Five Small-Cap Investment Traps:
Don’t Put Your Money Down a Rat Hole

Each morning my inbox contains a couple of notes from regular followers of Confident Trader, usually with questions, sometimes with counter-arguments and sometimes I actually receive some good advice from my readers. You can teach an old dog new tricks so keep those emails coming. I read every one with you in mind.

Which gets me to the subject of this edition of Confident Trader – common traps that await the self-directed trader – the fledging independent trader who’s “open to suggestion” and who relies on the advice of “experts” s/he watches on Fox News every Saturday morning, or on Cavuto each afternoon.

These free-thinkers recognize the importance of tending to their own nest eggs. However, based on the questions that float over my digital transom, there are a lot of people out there about to fall into common pitfalls – pitfalls from which escape is impossible. Here’s my list of warnings, delivered with the sound  knowledge of the small- and micro-cap market sectors.

You’ve been warned.

Pitfall # 1: The Initial Public Offering (IPO)
When a privately held company goes public, it issues shares of stock for the first time. These IPOs often look like tempting ground floor opportunities. They aren’t.

“It's a Can't Lose Stock.” Wanna bet?

More IPOs drop in value than increase after 90 days of market trading. Even top, brand names take a hit once they go public. However, over time a good company will work its way to the top so it’s not the “newness” of the IPO that concerns me (though it usually does) it’s the means by which IPOs are sold.

How much is a company worth? Analysts determine the value of a new public company and set the IPO price. But here’s the thing. IPOs are underwritten (sponsored) by the large money-houses – the big financials. So, the large caps that underwrite these IPOs have a vested interest in selling them.

In many cases, the underwriting firm will offer its institutional investors a lower buy in. So, when you buy an IPO through your independent broker, (1) that broker earns a higher commission on the sale of those IPO shares than s/he does on the sale of 100 shares of IBM because it’s a tougher sale, and (2) you’re paying a premium on per share price over what large, institutional investors pay.

And once all of the small investors (you) have bought in and the pundits have talked up the IPO’s share price, the big guys can dump their holdings for a tidy little profit.

When large, established companies go public, the IPO shares go fast to large, institutional investors. The price you pay will be higher and that’s not fair and that’s why I view IPOs with a skeptical eye. (Turns skeptical eye).

Pitfall #2: Pink Sheets
Well known stocks are listed on the NYSE, NASDAQ or some other well-recognized (reputable) exchange. But in order to be listed, these companies must meet stringent exchange and SEC regs. Not so with stocks listed on the daily Pink Sheets.

These are penny stocks. Some are traded on the OTC Bulletin Board (OTCBB). Some are traded directly between stock holder and the investor relations office, while others are bought and sold by brokerages that specialize in this niche market. So, why not take a flyer, right?

The stocks of companies you find listed on the daily Pink Sheets fall in to one of two categories: (1) they’re companies that have been delisted from a larger exchange because of financial problems or even “bookkeeping irregularities,” or (2) they’re companies that are undercapitalized and need money for R&D, market expansion – to take the company to the next level. You hear that a lot in press releases and unsolicited faxes touting the next big thing.

Pink Sheet stocks are VERY risky because they are, indeed, start ups or companies hemorrhaging red ink. So, it’s a lot easier for me to see share price increase a buck per on a stock selling for $60 a share than it is on a stock selling at $0.03 a share.

Final warning. Stocks traded on major exchanges are highly-regulated to create a level playing field for people like you and me. At least that’s the way it’s supposed to work in theory.

In the penny stock market, oversight is far less stringent, which only adds to an already high-risk bet. Look, if you’re into gambling, penny stocks can be fun if you never invest more than you can afford to lose. It’s like playing roulette at the casino. But as part of a long-term growth portfolio, no way. This is a sucker play 100% - oh, and you’re the sucker.

Pitfall #3 Factoring, FOREX and Pork Bellies
You can find a full range of investments – for example, buying account receivables from manufacturers and even municipalities. Buy the $4 million delinquent tax book for $2 million. The town gets much needed cash, eliminates an expensive headache and the company that bought those receivables can go after deadbeats with pit bulls if they want to. There are a million ways to make money. There are a million ways to lose money.

So here’s a rule of thumb: if you can’t explain the “deal,” and why you’re buying, in a single, short sentence – don’t invest. Well-intentioned, independent investors read an article on factoring or the raising demand for bacon. Fashioning themselves far-thinking investors, they move into investments they don’t fully understand. Do you have a clue what a landlord does? If you don’t, avoid real estate investments for rental income.

This means avoid tips from everyone – pundits, gurus, chartists, contrarians, listen, learn – but don’t buy into something that you don’t understand.

Ask the person recommending this “opportunity” to synthesize the prospect down to a single sentence. If s/he can’t do it, grab your money sacks and head for the door – like now. 

Pitfall #4: Email Spam and Web Fraud
I filter most of this garbage but every once in a while a piece of email spam gets through touting a stock. Forget it. Email spam pushing one stock or another employ the same boiler room tactics as cold callers pushing a new stock on you. In two words: Don’t bite.

I’m going to put internet fraud under this heading as well. There are numerous micro-and small-cap schemes using web-based resources that proclaim the seller has inside information. Okay, first, insider trading (inside information) is illegal and second, what idiot would give away a “sure-thing-can’t-miss-100%-guranteed-to-double-your-money-in-six-months?” Wouldn’t you keep your insider info secret? Of course you would.

Pitfall #5 Paid Stock Promoters
These companies are more like marketing and advertising agencies than brokerages. They publish dubious press releases but very little information about the company itself.

There are two kinds of companies that don’t have to file a lot of paperwork under SEC regs. “Reg A companies are those that raise $5 million or less in a year. Reg A companies only provide a financial statement. These companies raise money but, all-too-often, they disappear into the night – companies like Partners Oil or Cherry Electric – two small companies that took me to the cleaners early in my investing career. Fortunately, I learn from my mistakes.

Reg D companies are also exempt from certain filings. These companies are exempt from registering transactions with the SEC if the company raises less than $1 million through stock sales within a 12-month period. These micro-minis also don’t have to register transactions of less than $5 million if they have 35 shareholders or less. In other words, Reg A and D companies are smaller than micro-caps and come with all the risks associated with a new company that may or may not be under-capitalized because company information doesn’t have to be registered.

In either case, I avoid Reg A and D companies altogether and recommend that you do the same. These businesses are untested, the business model is untested and you don’t know much about the company’s management so, basically, with these small companies, you really are buying a pig in a poke (whatever a poke is).

In any case, these “exceptions” to the reporting rules are often pumped by stock promoters, via email spam, infomercials, unsolicited snail mail and other means.

There’s nothing illegal about promoting a stock – especially if you reveal how much you own. If you’re inflating share price for your own gain, well, that’s illegal unless you tell the reader that you have a position in the company. Most stock promoters won’t tell you what interest they have.

Final word: avoid stock promotions like the Ebola virus. Always consider the risk versus reward equation before taking a position. And be sure you understand what you’re buying before you send off that check to an unknown broker 12 time zones across the globe.

In other words, be smart. Okay?