Transformations

Successful business transformations can drive huge returns. A transformation is when a company pivots into something new or expands on its existing business, thus broadening its description and mission. When companies transform, they create unexpected value. An unexpected surprise creates a mad rush to buy. Successful transformations are like an IPO without a raise: a brand-new company with brand new investors forced to buy on the open market can be powerful.

For example, both Soluna Holdings and Millennium Investment 10-bagged when they shifted away from their existing businesses to start new bitcoin and cannabis ventures. Cogstate grew 500% when they repurposed their cognitive test used in clinical trials to a direct-to-consumer screening tool. Sanara Medtech is transforming by building a new wound care diagnostic and treatment ecosystem to layer on top of their existing product distribution business. Transformations are about more than just making the current business “bigger”. True transformations asymmetrically expand on a company’s existing business and description by pulling it into new and bigger areas. It leaves investors thinking, “I don’t know what this is worth, but it’s worth more”.

Transformations have incredible potential, but often investors don’t even think about them. Most investors consider new ventures as just “free call options” – or worse, management is doing “too many things at once” signaling a lack of confidence in the existing business. I think this is implicitly driven by accounting language. Accountants have made dozens of ratios and KPIs to analyze existing businesses and compare them to comps/the past (ROE, yoy changes, etc). Conversely, there is no ratio that quantifies the innovativeness of a company. GAAP thinks so little of innovation that almost all R&D is expensed rather than capitalized, suggesting that there is no residual value to R&D. Arbitrary rules like this subconsciously direct investors to focus on the existing business while ignoring new innovation or transformations in the making.

This means investors are very efficient at valuing businesses that currently exist, and very bad at valuing the future potential of transformations. Because of this, progress in an existing business won’t necessarily get investors excited, but surprise and unexpected 0 to 1 creation always move a stock.           

Transformations add this dimension of surprise to traditional investment frameworks. Old school value investors looked for stocks that were undervalued based on what the business had/did at a point in time. They focused on static measures like P/B or P/E and thus completely ignored the potential for transformation or future growth. Now growth investing has become more popular because it also takes into account future growth. Growth investors prioritize dynamic measures like ROIC and revenue growth, because they can use them to predict what the business will do in the future. But growth investors are still limited because they only look at the growth trajectory of the current business.

Transformations add a new dimension to growth investing by asking what could happen in the future to alter the current growth rate. How can ROIC increase? How can revenue growth accelerate? Semler Scientific is accelerating its revenue growth by in-licensing additional products to push through its unique distribution partners, transitioning from a one-product company to a comprehensive cardiovascular diagnostic ecosystem. Almost all businesses have diminishing returns to scale, so the only way for fundamentals to accelerate over time is through a business transformation that sees the company evolve into something different, bigger and better than it is today.

Microcaps

Microcaps are the perfect hunting ground for successful transformations. First, microcaps are categorically bad businesses (hence why they are “micro”), so they are the most in need of a pivot to turn them around. For example, Universal Biosensors was incinerating cash with basically no revenue until new management took over and pivoted their technology into new markets; now the stock is up 400%. Most successful microcaps began with a transformation.

Microcaps also move the most from successful transformations. Transformations create 0 to 1 absolute value. $100 million of absolute value is nothing to most companies but to a $10 million microcap it represents a 10-bagger. Most of the absurd returns that seem to consistently come out of microcap land are a result of transformations creating absolute value in a tiny nanocap. Hemacare mythically grew from a $3 million market cap to $300 million in 4 years after they sold their previous businesses and invested everything into building a new donor cell business from scratch. It’d be wrong to say that Hemacare grew their existing business 10,000%; rather they created a new venture using their unique assets which was almost immediately worth several $100 million, and this just happened to occur in a $3 million shell. That is absolute value creation.

Characteristics

I recently realized that almost all of my investments are bets on a transformation taking place. I believe that there are 4 main characteristics of successful transformations. These are: unique assets, driving forces, validation, and speed.

A microcap needs a unique or valuable asset to transform. There are three core assets to most businesses: people, product, and distribution (roughly corresponding to the three main expenses of G&A, COGS, and S&M). Successful microcaps transform by pivoting their unique assets into other markets (Cogstate pivoting its unique technology into the consumer health market, or Semler pivoting its unique distribution channels to selling other products). Unique assets are highly valued because they almost always have applications beyond their initial use. What’s unique and valuable in one market is likely unique and valuable in another as well.

Transformations must have a driving force. These can be external or internal. For microcaps, the initial driving force is usually external, where something outside compels a microcap to change. For example, when new external management took over Lark Distilling and The Joint and turned them around, both grew by over 500%. Cogstate found the opportunity to launch their direct-to-consumer technology because of external regulatory shifts in the Alzheimer’s industry. Driving forces can also be internal, though. This is especially the case for smallcaps already in the process of growing. The best companies have internal cultures of innovation that naturally create transformations over time, without the need for outside forces. It’s worth paying attention to companies that are always accomplishing unexpected things because they may embody internal driving forces of transformation.

Successful transformations are usually paired with validation from industry insiders. Validation is when people put their money, reputation, and/or time on the line for a company – skin in the game. For example, Cogstate’s transformation was validated when industry leader Eisai licensed their technology and bought a 10% stake in them. You could suspect Wavedancer would be successful when several industry veterans joined the company and invested $4.5 million in it, to transition it from a government services provider into a cybersecurity software platform. Validation is important because during a transformation there is a big gap between when industry insiders know and what investors know. Only industry insiders can make a qualitative judgement on the potential of a business that doesn’t yet exist – i.e. this is the time when validation is the most telling.

Time is the ultimate judge of whether a transformation will be successful. Transformative companies should be different and progress year after year. However, many microcaps just push the same story for years, while showing no fundamental progress of ever actually attaining it. Remember that it’s far easier to bet on a transformation that just started and has equal upside, and hasn’t yet had their strategy disproven by time. Further, the best companies continuously transform to grow – if a company can’t even execute on their first new venture how can they hope to repeat that process continuously in the long run?

Lastly, every microcap is trying to pivot but few succeed in doing so. Just because a company starts a new bitcoin venture doesn’t mean that it will 10x (on average it will go the other way). The purpose of this essay is simply to highlight the often overlooked value in business transformations and suggest some frameworks with which to analyze them. In the end, successful transformations still require execution. And the fact remains that great management teams, assets, and employees are the ones that execute.

Disclaimer: Nothing written in this article is investment advice. I am not an investment advisor. I and related parties may have a position in any company mentioned. Several companies mentioned are being discussed on MicroCapClub.