Taming the 'Wild West' of Microcaps

Editor's note: Investors today need an edge more than ever. Right now, at our corporate affiliate Altimetry, Joel Litman predicts that a specific group of microcap stocks is poised for 500% to 1,000% upside... Yet most folks won't even think to look at this part of the market. In this essay – adapted from a July 2020 issue of the Stansberry Digest – he explains the exact approach to avoid the duds and invest in these stocks the smart way.


The land of microcap stocks is the modern "Wild West" for investors...

It's a largely unpoliced expanse. It's generally not worth it for the financial lawmen to roam this land. Out of all U.S. and Canadian public companies with market capitalizations of more than $5 million, 65% are smaller than $1 billion... roughly 4,500 out of 7,000.

Despite such large numbers, their market caps are just a tiny sliver of the total investable size of these markets... only 4%.

No wonder the U.S. Securities and Exchange Commission ("SEC") has no time to fully police this space. The territory is too large, and the dollar value too small.

Because of this, the microcap landscape is filled with shady people looking to make a quick buck by taking advantage of investors...

These include hucksters like Jordan Belfort, made famous in The Wolf of Wall Street... and Jared Mitchell, one of Belfort's disciples, who convinced investors that microcap ForceField Energy was the future of LED technology, defrauding them out of hundreds of millions of dollars from 2009 to 2015.

However, like the Wild West, the microcap universe comes with incredible stock market opportunities with thousands-of-percent upside. Let me explain...

For context, 189 companies in the U.S. and Canada have a market cap of $50 billion or greater.

Over half of them – 99 in total – once traded as microcaps. You could have bought them when they were more than 50 times smaller. That means any of those 99 companies could have provided more than 5,000% upside for an investor.

The opportunity is massive... as long as you can avoid buying snake oil.

So, how can investors be confident in which microcap companies will succeed... and which will become the next ForceField Energy?

Numbers are the language of business. So we need to deal with two numbers problems before even thinking about the opportunity in microcaps...

First, an investor has to believe that the financial statements were prepared thoroughly. There's so little policing in this space that a management team could get away with not even reporting what's required.

Second, even if the financial statements are aligned with generally accepted accounting principles ("GAAP"), successful investors must adjust those GAAP numbers to get to economic reality.

When it comes down to it, you simply can't have confidence as an investor, especially in microcaps, while using traditional accounting standards...

The elite Wall Street pros know that GAAP standards aren't the guideposts that investors treat them as. These numbers aren't giving the right data to help folks understand what a company is worth and what the real returns of a business are.

That's why at Altimetry, we've created what we call "Uniform Accounting" – shorthand for Uniform Adjusted Financial Reporting Standards ("UAFRS").

Under Uniform Accounting, we make more than 130 different adjustments to bring the accounting statements to reality. We do this for 25,000 companies globally each week. It helps us see through the noise of "traditional" accounting.

But looking at the financial statements isn't enough on its own. You need to know whether you can even trust what the company says in its financial statements.

Because of that, we don't just do Uniform Accounting. We go an extra layer deeper...

We look at metrics – like working capital trends relative to revenue and allowances for write-downs – to expose companies that might be understating expenses or overstating revenue trends.

For example, this helped us avoid nut company Diamond Foods. Management announced in 2014 that it had been defrauding its walnut growers... The stock cratered from $79 to $14.

We don't only check for accounting anomalies, though. We also look at a company's auditors using a framework we call "Fundamental Forensics."

By starting at the auditor, we find out whether we can even trust the financials before we start to perform our Uniform Accounting analysis...

We use tools like the Public Company Accounting Oversight Board ("PCAOB") report to see if a company's auditor has repeated issues. The PCAOB is the auditor of auditors and reviews them every three years.

These reports help us find out if a company is using a high-risk auditor. That usually means the company is looking for low quality controls. We track these auditors over time, too.

Finally, we always want to make sure companies have management teams that are focused on the right things for the business...

We're looking at where management has previously worked, whether they have anything questionable in their backgrounds, and any other red flags. We want to make sure they don't have a legacy of selling snake oil.

In the early 2010s, we did this exact type of analysis on a mobile digital-advertising company that one of our clients was interested in. While the business looked great at first, our analysis of management discovered they had been involved in several previous pump-and-dump schemes.

Worse, our research on the company found that the CEO's girlfriend's home was listed as the company headquarters. By researching management, we were able to give our client the right advice to avoid the company.

Tomorrow, I'll explain more – including how the pitfalls in the microcap space can turn to your advantage...

Regards,

Joel Litman

Editor's note: Joel was able to call the bottom of the 2020 crash... with a series of stock picks that could have doubled your money – or better – 10 different times. In fact, the average gain on all his recommendations that year was 123%. So when he recently said, "The window has re-opened for this rare stock," our team at Stansberry rushed to get you the full details. If you've lost money this year, make sure you get the story here.

Further Reading

"The microcap space is a compelling investment universe," Joel writes. But microcap stocks aren't interesting just because of their short-term potential. As this success story shows, they can go on to become household names in their fields... Get the full story here.

Under conventional accounting metrics, it's hard to explain how Amazon went from a tiny company to a dominant e-commerce giant. But by stripping away the market distortions, Joel reveals why this behemoth continues to grow... Read more here: Amazon's Profitability Is an 'Iceberg' Under the Surface.