As an investor, analyst and market-watcher there’s nothing we find more exciting in the world of finance than small-cap stocks.
We know, small-cap investing doesn’t sound very sophisticated.
It doesn’t have the same mystique as FX or bond trading. And you won’t find many small-cap analysts occupying the guest seat on Bloomberg or CNBC.
But give us small-cap stocks any day. Whatever the industry, we don’t care. All we want to know is that whatever company we analyse has the potential for investors to use small stakes to make big returns.
That’s exactly what we’re seeing in the small-cap sector today, and a US$19 billion ‘small-cap’ takeover proves it…
You probably think we’ve gone bonkers. How on earth can a US$19 billion takeover be a ‘small-cap’ opportunity?
After all, applied to the Aussie market, there are only 12 stocks on the ASX with a market cap greater than US$19 billion. Those stocks are the likes of BHP Billiton [ASX:BHP], Commonwealth Bank of Australia [ASX:CBA], and Woodside Petroleum [ASX:WPL].
And yet when we refer to a US$19 billion small-cap takeover we mean it. Let us explain.
A Great Deal if Revenue and Profits Don’t Worry You
You’ve probably seen the news. Social networking giant Facebook Inc [NASDAQ:FB] is paying US$19 billion for mobile messaging firm WhatsApp Inc.
Founders Jan Koum and Brian Acton set up WhatsApp in 2009. Since then they have built up a customer base of 450 million people around the world.
A measure of the company’s success and growth is that they’re adding one million new users per day to their messaging service.
It’s a great business. Well, OK, it’s only a great business if things like revenue and profits don’t concern you. WhatsApp has negligible revenue so far as it provides its messaging service for free in the first year and only charges a nominal $1 for each subsequent year.
For that, Facebook is paying – we’ll say it again – US$19 billion in cash and shares. That values WhatsApp at about one-tenth the size of Facebook, and even if we assumed all of WhatsApp’s users paid one dollar per year (which they don’t), it would still be barely one-twentieth of Facebook’s revenue last year of US$7.9 billion.
So, what’s going on and what’s the takeaway from this?
Most analysts and investors will look at those numbers and scoff.
They’ll laugh at the expensive valuation. They’ll scratch their heads and wonder just how WhatsApp and Facebook can possibly make any money from providing a free messaging service.
And they’ll raise their noses in the air and tell their clients not to invest in such crazy ideas.
Well, that’s up to them. But as a speculator, as someone who enjoys the thrill of finding tiny opportunities that could one day turn into multi-billion dollar takeover targets, we love it.
Because despite the current price tag, WhatsApp is a small-cap story from start to finish.
There’s Only One Way to Get These Returns
You may not remember this far back, but when Facebook floated on the NASDAQ exchange back in 2012, we were one of the few analysts who suggested investors should go ahead and have a punt. We said the same thing about the Twitter [NASDAQ:TWTR] float last year.
That flew right in the face of the mainstream, who said they’d never touch Facebook or Twitter shares with a bargepole.
For a while they were probably right. Facebook shares sank for the better part of a year after listing. But around the middle of last year things started to turn as the company’s mobile advertising strategy began to pay off.
Over the past year Facebook shares have gained 140%. That’s a poke in the eye to those who say there’s no money investing in tech and social networking stocks. And after a poor start, Twitter is up 26.1% since it listed, beating the S&P 500 by 21 percentage points.
But if you think that’s a pretty good return, consider the return for the private equity firms that invested in WhatsApp.
As we mentioned, WhatsApp has only been around since 2009. Two years later in 2011, venture capital firm Sequoia Capital poured $8 million into the company in return for a 15% stake in the company. If you do that maths, that investment effectively valued WhatsApp at US$53.3 million.
That’s a small-cap valuation.
Now Sequoia Capital’s investment is worth US$2.85 billion. So when it cashes in its chips following the Facebook takeover, it will have made a 35,525% return on the initial stake.
That’s a small-cap style return.
Big Returns are There for the Taking
Of course, everyone would like to make a 35,525% return. But not everyone has the bottle to take the risk in advance.
Think about it. If founders Jan Koum and Brian Acton had approached you in 2009 saying they were after investors for a product they would provide for free, that wouldn’t contain any advertising, and that if customers stuck around for a second year of using this service they would pay just one dollar, would you have invested in their business idea?
Most people wouldn’t. And yet that’s the kind of risk small-cap investors take on a daily basis.
Many small-cap stocks have little more to their name than the promise of future riches. Sometimes the companies break that promise as they don’t reach their potential.
But sometimes the companies keep their promise and the stock takes off. Maybe you don’t get the 35,525% returns. Those gains are hard to come by. But if you have the attitude to risk that you need to be a small-cap investor, then big triple- or quadruple digit percentage gains aren’t just possible, they’re there for the taking.
That’s what small-cap investors search for…constantly. They’re after the opportunity to make big gains. And as the Facebook and WhatsApp deal show, these kinds of big transactions can happen.
As a risk versus reward proposition that’s pretty good in our book. So, pin-stripers on Martin Place can deal with what they consider to be the ‘sexy’ stuff such as derivatives. Good luck to them. But we’ll stick with what we know best, and with what we know works best in terms of speculation…and that’s small-cap stocks.
You don’t get US$19 billion small-cap takeovers every day, but when you see them, and you see where the target company has come from, it’s a great vindication for those looking to <a
rel=”nofollow” href=”http://ift.tt/1dU9JQv” target=”_blank”>build speculative wealth in the tiny end of the market.
Cheers,
Kris+
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