By Debbie Gallo
It
seems like everyone knows of someone who “hit it big” investing in microcap
stocks. But for every success story, there’s ten more of someone who invested
too late, sold too soon … who, basically, missed a golden opportunity. Most
people would say it’s luck – but luck can’t take all the credit.
Flying under the radar of most investors and the mainstream financial media, microcap stocks are frequently undervalued, offering the opportunity for great profits if, and when, they reach their full potential.
For many,
the chance of an enormous windfall in exchange for a minimal investment is the
initial attraction to the microcap market. But to be successful, experts agree,
requires more than just a desire to get rich. Dr. Richard Geist, President of
the
For all their potential, microcaps have a dark side, too. Often in development or build-out stages, these companies constitute a far riskier investment than equity in an established company. Moreover, their smaller size may exempt them from reporting obligations, enabling dishonest management to more easily defraud investors. Finally, the low share volume creates a market where even small trades can have a large impact on share price.
If, with all the risks, the challenge of microcap investing still beckons, read on for ways to help eliminate the mistakes that diminish profits.
Mistake # 1. Investing for the
wrong reasons.
In contrast to the one right reason to invest - belief in a company’s potential due to its strong management, strategy and products – there are several wrong reasons to invest.
·
Seeking a quick profit. Let’s address the
“quick” part, first. This is not the place to invest this year’s vacation fund!
With many companies still in the research and development or market-testing
phase, microcaps can take years to pay off, if at all. As for profits,
microcaps do have excellent potential returns for a relatively low upfront
investment, but letting greed guide your decisions will only hurt your profits
in the long run. “One stock is not going to make you Bill Gates, and this is
not the lottery,” warns Dr. Boyce Watkins, Finance Professor at
· Hopping on the bandwagon. A colleague tells you of a stock she bought for pennies that has shot through the roof. It’s tempting to believe the share price will keep rising but, realistically, you may have already lost your window of opportunity to buy in and turn a profit. That’s not to say you should completely disregard the possibility – just check out the opportunity thoroughly to assess if there is still room to grow.
· Impulse shopping. You’ve just received reliable information on a stock that’s about to jump and there isn’t time to waste on due diligence. You snooze, you lose, right? Wrong. No matter how legitimate the source may seem, buying securities based on unsubstantiated advice and rumors is opening the door to fraud. Unfortunately, it’s all too easy for fraudsters to disseminate false information with the help of Internet bulletin boards, exaggerated press releases and paid promoters. Be on the safe side and do your homework.
· Relying solely on the advice of a broker you’ve never dealt with before. Be very wary of brokers pushing a specific stock upon you, particularly if you have no previous history working together. While brokers are on the whole trustworthy, all it takes is one unscrupulous broker to part you from your hard-earned cash. Boiler rooms are made up of brokers who can be very persuasive and charming but don’t expect to find them when the share price plummets.
Success in the microcap market requires a significant investment of more than just capital. Without the additional commitment of resources, knowledge, time and patience, you can expect more losses than profits.
Mistake # 2. Failing to do sufficient research.
An investment is only as strong as the research behind it. Ongoing due diligence has many functions, not the least of which is preserving your peace of mind during the lean months of a bear market. Research can also identify new opportunities and indicate the best times to buy in and sell down.
Unfortunately, reliable public information can be hard to find on microcaps. Small companies may be eligible for reporting exemptions with their regulatory authority, though they may opt to voluntarily file financial reports. When you consider that institutional investors, analysts and most of the financial media focus on larger cap companies, where can an investor find enough information to make a decision? Don’t worry -- it’s out there if you’re persistent and resourceful. And if it’s not – don’t walk, but run away from the security!
Your first priority: make sure the securities and your broker are legitimate. Your state or provincial securities regulator can provide you with information about the stock’s registration and your broker. Ask about any previous complaints filed against your broker and if there have been trading suspensions on this stock before. At the same time, you can do a check on the management of the company – have they made money for investors before?
Next, use all available sources, including the appropriate regulatory authority, the Internet, commercial databases and the company itself, to find financial information – current and historical – and the company’s prospectus. Read it all with a critical mind. Do the asset values seem realistic? Are there any unusual loans to employees? Are the executive salaries reasonable? Did the auditor certify the financial statements? Was there a change of accountants from year to year? Does the business methodology seem solid?
Don’t stop there! Check out the sales history, current
orders, and future order announcements. If a
When analyzing the data, you may see situations you’d steer
well clear of in more established companies that are not automatic cause for
concern in microcaps. For example, there may be a valid reason a microcap
company could be in the red, such as research and development, marketing or
asset build-out costs.
Despite the difficulty of finding reliable data, the benefits of research are indisputable. (For a start, it helps to avoid a number of the mistakes listed in this article.) When you can satisfy yourself that the company’s business plan, product or service and management are sound and poised for success, only then should you place the purchase order with your broker.
Mistake # 3. Holding for the wrong reasons.
While the previous mistakes are simple enough to avoid, here’s a tough one: recognizing when a stock has reached its peak or failed to perform. This requires ongoing maintenance of your portfolio and the ability to let go of pride and proprietary emotions.
Separating emotion from logic while assessing your portfolio’s performance can be very difficult. Dr. Richard Geist attributes it to a mental filter that awards more value to things you own. He states, “The investor who filters life through [this] organizing pattern will often have trouble selling a stock until it has retreated far below his or her original mental stop price. This is because the feeling of ownership makes the company seem more valuable than it actually is to an objective observer.”
Dr. Peter Cohan of
The successful investor is one who performs an objective assessment of the company’s status, divests his portfolio of poorly performing stocks and focuses on new opportunities. One trick is to schedule regular portfolio reviews in which you re-analyze your investments as though you were thinking of buying in for the first time. Is the stock undervalued or efficiently priced? Does the company have potential to expand profits? Routine check-ins are more likely to be neutral than an assessment after a negative event.
Mistake # 4. Selling for the wrong reasons.
Bet you saw this one coming, didn’t you? Well, if there are wrong reasons to buy and to hold, it stands to reason that there are wrong reasons to sell, too.
Take panicking over a sudden drop in share price, for example. Events that would have minimal effect on a larger company’s shares can make a dramatic impact in the notoriously illiquid microcap market. Unsubstantiated rumors, a general downturn of the market, a large block of shares sold by one investor – these can all cause a dive that has nothing to do with the underlying performance of the company.
The best strategy is to stay calm and investigate the reason for the price change and the status of the company itself. If you are satisfied that the company is still on track, be patient and trust in your decision. One of the realities of microcaps is that you often need to hold your position for years, even through a bear market, to see the ideal payoff.
Another error is selling your entire position before the price has peaked. Since it’s difficult to know exactly when that is, a trick many investors use is to sell half of their position when the stock doubles in price. This conservative strategy recoups the initial investment, leaving the remaining shares to be held for future profit without risk of loss.
Mistake # 5. Giving in to self-doubt.
Typically, small companies are more at risk of failure than larger companies. The sooner you acknowledge that some of your hot picks are not going to pan out, the better investor you’ll be.
Why? Because nothing is more valuable to a microcap investor than self-confidence – and, as a serious investor, you will make decisions that test it. Seemingly solid companies will sink like a stone and stocks you cut loose will skyrocket.
Dr. Richard Geist has found that, “while most unsuccessful investors become preoccupied with their mistakes, blaming brokers, analysts, company management or themselves, successful investors … reverse themselves quickly, attempt to understand where they went wrong, and tend not to repeat the same mistake again.”
Rather than berate yourself, learn from your mistakes and hold on to your faith – you’ll need it to weather the storm of naysayers, pushy brokers and that nagging inner voice during rough markets.
Mistake # 6. Allowing others to take advantage of you.
This one hurts. The lack of transparency in the microcap market creates an atmosphere conducive to fraudulent activity. The best protection is to educate yourself on common methods of fraud and dissemination of false information. A good source of information is the U.S. Securities and Exchange Commission at www.sec.gov.
Treat tips that come to you by way of e-mail spam, Internet
bulletin boards, newsletters and “accidental” voicemail messages with
skepticism. These are all common methods used to spread false information or to
push select stocks. By the same token, high-pressure sales tactics from any
broker should be an immediate cause for suspicion, particularly when it’s a
broker you’ve never dealt with before. Don’t let yourself be rushed into any
investment, regardless of how tempting or time-sensitive it appears to be.
Follow your typical methods of due diligence and invest only when you’ve
independently verified the information and are confident in the investment.
Other ways to protect yourself include verifying the current
trading price of a stock you wish to purchase at www.quotes.nasdaq.com
for
Opinions vary about what makes a solid investment opportunity, but knowledge of these common mistakes can increase your odds of success. “Darwinian’s law truly holds in this market.” Boyce Watkins advises. “The smart investors prey on the not-so smart, leading to massive wealth transfers.” The microcap market is no place for impulsiveness, shortsightedness or greed. On the other hand, strong analytical and research skills, patience and self confidence are the hallmarks of success.
Regardless of what drew you to the microcap market, only when you learn to enjoy the challenge and learn from your wins as well as losses, will you see your best profits.
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So where do you find
enough information to turn a good lead into a confidence-inspiring investment
opportunity?
Start by confirming the good standing of your broker, the company and its management with the following:
Your securities regulator, whose contact information can be found at www.nasaa.org
The state or province of the company’s incorporation (they may also have annual reports on file)
NASD Investor Alerts and NASD BrokerCheck, at www.nasd.com
The following sources provide general company information, press releases and financial statements (where filed), without a fee:
The EDGAR database for
The SEDAR database for Canadian securities, at www.sedar.com
Info TSX Venture for all securities listed on the TSX Venture Exchange, at www.tsx.com
www.pinksheets.com
www.bloomberg.com
www.investopedia.com
Some databases offer subscription or “pay as you go” service. Check the library or ask your broker for information from the following:
Dun & Bradstreet
LexisNexis
Moody’s Investors
Service
OTC Bulletin Board (basic information available for free at www.otcbb.com)
Standard & Poor’s
Finally, don’t overlook the obvious – the company itself.
While you may choose to do an Internet search to research the company or broker, utilize that information with discretion. Public service organizations and established companies who make a living from providing reliable information are far more trustworthy than an anonymous blogger or posting on a bulletin board.
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