By Joel Litman
In 1880, nearly half of the territory of the United States of America was an ungoverned free-for-all. You could make it rich. You could lose the shirt off your back. You could die trying.
Nine out of 10 Americans lived either east of the Mississippi River or in a state bordering it, or in the states along the Pacific coast.
The Plains states and Mountain West region were populated with people looking to make a name for themselves in a land not already picked over by society. Others moved to the region looking to be as far away from society as possible.
And others there didn’t want the eye of law enforcement looking down on them. So as much as the Wild West was viewed for its opportunity, it also became known as a land of thieves, hucksters, snake-oil salesmen, and outlaws.
Still, people kept going west for a reason. While there was risk, there was phenomenal opportunity, too…
• If you could protect your claim to a gold or silver mine, you could become another George Hearst, a Missouri farm boy turned gold, silver, and copper mining tycoon.
• Or you could become the next Levi Strauss, starting with a small supply store and building it into a clothing and supply giant.
• Or even the next Fred Harvey, starting with one restaurant along a transcontinental railroad and ending with a restaurant-and-hotel empire.
The reward appeared worth the risk for so many following the famous phrase, “Go West, young man, go West.”
For many of those who did strike it rich, they eventually became determined to instill some civility on these untamed fringes of society. And so they brought in their own lawmen – individuals like Wyatt Earp or the formidable Pinkerton Detective Agency with its impressive firepower and legacy.
Private security, paid for by those who wanted and needed it, drove the first semblances of real lawfulness into the West. They brought in that hired protection because it was decades until it was justified or worthwhile for government-driven law and order to be installed. After all, only about 10% of the population lived there. The economy was simply too small and the territory too large for so many years.
Incredible Economic Opportunity
Today, there’s a very similar land of economic opportunity… the land of microcap stocks is the modern “Wild West” for investors.
It is largely an unpoliced expanse. It’s generally not worth it for the financial lawmen to roam this land. Out of all U.S. public companies with a market cap of more than $5 million, 70% are smaller than $1 billion… roughly 5,400 out of 7,600.
Despite such large numbers, their market capitalization is a tiny sliver of the total investable size of the U.S. market. Those 5,400 companies make up only 3% of the total U.S. market capitalization.
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 for government officials to focus their time. Most investor wealth is far away from the Wild West of microcaps, and the enforcers’ focus is on protecting the bulk of U.S. investors.
Because of this lack of government attention, the microcap land is filled with shady individuals looking for a quick buck to take advantage of investors.
Hucksters like Jordan Belfort – made famous in The Wolf of Wall Street – and Jared Mitchell in 2015, one of Belfort’s disciples, convinced investors that microcap ForceField Energy was the future of LED technology, defrauding them out of hundreds of millions of dollars.
However, like the Wild West, the microcap universe comes with incredible stock market opportunities with thousands of percent upside.
However, like the Wild West, the microcap universe comes with incredible stock market opportunities with thousands of percent upside.
For context, there are currently 101 companies in the U.S. that have a market cap of $50 billion or greater. Nearly half of them – 47 in total – once traded as microcaps and could have been bought when they were more than 50 times smaller. That means any of those 47 companies could have provided more than 5,000% upside for an investor.
If investors could have confidence that microcap companies were not being fraudulent nor the management being outright thieves, there would be massive opportunities.
When small companies become big, there’s incredible upside. These include Netflix (NFLX), Salesforce.com (CRM), American Tower (AMT), and Bookings Holdings (BKNG).
Netflix was worth $115 million in 2002… it is now worth over $190 billion. If you’d invested $10,000 in Netflix in 2002, it would now be worth $16.5 million.
So the opportunity is massive… as long as you can avoid being sold snake oil.
The problem is that snake-oil microcaps abound. The SEC simply doesn’t have the time or manpower to protect investors from the next fraudulent ForceField Energy… at least until it’s too late.
So, how can investors have confidence to know which company will be the next Netflix, and which will be the next ForceField Energy?
A New Sheriff in Town
This financial Wild West needs a new sheriff to help protect investors – or in some ways, to help investors protect themselves.
Numbers are the language of business. There are two problems with the numbers that need to be dealt with before even thinking about the incredible opportunity in the land of microcap stocks.
1. First, an investor has to believe that the financial statements were prepared diligently. There is so little policing going on in this space that a management team could get away with not even reporting what is required.
2. In addition, even if the financial statements were prepared properly in accordance with generally accepted accounting principles (“GAAP”), successful investors must adjust those GAAP numbers to get to economic reality.
You can’t know what the market really thinks about a company if you don’t know the company’s real performance. You can’t know what a company is worth if you don’t know its true earnings and cash flows.
When it comes down to it, you simply can’t have confidence as an investor, especially in microcap land, while using traditional accounting standards.
The elite Wall Street pros understand that GAAP and international financial reporting standards (“IFRS”) are not the guideposts investors used to treat them as. They aren’t giving the right data to help investors understand what a company is worth, and what the real returns of a business are.
That’s why we at Altimetry have created a framework we call “Uniform Accounting” – shorthand for Uniform Adjusted Financial Reporting Standards (“UAFRS”). Under Uniform Accounting, we apply more than 130 different adjustments to bring the accounting statements to economic reality. We do this for 32,000 companies globally each week.
Using Uniform Accounting, you can start to see through the noise of the accounting statements.
This is especially essential in the microcap space, where no analyst coverage exists to guide investors through distorted financial statements.
But looking at the financial statements isn’t enough on its own. Without regulatory oversight in microcaps, you need to know whether you can even trust that what the company is reporting on its financial statements is reality.
Because of that, for every microcap company we analyze, we don’t just do Uniform Accounting. We go an extra layer deeper…
We look at metrics like a company’s working capital trends relative to revenue and allowances for write-downs to signal a company that might be understating expenses or overstating revenue trends.
Looking at metrics like this allowed us to identify and avoid nut company Diamond Foods (DMND) before management announced in 2014 it had been defrauding its walnut growers. The stock quickly cratered from $90 to $17.
We use this same framework to review each company we might recommend. But we don’t only check for potential accounting anomalies. We check for potential auditor and management anomalies and use a framework we call “Fundamental Forensics.”
We use tools like the Public Company Accounting Oversight Board (“PCAOB”) report on a company’s auditor to understand if an auditor has systematic issues for specific audit areas. The PCAOB is the auditor of auditors and reviews them every three years.
The PCAOB highlights key areas where auditors are deficient in its reports – like revenue recognition, review of internal controls, or transfer pricing – as well as areas of risk for anyone analyzing financial statements.
We can use these reports to identify if a company has a high-risk auditor, a reliable sign that the company is seeking out low-quality controls to management’s decision-making and reporting. We track these auditors over time, too, which gives us a list of problematic auditors to immediately tip us off whether to avoid a company or not.
By starting at the auditor, we can determine whether we can even trust the financials to start to perform our Uniform Accounting analysis.
And we don’t just stop with reviewing the auditors and the financials. We also always want to make sure companies have management teams that are focused on the right things for the business, are properly aligned, and have a strong history.
We’re looking at where management has previously worked, whether they have anything questionable in their background, 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 one of our clients was interested in investing in. While the business looked compelling at first, our analysis of management discovered they had been involved in several previous pump-and-dump schemes.
Worse still, 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.
A lot of people are scared away from investing in microcaps. But by creating a system focused on making sure the financials are real… the management team is aligned with investors… and the company’s real Uniform Accounting performance and valuation are compelling, we think we can help police the microcap space and help investors find the right opportunities for significant gains.
It’s something we’ve been trying to talk to our institutional clients about for years. But they typically won’t listen…
Three Reasons Why You Can Beat Wall Street
Institutional investors shy away from microcaps for three main reasons. And because of that, smart individual investors can make significant returns if they find the right ones before money managers start to pay attention.
1. Lack of liquidity
Institutional investors struggle to allocate capital in high-quality microcaps simply because they don’t trade enough shares. Fund managers would end up with oversized stakes in tiny companies.
Hedge funds have no interest in investing $10,000 in Netflix to make $13 million. They want to be able to invest $10 million and turn it into $13 billion.
Back in 2002, $10 million would have been almost a 10% stake in Netflix. And once a fund’s ownership crosses the 5% threshold of a company’s stock, it needs to file a 13D – a special filing with the SEC to designate itself as a material shareholder.
That means more paperwork. And the simple act of filing might prevent the fund from trading more in the company’s stock because it’s now viewed as an insider.
Even worse for the fund, it would take time to get invested in the stock. It couldn’t invest all $10 million at once, or it would blow the stock up, since the average microcap trades less than $10 million worth of shares a day.
That inability to get in and out of these stocks in quantity keeps institutional investors away from microcap stocks.
2. Near zero Wall Street coverage
Without analyst coverage, institutional investors have to do more work on their own to find out what’s going on with microcaps.
Fewer people focused full-time on the company from the sell side means there are fewer people to hold management’s feet to the fire and provide insight about industry dynamics.
That lack of a helping hand means many people won’t spend the time necessary to successfully invest in the space.
3. Microcaps fall outside of institutional investor mandates
Many institutional investors aren’t allowed to own microcap names because of their own internal rules.
Funds are only allowed to invest in companies that meet the criteria they laid out when they wrote their fund documents, meaning they can only invest in large-cap companies, mid-cap companies, and so on.
For most of them, microcaps are off-limits.
Some of the most compelling, moneymaking situations we’ve seen over the past 10-plus years have been in this space… But because our institutional clients can’t buy them, they tell us not to even bother talking about them.
That’s why we think the lack of institutional investor involvement in the microcap world presents an amazing opportunity for individual investors. The inefficiencies in this market give us a chance to buy the right companies with the right due diligence for incredible upside.
When these companies appear on institutional investors’ radar, they take off… like Vipshop (VIPS), a company that appeared on one of our institutional client’s radar. After crossing over a $500 million market cap, the stock was 580% higher in 12 months.
And the Entire Space is On Sale
While these stocks have massive upside if you can identify the right ones, right now is an even more exceptional opportunity for the discerning investor.
While the entire market has fallen due to the COVID-19 pandemic, small-cap and microcap stocks are off significantly more.
The small-cap Russell 2000 Index and the Russell Microcap Index have both dropped more than 20% from their February highs. The market has punished these companies even more than the more well-followed names in the market.
And that is part of the reason why we at Altimetry are trying to take advantage of this opportunity.
We think of it like a land rush in the financial Wild West. Individual investors have a rare opportunity to be the biggest winners… but only if they use the right tools to avoid the modern-day snake-oil salesmen and robbers along the way.
Professor Joel Litman is the chief investment strategist at Altimetry. He helps investors get it right when Wall Street gets it wrong by using a team of 90 accountants and analysts who sift through more than 8,000 publicly traded companies around the world.
If you’re interested in reading more from Joel, he publishes a free daily letter called the Altimetry Daily Authority – where he talks about the hidden accounting of companies that Wall Street misses, as well as his health experiments like intermittent fasting. You can learn more by clicking here.