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Small-Cap Smell Testing
NOSE AROUND, ask questions, keep digging, trust your gut. There is a lot more to small-cap vigilance than meets the eye.
n a typical weekday morning, 44-year-old d. tod pauly, a.k.a. "tonto" in cyberspace, is at the desk in his home office by 5 a.m., tracking the stock market until it closes hours later. Despite some business involvement in the manufacturing industry, Pauly's true passion is his investments, which have mainly been concentrated in NYSE and Nasdaq stocks during his nearly 20 years as an active market player.
Ah, but then there's what he calls "the thrill of the micro caps." He loves them, he plays them...he has felt their sting. These investments are "always day trades," he confides from his home in Manitowoc, Wisconsin, because "they're just so dangerous."
Pauly learned that lesson the hard way, when he fell for the siren song of a onetime high-flier called GIFS (once known as Genesis International Financial Services) in 1996. The stock of this mining--n‚e insurance--company had plenty of things going for it; unfortunately most of them turned out not to be true (more on that later). Still, Pauly, who had bought in at $2.25 and watched GIFS climb to about $4 during its giddy heyday, was lucky enough to bail out in spring of 1997 at $1.86--before Tennessee's state regulators shut the company down and before the SEC stepped in and halted trading in its stock, in part because of Pauly's own discoveries about the company's lack of, well, reality.
"That was the stock that made me decide that I would do anything I could to help innocent investors protect themselves," notes Pauly. Between his own five-figure investment loss and the death threats he received via the Internet (mainly from fellow investors who suspected that he was a short-seller trying to damage the stock with his revelations), GIFS was one of those defining life passages that many of us, frankly, hope to avoid.
Still, these days--more than a year after GIFS's collapse--Pauly is more of a missionary than a lone ranger. "My old enemies now will ask me to look at stocks that they're considering investing in, because they've learned from experience what kinds of risks exist." He pauses. "All you need to do is have one big loss in this market to realize that you can't take anything for granted with these stocks."
Don't let anybody tell you that investing in the small-cap market is simple. To begin with, it's tough even to get agreement about what constitutes a small-cap stock. Confusion proliferates, even among investors, who sometimes mistakenly believe that small-cap as an investment term is synonymous with companies that possess either small revenue bases or especially low stock prices. It ain't necessarily so. What with rising stock prices and a flood of investor money pouring in--in part from the 660 or so mutual funds that focus on this market--the very definition of small-cap keeps changing. It probably makes sense to rely on an upper threshold of $1.5 billion (although plenty of investors and brokers set their own ceilings at half that number or even less). Still, Standard & Poor's includes companies with market caps as high as several billion dollars' worth in its own small-cap index.
You get the idea. It's tough to say exactly how many thousands of companies fit this difficult-to-define set of parameters. Some of them are practically giants or at least household names, and these tend to be the small caps that attract attention from mutual fund suitors. But there are about 5,000 companies (nearly 70 percent of all the U.S. listed firms) that compose the true small end of this market--the micro caps--in the estimate of analyst Daniel P. Coker, of Schroder & Co., the author of the forthcoming Mastering Microcaps: Strategies, Trends and Stock Selection (Bloomberg Press). These tend to possess market capitalizations of $300 million or lower.
With a spectrum that broad and that diverse, it's tough to generalize about small-cap stocks, especially when it comes to their risks and rewards. "Everybody's in the pool now," is the way Mary Calhoun puts it. A former stockbroker whose company, Calhoun Consulting Group, in Boston, focuses on securities-litigation consulting, Calhoun emphasizes, "The things that one sees in this market can sometimes defy belief. You'll see companies with absolutely ridiculous market capitalizations--maybe a billion-dollar cap--and no sales. Or a company with $200 million in capitalization but no sales, no history, only two guys and a secretary sitting in an office and talking about all the great acquisitions they're going to make."
Investors can play this market more conservatively by sticking to its biggest, most closely tracked end and can try to limit risks further by diversifying their bets through mutual funds. But there's no guarantee that mutual fund managers will sniff out small-cap risks better than individuals will: After all, Bre-X's fairy tales seduced quite a few fund managers (including those of American Express's IDS stock fund, which held about 1.5 million shares of the mining company). And recently, small-cap performance has been something of a downer compared with large-cap brethren. Morningstar reports that its universe of small-cap funds averaged just a 21.6 percent rate of return during the past three years, compared with 31.95 percent for the S&P 500.
No wonder investors like Pauly stray off the beaten path and try to focus on the smaller, more volatile, and potentially more profitable end of the marketplace when they look for the big payoff. But here dangers abound and can run the gamut from outright cons to garden-variety crummy companies, whose only prayer of a stock profit for investors lies with a fundamental-free momentum play, preferably one driven by the fantasy-ridden Internet.
"You're in a whole different world here, in part because these are companies that might have only one or maybe even no analysts following them," emphasizes Stephen R. Adams, the vice chairman of Van Kasper & Co., the San Francisco brokerage house. "Therein lie the opportunities and the risks." To Adams, those risks seem so high that he considers them worth taking only with stocks that possess both strong business fundamentals and the potential, in his assessment, for a 200 percent to 300 percent return within two or three years--a rare find for most of us.
Ask a small-cap expert how to ferret out potential dangers, and the answers can seem almost ridiculously basic, especially to investors who are used to the comfort zone that typically surrounds stocks that are scrutinized by 20 or 30 analysts on a regular basis. In a market with as many dark corners as this one has, information can't be taken at face value and nothing else can be taken for granted, either.
"I'd have to say that often the single biggest warning sign, at least for me, is when a company lacks a 'name' auditor," notes Calhoun, who currently spends most of her time investigating Internet-securities fraud. "You'd be surprised how many times--especially in small-cap stocks whose main activity is centered around Internet investors--you either see companies that don't have an auditor, or it's just an obscure little firm nobody's ever heard of. Or--and this is a common line--the company tells you that it's on the verge of hiring a big-name audit firm, but it's just waiting for one more thing to happen first." And remember, though annual numbers may be audited, no one is required to vet quarterly numbers.
Now, just because GIFS, for one, lacked a big-name auditor (actually, it lacked any independent auditor at all) is no reason to assume that every single small-cap company that's in the same boat is likewise on the verge of collapse. But as any small-cap expert will tell you, this is a market in which it pays to play the odds. And the odds are, if you can't be sure about a company's auditor, you can't be sure about the accuracy of its financials. Whenever you've got any apprehensions at all about a small-cap company's numbers, it pays to run the other way.
By the way, Calhoun's advice about auditors comes with an equally important corollary: Stay away from small caps that don't have up-to-date financial reports. Yes, there are plenty of them, although you can bet they're not the small caps most mutual fund managers are focused on. And just as with the auditor issue, some of these companies might also have a good tale to tell about why their current financials have been delayed--but if you hear one, the only safe course is to point your Geiger counter elsewhere.
"One line that keeps cropping up is, 'Our auditor can't complete the audit because we've just carried out an acquisition,' or 'We're right on the verge of a merger.' But anything like this is a real danger sign," Calhoun warns. "It's shocking how many times investors are willing to overlook a lack of financials."
Take Firamada, a New York City- based temporary-staffing company whose stock was active in May and June of this year. Around year-end of 1997, the company had about 20 million shares outstanding, but by late spring that number had risen to 70 million shares, trading below a dollar per share. After completing a recent acquisition, the company claimed to have $80 million in revenues. Meanwhile, it had never filed audited financials with the SEC--and it had no chief financial officer--although the company had promised investors on several occasions that the numbers were coming.
It's worth emphasizing that a small-cap company doesn't have to be scam-ridden to justify caution. After all, investors in this arena can just as easily lose most or all of their stakes if a weak or undercapitalized company is simply defeated by the marketplace, good intentions and all. Here's Stephen Adams's assessment: "This kind of company needs to possess very strong balance sheets--hopefully free of debt--if they're going to be capable of withstanding inevitable market downturns. That's why you've got to be completely confident about their financials before you should even contemplate taking the risk." (See "10 Ways Earnings Lie," from the July/ August issue.)
Adams's idea of a small-cap stock worth taking a chance on is Zindart, a company headquartered in Hong Kong, with a 100 percent U.S. customer base for its product line of Hallmark's and other companies' collectibles. "With no debt, it's been growing at 40 percent annually and is trading at $12.50, which is only about nine times earnings," he reports. Plus, he likes the company that Zindart keeps: The successful U.S. venture-capital firm Chinavest holds 53 percent of the young company's stock.
Similarly, Bart Boyer, a certified financial planner and president of Parsec Financial Management of Asheville, North Carolina, makes small-cap investments but only when companies meet what might seem to be a blue-chip standard. "I won't go near a company that has no earnings. In fact, I like to look for a five-year earnings history, with audited financial statements." But even with companies that meet those standards, there are other red flags that can scare him away, often relating to the company's business projections.
Pie-in-the-sky projections ("We will easily reach $100 million in sales very soon") should cause savvy investors to blanch; but in some cases, too-low projections should have the same effect. "Let's say you're looking at a company with a hot stock, less than a million dollars in earnings and 100 million shares outstanding," says Boyer. "What if it's projecting a $2 million increase next year. What is that going to amount to, two cents per share? How many times earnings are you going to pay for a company that's got no realistic hope for a big profit, unless you get lucky with some kind of momentum play?"
As Boyer and Adams emphasize, investors must apply the same rigorous financial analysis to these stocks as they would to any other and, of course, look for other standard signs of trouble, such as excessive or unusual insider selling. But at the same time, investors just need to be on the lookout for bad vibes. Lots of corporate name changes, for example, give experienced hands the goose bumps. True, it's scarcely a hanging offense. But it is amazing how often these switches crop up in the history of a company that lands in trouble. Naturally, GIFS had two of them.
Another broker warns, "Just stay clear of a company whose business or assets sound so complicated that you can't possibly figure out what it all means. On the same principle, shy away from corporate operations that are completely inaccessible, so that nobody can get out there and double-check that they even exist." In other words, it is better to be able to sit on an Ethan Allen couch or go out and touch a Fedders air conditioner than to buy into a gold mine that you have no realistic hope of visiting.
Beware of hype, in whatever form it may take. "People need to have a very clear sense of why they want to buy a company's stock. And it really can't be something as simple as, 'I read about it in a newsletter and it sounded great!' " cautions Claudia Mott, Prudential Securities' director of small-cap research. "You can get caught up in a newsletter and assume that everything you read in it is true, but there have been rumors that some companies pay some newsletters for positive coverage. That's not to say that all do, but no article should ever be a substitute for your own analysis."
And when it comes to acts of analysis, there's one simple rule of thumb: Scrutinize everything. It's worth mentioning that most small-cap experts keep their eyes on the number of shares outstanding because they've seen cases where companies play fast-and-loose with this number--often by failing to keep investors informed about how much stock they've issued and how often they've done it. This again would scarcely happen with companies heavily covered by analysts. But with all those small-cap companies doing business outside the spotlight, there's an undeniable risk. Warns Pauly, "I've found companies that had as much as 100 million shares more out there than they've told their investors about. So it's important to check whatever a company tells you with the information you can verify from its transfer agent." And pay attention to the transfer agent in any case. Other experts cite as a red flag any small-cap situation in which a company's transfer agent resigns.
Did bre-x strike you as a once-in-a-lifetime scam? Then you'd better run, not walk, away from the small-cap market, since the only way to approach it is with a healthy dose of skepticism and with a determination to verify, verify, verify.
Just consider Pauly's experiences when he decided to verify GIFS's claims--unfortunately, after he had already purchased the company's stock. "I had bought the stock because I liked what I read about it in some investment newsletters and on the Internet," he recalls. "But the first time I heard the CEO speaking in a conference call, I knew that there was something phony going on." He decided it was time for some double-checking, but in his wildest dreams, he never expected the kind of inconsistencies that he'd uncover.
"One of the company's chief assets was Miller Mountain, which was a gold mine in Idaho," he explains. "The company had already expensed about $75,000, which it claimed to be spending on repairs to the road that led up to the mine, which supposedly had been damaged by washout. So I got on the phone with a park ranger who looked out at Miller Mountain every day from his office window." The conversation started innocuously enough, with Pauly just trying to confirm that the roadwork was under way. The ranger mentioned that no one had even applied for a permit to repair the road. Pauly then mentioned the mine's owner, GIFS, only to be told by the ranger that the mine's owner was actually a man who lived out in Washington State.
Now determined to verify the authenticity of all of GIFS's assets and alleged business activities, Pauly started calling contacts in Mexico, where the company claimed to be storing a Certificate of Deposit worth more than $100 million. He eventually learned not only that the CD was not safely housed in a Mexican bank but that it had been seized by a U.S. government agency years earlier. Then there were the company's various insurance operations. Insurance, after all, was the business that GIFS had started out in, and it was a business line that management claimed was still going strong, thanks primarily to some operations in the South. But when Pauly called the insurance regulators in Tennessee, one of the main states in which GIFS claimed to do business, he was not able to confirm that operations were up and running. In fact, the state had revoked the company's insurance license.
Remember the warning about assets or business operations too complicated or obscure to understand? Well, GIFS had some in the form of "corundum deposits"; "they kind of sounded like they were some kind of precious mineral deposit," notes Pauly. "But they turned out to be as worthless as sandpaper. The company had just paid someone a lot of money to authenticate an inflated value."
The situation began to feel like something out of The Twilight Zone. For example, GIFS had announced plans to open up NASCAR-theme stores at certain roadside sites within a couple of months, but there were a few hitches, such as the company's failure to purchase or lease the land (though they did take some attractive photos of the sites). Pauly began posting warnings of his discoveries on the Internet, mainly on the Silicon Investor Website (www.techstocks.com), where he and about 60,000 fellow investors swap stock tips.
"That was when the counterattack began," Pauly recalls. "Suddenly I was under attack on the Internet by the company and other investors who accused me of being an evil shorter. Management started putting the spin on everything I had uncovered."
Meanwhile, though, Pauly kept digging. By checking the background of all the corporate officers, he learned that GIFS's CEO had a criminal record. "He was a three-time ex-con, and I was able to get my hands on his criminal records," he says. When he posted that info on the Internet, the attacks on him went from bad to worse. One man went on-line with a message that warned fellow investors, "This guy Tonto is a suspect in a major theft involving [GIFS].... The local police and FBI are in the process of doing a sting.... He might be tied to the Mob.... Beware of this guy, he is a hard shooter."
Pauly's investigations spanned two months, and needless to say, he got out of the stock as quickly as possible. But plenty of his fellow Internet investors continued to doubt him--right up until April of 1997, when the state of Tennessee Insurance Commissioner's Office shut down the company and started liquidating its assets. At 9:30 a.m. on May 1, the SEC suspended trading in the stock because of "questions that have been raised about the accuracy and adequacy of publicly disseminated information concerning, among other things, the value of certain assets claimed by GIFS and the purported sale of a GIFS subsidiary." The order was publicized on the Internet and elsewhere.
A more recent example of questionable information involved a company called Rocky Mountain International, originally Olympus Ventures, whose stock trading was temporarily halted by the SEC last December. (Transfer agent switch? Yes. Up-to-date audited financials? No way.) "It's the biggest soap opera on the Internet," is the way Calhoun puts it. "There are 66,383 postings about it on-line in Websites like Silicon Investor."
Another small-cap vigilante whom Calhoun admires was instrumental in uncovering some of the inconsistencies on this one. "I started trying to verify every single thing that management had said in its press releases," he recalls. "The most amazing thing with this company was management kept talking about its newly refurbished tramp steamer, the Pilar del Caribe, in a port in Jamaica. So I called the authorities only to find out that the ship existed, but that it had been seized by the Jamaican government, sold for scrap, and then beached on a cay as it was being taken out of the harbor. It was currently halfway underwater."
As for Rocky Mountain's stock, at press time it was virtually sunk as well, because potential market makers have failed to meet the SEC's 15c2-11 regulations (which prohibit the posting of quotes for securities in the absence of accurate and adequate information).
And so it goes. When it comes to small caps, Pauly has more stories than the Brothers Grimm. There's the company (now doing business under a new name, of course) that told its investors about some big new customers. Only thing was, when Pauly called those customers to confirm the information, it turned out they had never even placed an order.
But ah, the life of a self-proclaimed missionary isn't an easy one. "Right now, I'm heavily under attack on the Internet," Pauly acknowledges, still at his computer, still tracking stocks at a time when anyone who could had already left early to jump-start Memorial Day weekend. "Some of these people are vicious. They say I'm trying to destroy them. But I'm just trying to give them a few months' warning, so that they can get out without hopefully losing everything on one of these stocks."
Still starry-eyed about micro caps, or at least hopeful that you can crack that market on your own? Don't invest a cent in any company until you work your way through this checklist:
Focus on the financials. If they're not up-to-date and audited by a reputable accounting firm, throw them out. If they are, analyze all key ratios, with a special focus on debt-to-equity, price-to-earnings, growth history, liquidity, and other essentials. If any analysts follow the stock, read their reports.
Verify everything. You've read the horror stories. If you're not willing to do your homework, go back to safer bets.
Think like a securities investigator. Double-check the backgrounds of all corporate officers and directors through databases such as the SEC's EDGAR. EDGAR should also have a section that the company provides of all the drawbacks their operations could face. Check newspaper files to see if the names of the company or its management (in any of its incarnations) crop up in disparaging ways. Don't overlook credit checks, Better Business Bureau reports, and phone calls to any relevant state attorney general's office.
Tune into the Internet. Mary Calhoun recommends Silicon Investor and The Motley Fool Online (www.fool.com) as two particularly influential Websites. While you cannot trust all the information you find on-line, at the very least listening in will give you a good sense of the forces that are whipsawing your prospects.
Be wary of fads and crazes. "Remember pet foods and microbreweries?" Claudia Mott cautions. "Sometimes there are industries in which one company, but only one company, is going to make a good investment. And sometimes, despite the craze, nobody is going to make any money at all."
See who took your target public. Was it a big Wall Street firm, or a name in the underwriting business that you recognize? Your chances are better that someone else has looked closely at the underlying potential of the company.
Trust your gut. Does anything at all make you nervous, even if it seems too petty to mention? Then don't get involved. Did you already get involved? Then get out--fast.
--Jill Andresky
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