7. Watch out for involvement in unrelated businesses!
A mortgage processing company that becomes a casino company... overnight? A resort
management firm that branches off into... cosmetics? Not exactly matches made in heaven. But they are actual examples of publicly-traded small-cap companies -- Advanced Financial (American Exchange: AVF) and ILX Inc. (Nasdaq Small Cap: ILX), respectively -- and ones that also happen to have a history of excessively promoting their stock to the investment public.
When confronted with such a company, the prospective investor should ask: Why would a development-stage company, which has yet to successfully develop its primary line of business, attempt to establish a completely different, unrelated business?
We don't know the specific motivating factors behind the moves of the above small-cap
companies and others like them. Perhaps it's just pure stupidity. But sometimes these are signs of a company not really interested in building a long-term business. Sometimes these are signs that the company's top management, who are also the controlling shareholders, are trying to temporarily pump up their shares at the expense of gullible small investors -- and then sell out.
Whatever the reason, you don't want to be a part of it.
8. Watch out for reverse splits!
Here's how a reverse stock split works. A company's stock currently trades at $1. The company implements a one-for-five reverse split. Every five shares of pre-split stock
becomes one share. The investor, who had previously held 1,000 shares, now owns 200 shares of the post-split stock. The new stock price immediately after the split is $5. The
market value of the position, before and after the split, is $1,000. What could be wrong about that?
Because when such a reverse split takes place, it's often a glaring indication that all is not well at the company. True, the shareholder does not suffer a loss of asset value or a dilution of ownership value. But this equality is usually very temporary.
When a company undertakes a standard stock split, things are usually going well. The business operations are profitable and growing, and the shares are moving steadily upward. Such is almost never the case for the company implementing a reverse split.
Pure and simple, reverse splits are facilitated to improve the appearance of the company and its stock price. The company whose stock is $5 appears more valuable than one whose stock is merely $1. But if the company really believed in its future and wanted to reduce its amount of outstanding shares, it would start to buy them from the market.
Furthermore, the stock is now ripe for a secondary offering of more shares by the company. For the pre-split shareholder, his percentage ownership in the company will endure a magnified degree of dilution the moment the new shares hit the market. The company's objective for the share offering has yielded the desired capital, but the risk has been transferred to the shareholders. It makes no monetary difference to the company.
9. Watch out for Regulation S abuses!
Regulation S is a section of the federal law that permits publicly-traded companies to sell unregistered securities to overseas investors. These "overseas" investors, in some cases, are actually U.S. investors operating through offshore shell companies, often hedging their investments by using options or short sales. That's particularly true when the issuers are risky small-cap companies, which sometimes turn to Reg S offerings out to sheer desperation for cash.
In the past, these Reg S securities could be issued to the "overseas" investors and then sold back into the US market before the existing shareholders even found out it. But the SEC realized that this was a problem and recently changed the rules. A company that issues Reg S securities now must file a Form 8-K within 15 days of its occurrence. Because Reg S securities are currently restricted for 40-days after they are issued, existing shareholders will be warned about Reg S deals before the shares can be sold. However, purchasers of Reg S securities can still short the stock before the 40 days are up, and later use the Reg S shares to cover their short position. Therefore, existing shareholders can get hurt by Reg S offerings even under the new rules.
The most dangerous kind of Reg S offerings for existing shareholders are convertible securities which can be converted into common stock at a fraction of the stock price at the time of conversion. For example, the securities might convert into common stock at 75% of the average bid price over the previous five trading days. No matter how low the stock price falls, the Reg S investors can still convert into common stock at a price lower than the current stock price. And the lower the stock price falls, the more shares they get. Therefore, they benefit from the stock price dropping and will often even short the stock to help it fall further (and lock in higher sale prices of the stock as well.), and then cover their short position with the shares they get from conversion. They almost can't lose! It's the existing shareholders who are the losers. This type of Reg S offering will frequently cause a massive increase in shares outstanding, which means that existing shareholders now own a smaller piece of the company and hold shares that are worth much less than they were before. Watch out for all Reg S offerings, but especially watch out for this type of Reg S! |
