The Paul Andreola Way

Discover the small-cap discovery system

Adding to the list of investors I would love to grab a beer with is fellow Canadian Paul Andreola. Paul is an investor I deeply respect. He’s very active on Twitter, and openly shares his investing process in podcasts and presentations.

His expertise lies in fundamental cashflow and earnings analysis for small and micro-cap companies. With 30 years of diverse experience, including co-founding two public tech companies and serving as CEO and director of another, his background formed as the basis skill to identify companies with the potential for 100%-1000% returns.

Paul's style is primarily based on identifying smallcap growth stocks before they gain broader market attention. He calls this the ‘discovery’ process. Let’s dive into his methodology today.

“I don’t want to buy when there is blood in the streets, I want to buy when no one is in the streets.”

@PaulAndreola

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Books he Recommends

Your investment philosophy and process evolve over time, influenced by theoretical knowledge, but mostly through your own experiences as an investor. Initially, you draw inspiration from others until you refine your approach to become distinctly yours.

I think it's likely that much of Paul's process was shaped during his years as an executive, complemented by his three decades of practical experience. He still emphasises the significance of three books that have greatly influenced his investment journey. Here are 3 he recommends as worthwhile reads:

1. How to Make Money in Stocks - William J. O’neill

2. What works on Wall Street - James O’Shaunghnessy

3. 100 Baggers - Chris Mayer

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Knowing where to look

The person that turns over the most rocks wins the game.And that's always been my philosophy.

- Peter Lynch

Paul emphasises the significance of having a systematic approach to his search for opportunities. His method is straightforward: his team and him review every announcement on the Toronto Stock Exchange (TSX).

His focus on sub-$500 million market cap companies means he’s looking at ~2,300 of the ~2,800 listed on the TSX.

If this sounds like the impossible task, let’s keep a few things in focus:

• Firstly, Paul's interest is typically reserved for companies that are profitable, preferably those that have recently achieved profitability (more on this below). Currently, this translates to around 300 out of the initial 2,300, making the pool seem considerably more manageable at 13%.

• With a good system in place, knowledge gets stored and compounds. You don’t have to repeat the heavy lift as deeply every reporting season; your notes from the prior seasons will help you move much more quickly through the noise.

Still, there’s no way across it, this is a demanding task. Investing is not easy. Investing with a goal to have returns that are well above industry average is very difficult. One must put in the effort. If you do, rewards can be spectacular; Paul once shared his returns went from maybe averaging 10 to 15% a year to an astonishing 100% - 120% a year when he started applying more effort into this methodology (Source: Business Insider).

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The System

His system is built on 5 key criteria.

1. Hyper growth

   1. Seek companies with revenue and earnings per share (EPS) growth exceeding 25%.

2. Low PEG Ratio

   1. Target a price-to-earnings growth (PEG) ratio of less than 1.

3. High ROIC

   1. Look for companies with the capacity to reinvest their profits at a high rate of return on invested capital (ROIC).

4. No to Early Discovery

   1. Focus on companies in their early stages of discovery that also have high margin expansion potential. Their smaller size will keep large investors out, and offer a greater potential for mispricing.

5. Skin in the Game

   1. Paul’s preference is for leadership to own between 10% to 40% of the company.

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HyperGrowth

Paul explains hypergrowth as:

1. Growth of revenues per share of at least 25%

2. Growth of earnings per share of at least 25%

3. At least 2 quarters of profitability

The added emphasis on per share growth and earnings is important. At the smaller end of the market, there’s a lot of capital raising for acquisitions. This can make the reported growth figures look great, but the dilution is typically a high price to pay for it. Not to mention the painful beating companies suffer when raising. When you dig into the story and go through the math-ninja exercise, often the most common realisation is that organic growth is poor, and the acquisitions are there to mask this truth of the company having challenges with product-market-fit.

Two consecutive quarters of profitability is also very useful. Many business models can result in a company accumulating significant cash in one quarter, leading to profitability. One quarter doesn’t form a trend. Looking for a minimum of two quarters provides a more reliable indication of the potential for sustained profitability.

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Low Valuations

Paul’s low valuation system means:

1. Low price to growth per share (PEG ration) of 1 or less.

2. Low enterprise value (EV) to cash earnings.

3. Financials that are easy to understand.

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Return on Invested Capital - ROIC

This means:

1. High ROIC - a company’s ability to invest its capital at a much higher rate than their cost per capital.

2. A company that can re-invest its avaiable cash and profits at a high rate of return.

3. A good understand and clear dialogues from management about what will be done with the profits.

The best compounders he’s identified over the years had always mastered this.

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Early Stage of Discovery Cycle

1. Minimal Analyst Coverage: Limited or no analyst coverage.

2. Low Bullboard Discussions: Minimal discussions on online forums.

3. Limited Social Media Activity: Low engagement on platforms like Twitter, Seeking Alpha, HotCopper, etc.

4. Low Institutional Ownership: Minimal institutional investment.

5. Minimal Promotion: Limited or no promotional activities.

6. Size Matters: You want it to be small in size to keep the big investors out, until later. Paul says often his preference is sub $50M in market capitalisation.

7. Focus on Margin Expansion: You’re looking specifically for the potential for margin expansion.

8. Increased Potential for Mispricing: Smaller size and lower visibility contribute to a higher likelihood of mispricing.

Microcaps is the only place in the public markets where an astute investor managing a small sum has a structural advantage over institutions.

- Ian Cassel

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Conclusion: Are These Companies Real?

Yes, they are.

Paul has not only found one, but multiple "100-baggers" during his three-decade-long career, alongside dozens of "multi-baggers" that yielded returns of 5 to 10 times the initial investment.

While such opportunities are rare, they do exist. And that’s why we’re here ladies and gents. Here's to discovering the next one.

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Other similar articles

• My profile on Ian Cassel

• My notes from Free Capital

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