After 35 years of stockbroking for some of the biggest houses and investors in both Australia and the UK, the Secret Broker is giving Stockhead the wisdom of all his experience and war stories from the trading floor to the dealer’s desk. This week he turns his attention to picking value in small cap stocks.

My father was a man of few words but once when I was a young boy, in an effort to stop my incessant questions, he threw an old chestnut back to me.

“Well answer me this son. What weighs more – a ton of feathers or a ton of coal?”

“Easy!” I said, falling into the trap without further thought. “A ton of coal, as coal is heavier than feathers!”

It’s a time-honoured lesson in assumption. Like so many parents before him and after, my father went on to explain how they both weighed the same but as I had assumed that as one looks lighter than the other, my mind jumped to the wrong conclusion.

The next time I got a lesson in assumptions was when I was training to become the next Gordon Gekko.

My sage old boss explained to me how you could have a share worth 50c and a share worth $5 but the one worth $5 offered better value because it had a lower Price to Earnings (P/E) ratio.

He showed me how it works. Take a company’s share price and divide it by its earnings per share (EPS) and the one with the lowest ratio is cheaper. In this case, it was actually the company trading at $5.

Coal, feathers, 50c, $5. Got it.

He then went on to explain if no quick P/E ratio can be calculated, as is often the case with speculative stocks like explorers (as they are not yet cash generators), then there’s another way to decide if a company is better value. Simply compare the company’s market capitalisation with the total number of shares on issue.

If two companies have the same market capitalisation, the company with the least shares on issue is better value.

The reason? It’s because of share price gearing when raising future funds, as more shares are issued at a lower price to raise the same amount of capital.

Here’s a free lesson

Look up a company’s latest Appendix 3B filing on the ASX and calculate the number of shares on issue including any escrowed shares. Multiply that figure by their current share price.

Then you can toggle between different share prices to give you an understanding of a company’s share price gearing. For example, if it goes from 0.002 to 0.005, how much will the market capitalisation increase by?

For every 1bn shares on issue add $1m of market capitalisation for each 0.001 share price movement upwards.

Sure, you can double your valuation in one session but you can also halve it just as quickly. As this old trader has learnt the hard way, penny stocks go up via the escalator and come down via the elevator.

If a company has too many shares on issue and you factor in average ASX compliance and directors costs of about $500,000 a year (just to keep a company listed on the ASX) that means at below 1c a share, a company is starting to enter what I would call the “hyper share inflation zone”.

Over time, it can mean a dreaded share consolidation is going to be on the cards.

Don’t get cocky

An example that I use when explaining the hyper share inflation zone was a time when it managed to turn a client’s holding of 100,000 shares into just 200 shares after the mother of all consolidations.

The aptly name Cockatoo Coal (feathers and coal again) disappeared off the boards with enough paper on issue to make a Zimbabwean banker blush. Its 77bn shares came back to life with a new name after a 500 to 1 consolidation to just 154m shares.

The company that listed at 20c and once reached $1 a share, kissed goodbye to the ASX at 0.001c a share and came back with the original Cockatoo shareholders’ investment virtually worthless.

And after several reincarnations and further blow-ups of shareholder value, Cockatoo now trades on the ASX under the name of Bunji Corporation Limited.

How appropriate.

Do you want the secret broker to run the ruler over a particular stock? Email: thesecretbroker@stockhead.com.au