented 80% of revenue. But the firm was diversifying and actively growing alternate revenue streams from ‘bolt on’ acquisitions.

I saw the yield as my reserve chute; even if the capital gains didn’t materialise in the next 12 months I could be happy to sit on it provided the yield wasn’t put at risk.

However patience finally got the better of me. In late January – 3 or 4 weeks from the next reporting date – the dreaded asterisk next to the stock code…and the “trading update” header on the announcement. Yep, profits going to be down for various reasons, and dividend to be cut. Since that was my primary reason for holding the stock I put the sell order in straight away, but not before it had lost 10%. Luckily, it had put on some capital gain recently and the 10% brought it back, literally, to my entry level. I made a grand capital gain of $0.35, but also kept my dividends which gave me an IRR on the stock of about 13%. It’s not a wipeout by any stretch but the market’s put on over 20% in the same time frame and I did have two opportunities to get out close to 90 cents but greed got the better of me.

I’m reminded of some important pieces of investment wisdom – taking these on board earlier would have resulted in a tidy overall return, ahead of the market.

1. Don’t buy businesses with bad economics – this particular case the company didn’t have any pricing power with their suppliers and were forced to increase their working capital quite a bit (i.e. using up more cash) when one of the major customers simply decided to lengthen payment terms


2. If your primary reasons for holding a stock or position change, then change your position


3. Cross check your valuation – whether it’s with a broker’s report or by using another method, don’t just rely on multiples or DCF

Overall a good reminder and I was lucky to still come off in front.