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Dr. Richard Geist's First Column

By Dr. Richard Geist Ph.D. (click here to read Dr. Geist's Bio)

There are four primary factors that contribute to success in the micro-cap market:

• Financial understanding--knowing how to evaluate a company's performance and its management
• Experience--a good intuitive feel for products and services that will impact society
• Luck--unpredictable good fortune blessing a few of your holdings
• Psychology--understanding enough about yourself to avoid emotional mistakes.

The Successful Investor: The Right Thinking Style

Successful micro-cap investors appear to have personality characteristics that are in harmony with the nature of small company development. For example, most small companies worthy of consideration tend to have a visionary product or service that has the potential to change forever the way large groups of people carry on their lives. At the same time, however, they often provide very little long term financial information that allows for an accurate assessment of intrinsic value. As we have seen with many young Internet stocks, analytic skills alone are not enough to determine the merits of the investment. In order to understand and embrace such forward-looking ideas, one must have a particular cognitive capacity--the ability to engage the right side of the brain. We know that the left and right sides of the brain function somewhat differently. The left side of the brain helps us with analytical, rational, intellectual, deductive, and disciplined reasoning. The right side of the brain seems to direct more imaginative, intuitive, symbolic, emotional and contemplative thinking. Most investors in, and founders of, small visionary companies have the capacity to utilize right brain thinking. Thus, management frequently appears to act irrationally and uncommunicatively, making snap judgments that they do not explain clearly. These are examples of right brain signals that are directly translated into decisions without being verbalized along the way. This is one reason that traditionally trained financial analysts--who depend much more on their rational, intellectual left brain for analysis--do not attempt to analyze small companies. To be a successful micro-cap investor requires that one be able to think intuitively and inductively. Without these cognitive capacities, one is better off sticking to well-analyzed large caps.

Successful Investors:  Feeling Like an Outsider

Successful micro-cap investors report a long history of experiencing themselves as not quite belonging to or fitting in with their world. They remember themselves as being different from others in their peer group. These investors were not loners--they had friends, often intimate friends--but they carried with them a vague sense of not being adapted to their world. Rather than stepping outside of society, however, these successful investors remained within the system and developed the capacity to belong while concurrently valuing and believing in their own idiosyncratic ideas. Thoreau's notion of walking to a different drummer is applicable here; but with the addition of coming to terms with having taken the road less traveled so that remaining an outsider became part of a valued identity used in the service of picking stocks that are off the beaten track. This characteristic is in direct contrast to those who invest in large cap stocks; the latter tend to be much more comfortable investing in companies where there is plenty of companionship from individual investors, institutions, and analysts who painstakingly examine the financial histories of the companies.

The Successful Investor:  Tolerance for Loss and Separation

Because there is a much higher failure rate among micro-cap companies, successful micro cap investors have developed the capacity to tolerate loss. They have come to terms with the fact that many of their stock picks will crash, but they also know and are comfortable with the idea that all it takes is a few really large winners to come out significantly ahead of their peers. Belief in this principle helps these investors tolerate mistakes without undue self-criticism or threats to their self-confidence. While most unsuccessful investors become pre-occupied with their mistakes, blaming brokers, analysts, company management or themselves, successful investors expect to make mistakes as part of the investing process. They reverse themselves quickly, attempt to understand where they went wrong, and tend not to repeat the same mistake again. Most of these investors seem to enjoy the process of investing more than they enjoy making money.

The Successful Investor: Decentered Awareness

Within the micro-cap market there is usually a wide disparity between the quasi-logical world of the market and the more emotionally laden fantasy world of the investor. While not eliminating emotion from their investment decisions, successful investors appear to have the capacity to decenter from themselves. Decentering is a learned process whereby, in the middle of emotional turmoil, we step back and begin to incorporate disparate opinions by asking how other viewpoints and theories could alter our perceptions, what could be right or reasonable about others' views or convictions about a stock or management. In other words, the investor participates in a silent dialogue with the market in which new, more complete meanings begin to emerge. For example, market events and company events frequently evoke isolated emotional states. The Dow drops 250 points and we feel pessimistic and angry, as if the long awaited bear market is beginning, even though there are numerous market indicators which would allow one to feel positive and optimistic at the same time. A favorite company reports unusually good earnings for the quarter and we feel ecstatic about its future prospects and want to buy more stock, despite the fact there are several financial ratios indicating trouble ahead. In each case we experience isolated emotional states that give us very different clues than if we were looking at a whole picture. Without the capacity for decentering from these emotional states, one is more likely to pay attention to just one of those feelings and act on it with blatant disregard for the other emotions being experienced. This is a common reason for investors getting whipsawed by the market.

The Successful Investor: Comfortable self-reflection

There is much evidence in both the academic and clinical psychology literature that as the ambiguity of an external stimulus increases, we are more likely to interpret and organize its meaning according to the themes that structure our own subjective world. This phenomenon is familiar to every child who lies on the grass and perceives specific objects in the vague cloud formations above. Almost by definition micro-cap investment decisions are made with a dearth of information that is at best ambiguous. Especially in the micro-cap market, where there is no reliable history of earnings and revenues, forecasts are often nothing more than projections of the investor's own subjective reactions to a company's services or products. If the micro-cap external data is highly ambiguous, it increases the likelihood that much of our "understanding" of our investments is shaped by the idiosyncratic lenses we use to make meaning out of the external data. The successful micro-cap investor has some awareness of his or her lenses or organizing patterns. For example, one of the common organizing patterns that some investors experience is: "something I own is more valuable than something I don't own." The investor who filters life through this organizing pattern will often have trouble selling a stock until it has retreated far below his or her original mental stop price. This is because the feeling of ownership makes the company seem more valuable than it actually is to an objective observer. It is the capacity to comfortably reflect on one's organizing patterns as they emerge from repetitive investment decisions that contributes to being a successful micro-cap investor.

The Successful Investor: De-coupling Risk from Loss

Most successful micro-cap investors appear to discern risk differently than the average investor. Rather than viewing risk as either chance or consequence of loss, they seem to experience it as de-coupled from loss. They are closer to John Maynard Keynes' 1921 statement that "most of our decisions to do something positive can only be taken as a result of animal spirits...and not as the outcome of a weighted average of quantitative benefits multiplied by qualitative probabilities." Successful micro-cap investors do not eschew risk, but they certainly seem to emphasize the possibility of reward over risk. What substitutes for risk is the intellectual challenge of studying products, services, and management. This intellectual challenge allows for failure while turning decision making into an art that is enjoyed for its own sake--an art that is accompanied by a strong belief in their own capacities. This is why many successful micro-cap investors avoid diversification as a method for minimizing risk. These investors seem to know that, as Peter Bernstein once said, "diversification doesn't prevent loss; it just prevents loss all at once." Successful micro-cap investors have enough confidence in their own research and decision making that they can concentrate their investments to take advantage of their own investment judgment.

A Real Life Example

On my recommendation an investor bought Mitek Surgical, a small cap designer and marketer of surgical anchors for attaching soft tissue to bone, at $20 per share. The stock increased to $24 dollars and then seemed to consolidate. Several months later the Company announced a change in their distribution system from the use of an outside sales force to the development of an in-house sales group. A significant charge against earnings was taken to retrain the sales force, and MYTK management predicted lower earnings in the coming quarter. The stock was immediately battered back to $13 when my fellow investor called to discuss the situation. Anne was focusing only on the one isolated element of the next quarterly earnings report and ignoring the more complete picture of a fundamentally sound company. More importantly, however, Anne was aware of one of the organizing principles in her life: when something good happens, something bad is sure to follow. Viewing Mitek through this lens, the stock had already gone to $24 (something good), so she was automatically inclined to take her loss and move on when the stock dropped (something bad). Once she became aware of the fact that the external data were filtered through very subjective lenses, which reshaped the meaning of the ostensibly objective information, she resumed her intuitive, positive sense of the company and could decenter from the recent announcement. Anne decided to keep the stock. I didn't hear from her again until 6 months later when Johnson and Johnson bought Mitek for about $30 per share.

Do I have what it takes? To decide whether the micro-cap market is the right place for you to invest, try asking yourself the following questions:
1) Am I capable of intuitive, inductive, imaginative thinking?
2) Do I feel comfortable and have the courage to follow my own convictions?
3) Can I tolerate making mistakes and be willing to analyze them?
4) Am I able to step back from emotional turmoil and separate facts from emotion?
5) Do I understand the idiosyncratic lenses through which I'm likely to view the world?
6) Am I able to view risk as an intellectual challenge to solve rather than fear it as chance of loss?

If you are able to answer positively to these questions, you are emotionally ready to take on the task and challenge of micro-cap investing.

©1999 Richard Geist

To Reach Richard Geist Directly with any questions or comments:
Financial Strategies and Investing
1905 Beacon Street.
Waban, MA 02468
email address: cc003855@mindspring.com
Phone: 617-332-3323

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