If you’ve been investing long enough, you probably made a few investments that didn’t turn out the way you expected. Sometimes things happen that are just out of your control, things that you could barely have foreseen. Other times, you probably just made a bad decision. Making mistakes is part of the learning process, and it’s a great way to become aware of some common pitfalls to avoid next time.

Today I want to share some of the common red flags I see over and over in the microcap space. This list is not exhaustive, and not all red flags mean that the company is a bad investment. If you analyze a company and find absolutely nothing to worry about, there’s a good chance other investors think the same and the stock will not be a bargain. To find great investment opportunities, you need to be comfortable with some level of risk (i.e., red flags). The first step, though, is to be aware of the red flags. Here it goes:

 

1) Poor Management Track-Record

With microcaps, you are often betting on the jockey more than the horse. It is utterly important to invest in a management team that is competent and honest. To gauge competence, I often look at the previous track record. If management has been destroying shareholder value (burning money) for many years and there’s no end in sight, I don’t like the odds of that changing.

If the CEO doesn’t have a long history with the company, I take a look at his bio and previous achievements. I’m always a bit skeptical when I read vague bios where the previous achievements look amazing, but there’s really no way to verify anything: founded and sold companies for undisclosed amounts, no names of previous employers, etc.

I also like when management’s interests are aligned with mine as a shareholder. I want management with a low salary and a large equity position. The other way around is a red flag.

 

2) Poor Capital Structure

As an equity owner of a company, you are essentially at the lowest rank in the capital structure. If anything goes wrong, lenders and other creditors will likely recoup their money before you do. That’s why it’s important to pay attention to the capital structure.

I try to avoid companies with high amounts of debt, especially when it’s high-interest rate debt (I consider over 12% to be pretty high). Some lenders will also ask for additional equity compensation such as shares or warrants based on the amount of money loaned. The microcap space is littered with companies that took on very expensive debt, couldn’t repay, took on more debt and eventually went bankrupt, with the lender essentially owning the whole company.

 

3) Poor Share Structure

You might think there’s no difference between a company with 10 million shares at $2.00 or one with 100 million shares at $0.20, but there is. The number of shares outstanding shows you how management treats their shares. If they issue them like there’s no tomorrow, you should be careful because you will likely get diluted in the future. You want to invest in management teams that treat their shares like gold, and a clean share structure with a low share count and few or no options and warrants is a good example of that.

 

4) Too Much Stock Promotion

Generally, good companies don’t need to promote themselves too much because investors will find them anyway. Why can’t you find companies trading at a P/E of 5 or less on a regular basis? Because investors find these companies and bid them up. I’m not a huge proponent of the efficient market theory, but I believe the market is fairly efficient most of the time.

Companies that spend a lot of money on stock promotion do it because they don’t have a real business yet (and maybe never will).

It’s okay for public companies to maintain some level of investor relations. I’m not talking about companies that have one investor relations (IR) firm and attend two or three conferences per year. I’m talking about companies that have three or four IR firms, can’t sign up fast enough for every conference, spend huge amounts of money on promotional articles and videos, etc.

How much is too much? Well, that’s a good question and unfortunately, I don’t have a rule of thumb for that. Not all companies disclose these promotional expenses on a separate line in the financial statements, which makes it hard to really know. What you need to think about is this: the more you hear about a company, the more people are probably also aware of it and the less likely it is to be undervalued. The goal is to find undiscovered companies, and they don’t pay for promotion!

 

5) Use of Buzzwords

It seems like every year, there’s a new investment ‘’theme’’ that takes the microcap world by storm, and suddenly all companies who were going nowhere decide to pivot their business model to take advantage of this new fad.

You know what I’m talking about. Companies that leverage Artificial Intelligence, machine-learning and Big Data to revolutionize the cannabis industry by developing a cutting-edge and best-of-breed blockchain technology to capitalize on the new paradigm shift.

Enough said.

 

6) Related Party Transactions

In all financial statements, companies are required to disclose the transactions that were done with related parties. That means directors, officers, family members, or companies controlled by any of them.

All companies have some form of related party transactions, and it’s generally not a big deal. But sometimes it is.

What you want to avoid are companies that have very significant amounts of related party transactions. An example would be a company buying almost all its inventory from a supplier controlled by an insider, or generating most of its revenues by selling to a distributor owned by an insider. When that’s the case, there is a risk that the economic profits of the business are diverted to an outside entity. Let me give you a quick example:

Company A is a public company that manufactures a product for $50 that it can sell for $100 to the end customer. Instead, it sells it for $55 to a distributor controlled by the CEO, which then resells to the end customer for $100. Who reaps all the profits? Not the public company shareholders.

Again, not all related party transactions are harmful and not all management teams are dishonest. It’s just a red flag to be aware of. Use your judgment.

 

7) Low Conversion of Net Income to Cash Flows

Accounting rules can be quite complicated for the layperson, and I’m not going to dive into too many details here. What you need to know is that there are many ways for management teams to manipulate the income statement (by deciding how they record revenues, how they depreciate their assets, how they assess if their accounts receivable are impaired, etc.).

What they can hardly manipulate is the cash flow statement. How much cash goes in and out of the bank account is not subject to any interpretation, it is what it is.

When you look at the Statement of Cash Flows (in the financial statements), pay attention to the cash flows from operating activities. In general, cash flows from operating activities should be higher than the net income reported on the income statement, because the cash flow statement adds back all the non-cash expenses (depreciation, amortization, stock-based compensation, etc.) that were deducted on the income statement to arrive at the net income.

When operating cash flows are lower than net income, it’s probably due to movements in working capital. That means there were more cash outflows than inflows related to inventory, accounts payable and accounts receivable. That could mean the company is having troubles collecting money from its customers. That could also mean the company is inflating its sales, which creates higher net income but doesn’t convert to higher cash flows because the company is not able to collect the cash.

 

8) Fantastic Financial Projections

Did you ever see a revenue forecast you didn’t like? Most company executives will paint a rosy picture when presenting their company to investors. Management teams of young companies without much of a track record, such as most microcaps, can forecast all sorts of good things in the future and it’s easy to believe them.

And you know what? Sometimes they will be right.

But that doesn’t mean you should let your guard down. When I see an investor presentation where the company projects going from $0 in revenue to $100 million in three years, the alarm goes off in my head. It just doesn’t happen very often. You need to understand that businesses take time to scale up, and all sorts of operational challenges will come along the way.

When forecasts look too good to be true, they probably are. Unless the company’s bold forecasts are backed by a solid track record of execution in the past, I will generally make my own assumptions and avoid relying too much on management’s numbers.

Will I miss some companies that actually make it? Sure. But what I’ll also miss are the 95% that don’t live up to their lofty forecasts. The bottom line is that you need to be skeptic about forecasts to determine if they make sense or not. When there’s no way they can make sense, that’s a red flag.

 

Wrap-up

Warren Buffett was famously quoted for saying:

“Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”

Being aware of red flags and trying to avoid situations where you could lose money is paramount, especially with microcaps. Companies don’t get scrutinized as much as mid or large caps, and there are more pitfalls than anywhere else for individual investors.

Always remain skeptical and use your judgment.

Be careful out there!

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