This week in Strategy Lab, I’d like to talk about small-cap stocks. There is a lot of money to be made here. But it comes with significantly more work and potentially more risk.
Why more money to be made? Because many small-capitalization stocks are not on the radar of Wall Street analysts. With the technology sector in Canada, many of these stocks are not even on the radar screens of Bay Street analysts. If analysts are not paying close attention to a story, then the stock is not being widely marketed to investors. Lack of marketing means investors don’t know as much about the company. Ultimately, this translates into a lower stock price.
Now, hold on a second. Lower stock prices don’t automatically mean you’ll make more money. The only way to make money (aside from speculating) is to pick companies whose businesses actually perform well. When a business performs well, analysts take notice and write or talk about it more. The analyst attention is more of a catalyst to a rising stock price than a cause of it. The stock price would eventually rise on its own. Analyst interest just speeds things up.
DragonWave Inc., a small-cap Ottawa-based technology company, is a great example to illustrate what I’m talking about. I don’t own the stock, but it’s on my radar as a potential investment pending a turnaround in the business.
Unless you’ve been living under a rock, you are aware of the rapid growth in wireless data consumption by the average consumer. All kinds of smartphones and tablets connect to cellular networks. They chew up our allotted data buckets – those monthly wireless data plans – while we surf the Web, post pictures to Facebook and watch the latest hilarious videos on YouTube.
Early cellular networks weren’t built to handle this much data. Cellular towers were built for phone calls and connected back to the phone networks with slow copper connections or equally slow wireless connections. When 3G (and now 4G) networks arrived, the wireless operators had to figure out a way to get more data to these cellular towers, to feed the big data consumption habit.
DragonWave makes something called “wireless backhaul” equipment. These are fancy radio transmitters that connect cellular sites to the rest of a wireless operator’s network, enabling data to move back and forth from the Internet to a cellular device. DragonWave’s wireless backhaul equipment is built to handle huge quantities of data, which is what we need in a 4G wireless world.
At the start of 2009, DragonWave’s stock traded at about $1. One year later, it traded at almost $14. Why? The company had one customer named Clearwire Corp., which was building out a huge wireless network in the United States. Clearwire had decided DragonWave’s equipment was the best in the industry, and they started buying lots of it. DragonWave became very profitable very fast. Analysts took notice, and everybody started wondering who would be the next major customer to push DragonWave up to the next level of success.
The time to buy DragonWave was prior to this growth. For anyone paying close attention, it was rather easy to predict. Clearwire had already settled on DragonWave equipment, and was waiting on a big injection of cash from investors. Once Clearwire investors piled $3.2-billion into their company, raised through a variety of stock issues, DragonWave’s revenue started to soar.
Very few people were paying attention. DragonWave was, prior to this growth, a small company that was losing money. They had no big-name customers to brag about. Analysts are very busy people. They are usually responsible for covering too many stocks, making it impossible to divert enough attention to some of the more interesting, smaller names. That is, until these smaller names become interesting by way of impressive financial results.
Today, DragonWave is back to being an off-the-radar stock. Clearwire ran out of capital to continue building its network, and DragonWave’s revenue crashed. The stock is back down to about $1.65. DragonWave hasn’t won enough new business to offset this loss of revenue. To make it even more complicated, they acquired a competing business from Nokia Siemens Networks, which comes with more operating risk, more cash burn, but perhaps wider relevance to the wireless data industry.
I really like DragonWave as a company, and I admire its management team. But I don’t like the stock. Not yet. That said, I believe the company is a leader in an important growth industry, and if it manages to digest its Nokia Siemens acquisition without running out of cash, it might turn out to be another situation like 2009. It might be an incredible opportunity. The stock is ignored by analysts and investors right now and nothing will change that until something newsworthy happens. For those paying attention, the news will develop, slowly, before our eyes.
Pay attention to the small cap-stories that interest you and are off the radar. It just might pay off.