Bill Cara’s Mission 5x5, #2

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Today, while most of you look to the Nasdaq Exchange for its large-cap 100 listings, I see it as a professional marketplace for the type of highly speculative small- and micro-cap companies that have been served for years by Canada’s junior stock exchanges where, incidentally, I started trading in the 1960s.

Having been awarded my university’s highest business school award and the Wall Street Journal Student Achievement Medal, I thought I knew how to trade. The Vancouver Stock Exchange soon taught me how little I actually knew. During those challenging years, markets and regulators came to grips with risk-taking entrepreneurs whose dreams, hopes, and emotions beguiled retail investors who shared the same mind-set. Like me, they had enough experience to play the game but not enough to win.

There were several developments at that time that put small company investment bankers like Peter Brown and the Canadian venture exchanges on the world stage, and provided me with the reasons I needed to stay in the game:

(i)    People quickly saw that professional entrepreneurs vastly out-numbered the wasters and fraudsters.

(ii)   Smallish financings often led to the creation of major corporations.

(iii)   Institutional investors soon got involved in 2nd, 3rd and 4th stage financings, and

(iv)   The Toronto Exchange then bought out the speculative junior exchanges, giving their stakeholders the credibility to flourish worldwide.

I survived those years. In fact, I learned the game – upon occasion, the hard way. I played it to win. I thrived.

Today, I go hunting for 5x5 returns – five times capital growth in five years – in small cap companies. That is a tall order, but the Nasdaq exchange is definitely the place to find the next mega-caps such as Apple (AAPL) and Oracle (ORCL). And, by the way, note that these companies always seem to have one essential ingredient: a star promoter.

It’s not all wine and roses, though. It can be a nasty business. Writing about my concerns could consume this entire article and more, but here’s a brief list:

  • Questionable legitimacy of so-called audited financial statements and other corporate and insider personal filings
  • Wash trading by promoters to make the public think there is lots of liquidity when there is virtually none
  • Trading by broker-dealers who are “in bed” with the promoters, having done their Reverse Take-Over (RTO) deals and maintaining the initial shareholder lists
  • Broker-dealer networks that manipulate market prices as they trade up and down The Street – not with the public, but with themselves and in alliances with certain helpful newsletter writers
  • Naked shorts that never settle, flooding the market with an endless supply of counterfeit securities positions, expecting the company to end up bankrupt so that the fraud is never uncovered
  • Illegal transfer to offshore corporations of gains by insiders, leaving tax deductible losses onshore
  • Less than objective sell-side analysts or so-called analysts hired by broker-dealers and promoters who pump out misleading information, including promotional information sent to the wire services as “news”
  • Newsletter writers who also work as investor relations specialists for payment in their employer’s stock
  • Purposefully deceptive trader tactics that serve only to play the fear and greed game, with no regard whatsoever about the negative impact on the corporation, the promoter or the shareholders
  • Broker warrants that backstop any losses from inadvertently shorting stocks of companies that grow their share prices legitimately.

The overall concern I have is that each of these points typically represents a fraud, but is awfully hard for regulators and criminal authorities to prove. So, much of it falls between the cracks and is forgotten. Such egregious behavior is over and above mundane matters like promoters who use the proceeds of corporate financings for personal use, and that kind of thing.

Any more of this talk and I might scare you out of trading this important marketplace. So, why play? It’s simple:

  • Regulators are a whole lot more experienced and informed and better connected than they were say 25 years ago. Putting aside a few high profile cases like Madoff they do ferret out the bad actors, while it may take time and your help.
  • The Internet makes the small-cap world a very small place indeed, and virtual networks of due diligence-oriented investors are growing much faster than the numbers of listed companies.
  • The best investigative reporting today comes from alternative media, people who blog like you and me and the marketplace is now global, so every candidate for risk capital is run through a rather stiff gauntlet.
  • If you can avoid the pitfalls, the financial rewards can be huge. Plus, there is the satisfaction of helping entrepreneurs create and develop worthy products and services, which employ workers and build wealth. Honestly, for me the personal satisfaction is even greater than the monetary.
  • Legitimate businesses use the capital markets to grow, in some cases, into very large corporations. 

The one thing about small-cap stocks that separate them from the rest is that they take a lot of time to research. But, if you don’t do the homework don’t do the trading. Otherwise, expect to pay for the most costly education in the world. I did, and that was after I had earned four university degrees and professional designations in economics, finance and accounting.

I hope to spare you much of that, but you can only learn the game by actually buying and selling these stocks, which means suffering losses. It’s unavoidable. I have already proven this case to you.

Our two small-cap portfolios

The 20-stock Advanced Market (mostly US companies0 small-caps jumped to a gain of +3.490%; but the Emerging Markets 20-stock portfolio dropped -1.292%. The week’s net, however, was a gain of +1.011%, which – although all unrealized gains – was a nice win for one week.

I still hold all the same stocks I started with despite taking huge losses in two of them of -18.3% and -17.6%. I might have put stops in place but decided against it because:

(i)   I don’t want to motivate the brokers handling the order flow to take me out.

(ii)  My corporate fundamentals model ranks those two companies #4 and #14 best in a highly filtered sub-group of about 80.

(iii)  I’m here to learn about these companies, not scalp prices. Besides this week I also had one stock up +26.7% and another up +18.6%, and I didn’t sell for the same reason.

Whether it’s large-, mid- or small-cap stocks, the prices are sensitive to various influences and you need to get in-sync with these drivers. This takes time. Traders deal in mass psychology issues, and it’s impossible to immediately figure out the style of the players you are trading against. It often takes me from 3 to 6 months from the time I start trading any particular stock to get in the rhythm needed to know when it is over-bought and the right moment to lighten up. And selling a stock doesn’t mean the end. If you happen to like the company behind the stock you just sold, you should continue monitoring to see if it comes back to a price that would entice you to buy again. Usually the technical indicators give you lots of that information, but not always.

Trading small caps is an emotional (optimism/pessimism, greed/fear) experience, but emotional players are usually losers. Successful trading takes patience. Respect the intelligence of your fellow traders. Learn the dance. Let prices come to you. Yes, these are the things I blog about. Trading is trading.

I was going to discuss some of the individual stocks this week, and also re-publish relevant text from my book Lessons From the Trader Wizard. However, I was asked to keep these articles short, so I’ll cut it off and get back to the trading desk. It’s been a good morning.

Have a profitable week. I’ll return next Monday in the noon hour with insights and notes on some of the 40 companies I’m invested in.  



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks

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