Fabrice Taylor, CFA, publishes the President's Club investment letter, for which he and The Globe and Mail have a distribution agreement.
To make really big money in small caps you have to get in before the big boys do. That means investing in fledgling companies that will grow enough for institutional investors to take notice and follow suit.
That's not easy, but here's a tool that can help: the list of companies that graduate from the TSX Venture Exchange to the big league TSX. This approach led me to a stock idea that looks very promising for both an attractive short- and long-term return. More on that stock shortly. First, the thesis:
Since 2000, 608 Venture companies have made the rite of passage to the TSX. Roughly half are still listed, the rest having disappeared through merger, acquisition, privatization or delisting.
More encouraging is that about a fifth graduated to the S&P/TSX composite index – a sign of cachet and success, because only the best and growing companies are invited to join this benchmark.
It's difficult, if not impossible, to calculate how well you would have done investing in these graduates, although it seems quite well.
But recent data give a better indication.
In 2013, 20 companies graduated from the Venture Exchange. On average, this basket of stocks did exceptionally well.
If you invested in those companies that had revenues, the average return was 128 per cent. Four of the 14 stocks delivered more than 100 per cent. The median would be about 12 per cent (both figures include dividends).
Of even greater interest, in the first three months after graduation the average total return was 15 per cent and the median 6 per cent – both very good returns.
These are limited data but they do suggest both a short- and longer-term pop on stocks that graduate, which makes sense. Companies don't uplist, with all the expense and hassle that entails, unless they're confident that business is getting better. And it's absolutely true that some large institutions just won't look at Venture-listed names.
Now back to the stock idea: Patient Home Monitoring.
As the name implies, PHM is a health-care concern. Specifically, it is riding a wave in U.S. health funding that increasingly pushes the onus of care onto the patient for certain kinds of self-monitoring.
The principals behind the company, Michael Dalsin and Roger Greene, have carved out a niche over the past decade as experts in profiting from changes to health-care funding, first at a private equity firm and now through a couple of Venture-listed startups and a soon-to-be-listed closed-end fund on the TSX.
California-based PHM is currently the second-biggest company by market value on the Venture Exchange, and it has applied to graduate to the bigger index, which should happen soon. PHM's market value has grown from less than $10-million two and a half years ago to almost half a billion today.
Over the past three years PHM has raised $83-million and made eight acquisitions, generating annualized revenues of $115-million, and cash flow of $30-million. The company also has $65-million in cash that analysts believe can be used to acquire $27-million of additional cash flow.
PHM stands out among other consolidators because of the synergies it can create through cross-selling with its ever-expanding database of patients. For instance, if one of its subsidiaries caters to clients with heart problems, the odds are that some of those patients also have, say, sleep apnea, which allows PHM to acquire a firm that caters to that sleeping disorder and sell services to its existing cardiac patients. This organic growth, meaning expansion that increases returns on equity, is the holy grail for stock investors.
PHM's success is evident in the 1,800 per cent increase in stock price in the past 30 months. But there may be more to come.
Mr. Dalsin tells me that many institutions call him to ask when he'll join either the TSX or the Nasdaq. He has resisted because of the costs. But he now believes it does make sense for the stock (of which he is a major owner and avid buyer).
Health care is a hot sector. The best performing graduate from the Venture class of 2013 was Concordia Healthcare Corp., which delivered 154 per cent in the first three months after uplisting and more than 1,300 per cent so far.
It's unlikely PHM will deliver that kind of spectacular return over a similar period, but I do believe that big Canadian investors have limited choices in the space and that the stock will be well received once it starts trading on a more "respectable" exchange.
Add to that compelling longer-term upside potential (more than 10,000 Americans turn 65 every day) and this should make for an attractive investment as long as the company continues to execute properly.
Disclosure: The author personally owns shares of Patient Home Monitoring.