3. Watch out for obfuscation, confusion and pie-in-the-sky promises!
Why would some companies choose to be quoted on the "Pink Sheets," or the OTC Bulletin Board? Actually, many fledgling firms don't have a choice, since they are unable to satisfy the minimum listing standards for the Nasdaq National Market or even The Nasdaq SmallCap Market.
But promotional literature sometimes inaccurately lists the stock as "Nasdaq Bulletin Board." Nasdaq would want you to know that there is no such thing, that these stocks are not authorized for quotation in the Nasdaq system and are not part of any major national securities market.
Often that obfuscation of a basic fact is deliberate. And if a company or its promoter will lie about such a small matter, what else will they lie about?
Try this: Unspecified claims of "major" developments, such as a "pending" acquisition or an "imminent" distribution agreement with a well-known company, are common distortions featured in scam stock promotions. Maybe an announcement is truly forthcoming, or maybe somebody made one phone call. But it makes a more exciting story to tell, and that's all that really concerns the unscrupulous promoter or broker.
Or this: Dramatic increases in projected sales or earnings. For example, Havana Republic
(OTC Bulletin Board: HVAR), a cigar manufacturer which began operating only in 1996, says it expects to sell five million cigars in 1997. Toppers Brick Oven Pizza (OTC Bulletin Board: TBOP), a company with no reported income in 1996, forecasts $27 million in 1997 revenues and $165 million by 1999.
These firms may actually believe their pie-in-the-sky projections, but you shouldn't. Even
projections from the biggest and most established companies should be viewed with caution. Outlandish projections from small, unproven companies are hardly worth the paper they're printed on.
4. Watch out for weak fundamentals!
Fundamental analysis is not unique to the larger-cap stocks on the New York Stock Exchange or the Nasdaq National Market System. One may analyze the financial statements of their small-cap brethren as well to gather clues of investment worthiness. It's all in the financials.
Firms with a strong track record of three to five years of sales and earnings growth of 20-30 percent per year, for example, may offer promising investment opportunities regardless of where the stock is listed. Companies with little debt, preferably no more than 25 percent of total capital, can better bankroll their expansion.
On the flip side, young companies often have very high profit margins and high returns on equity but, when competition starts to make an impact, profit margins and revenue growth likely will decline. Beware these situations when evaluating a small-cap stock:
*The stock sells at a much higher price-to-earnings multiple than its recent sales growth rate.
*The stock sells at a valuation of more than three times total revenues.
*The company's total market capitalization exceeds the size of the total market its
products will serve.
*The company's income statement reveals unusually excessive general and administrative expenses
*The company's cash flow statement shows losses from operations in contrast to net earnings
*The company has nothing but a concept and generates no revenues.
Cheap stocks aren't always cheap because they're second-rate companies. Plenty of small-cap companies truly possess a promising product or service that has yet to hit the market. In the absence of sales or profit-generating assets, you must attempt to quantitatively judge the value of future products -- an extremely difficult task unless it's a business you thoroughly understand.
It is equally critical to judge the quality of the people running the business, and there are some effective warnings to consider:
5. Watch out for excessive executive compensation!
Meet Angelo S. Morini, Chief Executive Officer of Galaxy Foods Company (Nasdaq
SmallCap: GALX). During fiscal year 1996, Morini received a base salary of $250,000. He owns 18 million shares of company stock, worth $13-$14 million at current market value, which he purchased not with cash but with a note payable due in 2000, when he may extend the note for up to five additional years. Galaxy Foods covered $9,107 in lease payments for Morini's automobile and $5,597 in club dues during fiscal 1996. Again, it's all in the company's financial statements.
Galaxy Foods suffered nearly $8.5 million in combined losses during fiscal years 1995 and 1996. So Morini is rewarded handsomely for his questionable leadership of the company. And there are lots of Angelo Morini's in the world of small-cap stocks.
The controversy over excessive executive compensation isn't unique to small companies, of course. But capital at small companies is far more scarce, and limited resources usually are needed to fund ongoing operations and stimulate growth. High salaries, generous options and other perks are all legal, but not exactly a sound strategy for successful long-term business development. Do you really want to invest your hard-earned money so that someone else can live a life of luxury?
6. Watch out for suspicious backgrounds!
In your prospectus, carefully review the backgrounds of company management. Does at least one member of top management among the president, chief executive officer or chief operating officer have substantial previous experience in the company's primary line of business? Does any part of their backgrounds indicate experience with entrepreneurial or turnaround situations? Did any of these situations ultimately result in the establishment of successful, ongoing businesses?
If the company officers' dominant overall experience involves "investment banking," beware. This situation may be no more than a bunch of ex-brokers that have obtained a shell company to play with. This group will know how to move the stock, but probably little about the industry it's joining. Their intentions may be pure, or they may be out to lure gullible investors into a "pump and dump" scheme.
And review each of the officers listed in the prospectus. If the list of top officers and/or major shareholders is stacked with the CEO's in-laws, you're probably better off finding an opportunity elsewhere.
Don't get burned by management lacking proper quality and preparation -- or motives. Let them play with their own matches. |
