As 2021 fast approaches Canadians can soon top up their Tax-Free Savings Accounts (TFSA) contributions with another $6000.
TFSAs have been a boon for Canadian investors. Once money goes into one of these accounts, it’s off-limits to the Canada Revenue Agency. Your investment gains are tax-free, and so are withdrawals.
The typical prudent investor maxing out his or her TFSA contributions and compounding at 8% per year would have a nice tax-free nest egg of around $116,000.
As with everything there are outliers.
Dan Richards is not your typical investor. He has parlayed his $69,500 TFSA contributions into a $1.37 million account.
And he has done so by investing in names most people would scoff at.
Names such as EVI Industries, Sangoma Technologies, Xebec Adsorption, Score Media, Gatekeeper Systems, and others.
His entry point into these businesses is early, typically the market cap is under $100 million. At this stage, most people would call the company a penny stock.
Richards likens the term penny stocks to slander, he calls himself a microcap investor.
“Penny stocks have a bad wrap, people get images of pump and dump schemes and boiler rooms. There are plenty of legitimate small, profitable, and growing businesses that are publicly traded.”
Apart from being a full-time investor, he runs offbaystreet.ca to help educate investors on the misunderstood microcap space.
Richards compares microcap investing to public market venture capital/ private equity with often better terms.
“All of the big private equity names we know today got their start with small, boring businesses and it’s actually when they had their best returns. Yet you tell someone you are investing in a $30 million dollar funeral home roll-up they laugh…but that’s exactly how Park Lawn started and today it’s those early inventors who are laughing.”
“It’s insane the money some of these tech companies are raising these days. I can look on Crunchbase and find a company with zero revenue and no product raising millions. Then you look on the TSX Venture and find a similar company with proven product and revenues trading at quite reasonable prices, but people don’t want to touch it because of the stigma.”
Richards openly admits not all microcaps are good businesses and the market has its stigma for a reason.
He carefully weeds out a vet’s potential names by looking at the financials, track record of management, and using “scuttlebutt”. A term coined by the investor Peter Lynch to describe boots on the ground research, talking to customers, employees, and vendors.
Richards says the idea with microcaps is to find a great business and “beat the street”. Despite being great businesses institutional money can’t enter these names until they get bigger, and more liquid. “Once they get bigger and the institutions start to buy-in is typically when I look for an exit.”
Richards offers the following tips to build a million-dollar TFSA;
-I stick to small and microcap names. These have the highest risk/ reward profile and are misunderstood by the market in general.
-Consider the downside as much as the upside. I generally tend to avoid biotech and mining as these stocks tend to be very binary in their outcome.
-Don’t get overconfident with position sizing. It’s fine to let your winners run but on initiating a position never put more than 15% of your portfolio in a single security, no matter your conviction. With a TFSA you don’t get the opportunity to add that back if you are wrong.
-Consider your portfolio construction, think about the names in your portfolio, the drivers of those businesses, and their correlation to one another. Ideally, you want all uncorrelated positions, it’s not practical to follow this to a T in the real world but you should at least consider it when adding names.
For example, say you find three attractive businesses. One in the restaurant industry, a boat manufacturer, and a high-end resort or hotel name. All three may be attractive names on their own and trading great multiples. But they are all heavily dependent on high-end discretionary spending as the driver. If high-end discretionary spending takes a hit, all of those names will take the same dive.
Richards final bit of advice is a warning for those looking for a quick buck. “It doesn’t exist. You have to do your homework and be patient. Doing nothing is the most difficult part of being an investor. You can hold a name for months, even years, and nothing, all of a sudden the company hits an inflection point and the stock takes off.”