Idea Brunch with Jan Svenda of MS Microcaps

Welcome to Sunday’s Idea Brunch, your interview series with great off-the-beaten-path investors. We are very excited to interview Jan Svenda!

Jan is an equity research analyst at MS Microcaps, a microcap-focused firm building tools for the microcap community and “delivering the best microcap alpha in the market.” MS Microcaps was recently founded by Maj Soueidan, the co-founder of GeoInvesting, an investing research platform launched in 2008. Before joining MS Microcaps, Jan worked independently as a deep-value special situations investor and published research on microcaps, frauds, and manuals on “dark” or extremely illiquid stocks. Today, Jan lives in Czechia and is active @JanSvenda on Twitter.

Jan, thanks for doing Sunday’s Idea Brunch! Can you please tell readers a little more about your background and your passion for microcap investing?

Thanks for having me, Edwin. I started out with an internship at Morgan Stanley during my university years. When we were asked to pitch a stock, I asked whether I could pitch something outside of MS’s coverage as I was publishing my stuff on Seeking Alpha then.

Their first response was, ‘You don’t think you could find something more interesting, right?’. That would be a fine answer to a 21-year-old, but the fact that they did not let me present speaks to the inflexibility of the environment. I understood that I wanted a position where I could experiment.

I then worked for an equity research firm in London for a year but realized that to truly bring value, I needed to go even deeper. This was prompted by reading the great interview of Thomas Braziel, who described his special situation investment in Ethanex, where he started to buy up a stock, which was, in essence, a bankruptcy claim, and made over 2,000%. I saw this and understood that this is where I can succeed.

I decided to run my own newsletter focused on OTC stocks, especially dark stocks or stocks that are not registered with the SEC and do not report to the agency. This has led me to a few consultancy gigs with funds focused on this area. This way, I polished my skill set as I got to analyze historical land ownership in Hawaii, scour legal dockets about the wreckage of the Titanic, or try to unearth information about a long-gone oil trust that had only one phone number available, which led to a kindergarten in New York.

Perhaps one public win from this time is my report on Vulcan (VULC), which I wrote with the help of other interested investors and which led to the company's liquidation to unlock the premium. They did not want to fight the shareholders anymore in the light of my manual on how to force the insiders to abide by the law.

After dark stocks, I focused on short-selling, which provided me with a unique opportunity to analyze stocks from a different perspective and again sharpened my ability to sniff out crap. This was when I first connected with Maj for a period of time, and we both agreed that the microcap space is a fertile hunting ground for all kinds of alpha-generating opportunities.

Not only for vanilla equity investments but for all sorts of other opportunities due to many trends over the past few years. Since Maj also has a storied history in short-selling, he was part of the China Hustle and busted many Chinese frauds, our skill sets are similar, and we can truly harness a long/short strategy.

A lot of new investors struggle with small-cap/microcap/illiquid stock investing when they start and often fall into value traps or businesses with self-dealing leadership. What are the ingredients for success for new small/microcap investors, and how have you evolved as an investor over time?

Let me answer this in a bit of a roundabout way. Let me share why I believe microcaps / OTC stocks are actually interesting to invest in the first place. It has to do a lot with how the space is perceived, perhaps due to many experiences that you mention.

1/ Reputation. Microcaps are just a step away from being called pink sheets or penny stocks. Therefore, most people think the businesses are crappy and are trying to chase the latest fads. Even the SEC warns against investing with a section called ‘Microcap Fraud’. Wonderful.

We will be the first ones to say that investing in microcaps carries specific risks, but dismissing the whole space is exactly what creates opportunities in companies that have been around for more than 30 years, have solid products and a real business model.

2/ Obscurity. While there are plenty of microcaps that offer straightforward products, many times, the investments can touch upon weird and complex corners of the marketplace. A lot of times, investors might not fully understand the initial overview of the business and get spooked. Perhaps the business is weird, perhaps it requires different research methods and so on. I mean, one microcap even set out on a hunt for Big Foot, so it can’t get weirder than that.

3/ Data. If you have Bloomberg, you are pretty much set, and you can get most of the financial data on the planet, except microcaps. There are still pockets of data that you simply need to know from experience. Otherwise, you will not find them on an automated screen, etc.

Outside of Bloomberg, you are left with data that can have serious mistakes or is missing completely, even for companies that file with the SEC (happens regularly on Sentieo).

The easily scalable market for data is small in microcaps. Therefore, investors can be discouraged by the lack of available data. This is also why we work with Maj on creating tools for investors to ensure the data situation gets better.

4/ Bad corporate governance. As you say, management teams can feel like they are flying under the radar and can pull off all sorts of stunts. I will even share one such example in this interview. This is a valid risk that you need to carry in mind, but there are solutions. Activism exists, and you do not have to be left alone in a messy situation.

5/ Volume. Many investors agree with all the above and understand that this is what creates the opportunities, but they then come up and say that the space is not worth it due to volume. In February of 2022, we created an index of Tier One Quality microcaps, which has outperformed the SPY by about 17% so far. In this index of about 70 stocks, we saw some of the top performers with average daily volumes of over $1m. Sure, you can’t easily build a $300m portfolio of microcaps, but can you allocate a portion of it with the perspective of substantially beating the market? Yes.

Not to mention that if you do not mind holding long-term, the capital allocation can significantly expand due to the number of institutional opportunities (financing, business development, etc.).

Therefore, the first step for investors is to actually understand these factors well and be ready to navigate the space with these in mind.

Outside of understanding why the opportunity exists, I would just point out a few other things.

Action. Evolution comes as you gain experience, and experience comes only if you actually try things. Experience can be costly in terms of time, but it is something you can hardly get from reading The Intelligent Investor for the 10th time. Call the management, reach out to other investors, try to understand what a specific line item on the balance sheet truly means, etc.

Perseverance. Investing in smaller stocks can be frustrating. As discussed above, there are many stories of people losing and never coming back, I believe you have to go past that.

Another general learning is that momentum can be your friend. Coming from a deep value perspective, I always acquired this inner peace when I saw the stock was hammered and down for months or years. It has not been discovered yet.

Maj disrupted this belief and pushed us to investigate stocks that are on the way up and can continue to go up because the market is slow to realize the extent of the good news in the microcap space. I always thought, it is up, I missed it, or it is up, so I sell it. Now I think whether it can match our multi-bagger checklist and see further expansion.

Last but not least, having short-selling experience can be a crucial advantage to investing in microcaps. The space holds many quality companies that were forgotten, but as you say, it also features an equal if not larger number of companies that are in the business to line the pockets of insiders. Understanding the tricks can be a lifesaver.

You mentioned you’ve talked with a lot of management teams while diligencing microcaps. What are some of the red flags or positive signs you look for on calls with management? Have you had any particularly notable calls over the years?

It is tough to generalize. There are certain recurring features that are great and are a staple in our research checklist. We search for management teams who are focused on the business, not the share price. They should not dilute shareholders, and they should own stock. All common sense. The hard part is to stick to the process in grey areas.

The management team calls can then tell you a lot about how the CEO views the business, whether they are excited, careful, or simply bored and uninspiring.

One notable call we did with Maj that I recall from my recent memory was with Richardson Electronic (NASDAQ: RELL — $142 million). This is a great business run by Edward J. Richardson. They have several lines of business, but perhaps their most exciting part is a division that created a new energy storage solution for wind turbines. The call was tremendous because you can understand Mr. Richardson’s enthusiasm for building a sustainable business with a lot of added value. Maj conducted an on-site visit after the interview, where he took pictures and videos interviewing employees of each of their divisions.

Lastly, I would also say that RELL is a great example of what we call BigCap Micro: Microcaps that have hundreds of millions in revenue but are trading at microcap valuations. These companies usually have a long history of innovating and creating solid products, but for one reason or another, they never shook off the microcap label. Well, many times, the catalyst is just around the corner, and it can come sooner than investors think. Don’t forget that Monster Energy was a busted-up microcap at the start of its multi-bagger journey.

We caught RELL in mid-October 2021 at around $10 per share and saw the stock get over $24 per share about a year later. Now, it has lost some of its gains, which means we could soon revisit the story.

What are two or three interesting ideas on your radar now?

Since we launched the Tier One Quality Index in February 2022, we got back to focusing on our prime strategy for selecting microcaps. The index tries to identify top companies that are also meeting multibagger criteria we created. We now scan many microcaps and try to form an opinion as quickly as possible through the use of Cliff Notes. These are structured notes that highlight our core research process and reasoning as to why we like the stock. We publish these on Substack.

The Tier One Quality Index is comprised of stocks highlighted through Cliff Notes. Since February of 2022, it is up 25%, with the average peak return of each stock sitting at over 76%.  And by the way, that is from doing no active management. We are just creating a great hunting ground for microcap investors. These stocks will come in and out of favor over time.

Looking at the index, I would say one of the most promising stocks I can see now is: