Tuesday, March 07, 2006

Back Again

As you have no doubt noticed, it's been a while since I've written here. Why? Because the exercise was too predictable. With every e-mail that I received saying, "Hey, you ought to profile 'ABCD'!" I knew exactly what I would find. The same thing we always find. Capital raised. Capital gone. Fat and happy management. Bagholders left with worthless paper.

On multiple occasions over the past year, I have been confronted with the question, "Why are you doing this?" Implicit in that question, of course, is the presumption that I stand to gain from speaking out against this scam.

If anything, I stand to lose from speaking out. For I am a naked short seller and my activities are profitable because there is such an enormous population of misinformed, naive investors who continue to bid up the prices of certain shares to levels that any reasonable financial analyst would identify as "absurd". Why would I want to cull the herd for no financial gain?

The fact of the matter is that, even if the "naked short seller" scam were to disappear tomorrow, I would be able to find overvalued securities to sell short. Our markets are not homogenous; they're lumpy. There will always be sectors, and individual securities, that get ahead of themselves that will present profitable opportunities for short sellers, "naked" or otherwise. It doesn't have to cost me anything for novice investors to learn how to identify a crook trying to dump worthless stock on them using the "naked short seller" scam.

Enough of the spoon feeding. I'm not going to detail individual companies any more. I'm going to give you the tools to do it yourself. So if, after everything you've seen of these scams that seem to gravitate primarily to the Pink Sheets and the OTCBB that you still want to dip your toes into this septic, stagnant pond, then I would urge you to:


(This applies to securities of the major exchanges, too.)

As you seek investment opportunities in the micro cap sector, the
importance of reading and understanding SEC filings can not be over
emphasized. With the opportunity to enjoy fantastic investment returns in the
micro cap sector comes the risk that you will be victimized by "pump
and dump" artists. It is the information contained within a company's
10-K and 10-Q filings that can help you identify and avoid these scams.

Too many investors make their decisions based upon glossy, investor
relations materials, promotion-oriented message board posts, or websites
where investment fundamentals are either ignored or distorted.
Inevitably, the responsibility for determining whether or not a company's
finances merits your investment consideration rests solely with you. You do
not need an MBA or a CFA to do enough financial analysis to recognize a
company that does not deserve your hard-earned money.

Any investor in a company should be able to answer the following
questions before they put their first dollar into a company's stock:

(1) Where is the current market pricing this company?

(2) What does an investor get for this current market price?

(3) How has the company whose shares I might buy treated the capital
they've raised to date?

(4) How has the ownership interest represented by one share of a
company's stock changed in the past?

There is only one place to find reliable answers to these questions,
and that is in a company's current 10-Q's and 10-K's. So the first rule
of any investment in a micro cap is to demand that the company be
current in their filings. Yes, there are some non-filing companies whose
shares have made money for investors, but as a group, this population of
companies represents a very, very bad bet. No matter how enticing
their promotional literature may be, if you're buying shares of a company
that is not current in their SEC filings, then you're buying a
proverbial pig in a poke. You will find plenty of excellent, speculative
investment opportunities in the sphere of companies whose SEC filings are
current. There is never, EVER an excuse for you to invest in a company
that is in a non-filing status. As an old acquaintance once said,
"There will always be another bus coming." Make sure the one you get on has
tires, seats, and a windshield.

So your first task, as an investor, is to get some SEC filings. If
you're reading this, you have the only tool you need (a web browser) to
get them. Go to www.sec.gov. Navigate to the EDGAR site. Search for
your company. Get as many of their 10-Q's and 10-K's as you can. It
will take you all of ten to fifteen minutes to accomplish this first task.

"Where is the current market pricing this company?"

As I watch novice investors, one rhetorical question I see all too
often goes along the lines of, "It's only 20 cents. How much downside can
there be?"

The downside of all stocks is the same. You can always lose 100% of
your investment. If you buy shares in a 20 cent stock and it goes to
zero, you lose all your money, same as if you buy a 20 dollar stock and it
goes to zero. Nominal price alone is not an indicator of a stock's
downside risk.

One of the most important numbers to find in your most recent 10-K or
10-Q is the fully diluted number of shares the company has outstanding.
Take this number and multiply it by the current share price. That's
where the market is currently valuing your investment candidate. And
your task as an investor is to decide whether the current market price is
justified given the rest of the information we will find in these K's
and Q's.

"What does an investor get for this current market price?"

Your first stop on a company's 10-K or 10-Q should be at their balance
sheet, specifically, the asset side of their balance sheet. What kind
of "stuff" does your candidate own? Certainly, you'll find some cash
and other "current assets". One "current asset" you should pay
particular attention to is "inventory". Every business obviously needs
inventory, but the value of the inventory on the balance sheet doesn't
necessarily reflect the value of the inventory in the real world. It is a
category that is capable of being abused, where inflated values for
"inventory" may inflate the book value of the company you're examining. As
you evaluate this number, consider how their inventory compares to their
quarterly gross revenues. An inventory figure that is unreasonably
high relative to sales may be indicative of stale, over-priced inventory
that can't be sold at prices that would be profitable.

Other "assets" you should very carefully scrutinize are "goodwill",
"prepaid expenses", other intangibles, and, especially, loans to officers
or affiliates. As an investor, you should not be very tolerant of
managements that use your company as an ATM card.

While the market value of any company should always be greater than the
sum of all its tangible assets, it should set off alarms in your
analysis when you encounter a company whose market valuation is many times
greater than its "book value", "book value" being its total assets less
its liabilities. A company's management is supposed to take the assets
at its disposal and engage in activities that create value for
shareholders. But when a company's management or its promoters tries to tell
you that they're capable of taking their asset base and creating value
that is 10, 20, or 100 times greater than their assets, you should
approach the enterprise with a great deal of skepticism. Or, better yet,
you should take your money and find a better investment opportunity.

"How has the company whose shares I might buy treated the capital
they've raised to date?"

One of the best indicators for how management is behaving towards its
owners is in the Income Statement portion of a 10-K or 10-Q. Companies
don't make their investors money by leaving their capital in a bank
account to earn interest. That capital goes to work. As a prospective
investor, you need to ask, "Where does management put my money?" The
goal of most micro cap companies is to mature into small cap, mid cap,
and, with luck, large cap companies. The label that most frequently gets
applied to these micro caps is "development stage".

"Development stage" implies a number of things. It implies that you
should not have any immediate expectations of appreciable sales or
earnings. Applying an earnings benchmark to a development stage company
completely misses the point of what it is these companies should be doing.
"Development stage" implies that management is working on building a
resource. Even without sales or earnings, an income statement is still a
good place to see how management is going about building you, the
prospective owner, a resource. Therefore, when you look at the income and
the cash flow statements, you should see a lot of money allocated to
capital expenditures or research and development (R&D). What should steer
you away from any development stage company is an inordinant amount of
money being wasted on general and administrative (G&A) expenses. All
companies, regardless of size, need to spend money on lawyers,
accountants, and office managers. And, for better or for worse, a micro cap is
going to spend a proportionately larger amount of money on G&A than a
larger company. But if you see more than a third of a company's
operating budget being wasted on G&A, close the file and move on to your next

"How has the ownership interest represented by one share of a company's
stock changed in the past?"

Small, development stage companies typically dilute their common stock
as they go from a company with a concept but no sales to a producing
firm with sales that, hopefully, will generate profits for its owners.
Along the way, for good reasons, managements may need to issue more
shares to raise additional capital to fund their development. However, as
a prospective investor, you should be acutely aware of how much of your
ownership gets diluted away as your company goes from development stage
to production. There is no rule of thumb for what constitutes a
reasonable amount of dilution and what would be excessive. Yet it's an
attribute that should not escape your attention. If you are evaluating a
company that has diluted its ownership by 50% over the past year, you
should expect to see some sort of dramatic improvement in the company's
balance sheet or progress made in terms of R&D spending or capital
expenditures. But if you see massive dilution without improvement in
financials or progress made towards key production milestones, then you should
strike the company off of your list of prospective investments and
begin evaluating the next candidate.

This little guide is not intended to turn you into a master securities
analysis. These simple screens will not help you determine whether a
company might be 10% undervalued or 10% overvalued. They are simply a
set of guidelines for determining whether a company deserves your
consideration at all.

The micro cap world is full of uncertainty. That's what makes it a
place with wonderful opportunities, but also a place where less than
reputable managers and promoters can victimize investors. If you are going
to invest in this sector, you must keep in mind that even a good
company with honest, hard-working management may fail for reasons beyond the
control of management. Careful financial analysis will not guarantee
you success with investments in the micro cap arena, but you can at
least protect yourself by weeding out those companies and managements that
never deserved your investment capital in the first place.

James R. Brownfield
Sarasota, FL


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