NOTE:  This Trading alert was originally posted at Ritholtz Research & Analytics on FRI 9/8/2006 3:00 PM EDT by email.

This is posted here not as investing advice, but
rather as an example of a trading call for potential subscribers. We
expect to post future advisories in a similar manner — after the call,
but in the correct chronological location on the blog.

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Q. You mentioned Micro-caps
recently — Why? Some time ago you
showed a chart showing that the market is shifting to big caps from small caps
– why even look at smaller capitalization stocks?

A. I look at Micro-caps for a
few reasons: 1) They are not well covered by Wall Street, and therefore
opportunity exists; 2) They offer large potential upside; 3) I have had some
pretty good luck with them over the past 10 years.

 

My prior mention of Micro-caps
generated a surprisingly large response; This alone makes me nervous. Since subscribers
have insisted, I am sending out these details about the pros and cons of these
speculative issues.

There are a few small caps I am watching, and a couple I already own. Depending upon how these develop, I may end up recommending these –  HOWEVER: 

As a rule, I do not particularly
like Micro-caps. They tend to be too thinly traded. They very often do not
comply with reporting rules or Sarbanes-Oxley. They are heavily promoted, by
both paid IR people and other less savory characters. My general take has been
that outlandish percentage of micro-cap situations will eventually go to zero.

But as I mentioned last time,
I’ve had a pretty good run with a handful of these. In particular, I like special
situations
. I want a good combination of factors – I look for insider
ownership, strong intellectual property and a good patent portfolio, clean reporting,
strong management and most important of all, a positive catalyst – a good story
that can flower into a great stock.
These incidences are
exceedingly rare. Because of that infrequency, I have developed caveats about
speculating in these companies:

1) Think
of them as STUBS – an option that doesn’t expire. That means you only purchase in
smaller lots than your stock buys. If you typically buy equities in $50k blocks,
then you would only buy $5-10k worth; If its $10k, then you buy $1-2k.

2) Due
to the combination of low prices and high volatility, stop losses do not really
work on these. Swings up and down tend to stop you out prematurely. Without a
stop loss, it is my working assumption that my purchase will get cut in half;
Therefore, I only buy smaller amounts.

3)
I would rather average up – buying more when the stock is working – than
average down. I hate to add to losing positions;

With those caveats in place,
here is a discussion of some winners and losers I have had in this micro-cap
space. These are simply war stories to
give you an idea of how these can trade. I’ve never put together an audited
track record of my special situations buys – I’ve had plenty of losers to go
along with my winners.

Even the micro-cap big winners
have had dangerous track records. These are not recommendations, they are war
stories:

Visual
Data (VDAT):
  In the late 90s, dot com
madness, a firm I worked at had a banking relationship with Visual Data; The
firm had an online library of videos; They were tryinjg to commercialize the
space long before broadband.

The
stock was stuck under $2; I discovered a prior convertible offering that kept
issuing stock any time it got neat $2. I
proposed the firm raise $3m to buy out the convert holders – thinking the stock
could go to $3 or $4. It
went to $46, and then back down to $1. Yes,
lots of people made lots of money – and then gave much of it back.

NX
Networks (NTRX)
– another late 90s round trip success story. At the height of
the internet, with Sycamore and Juniper chasing Cisco, this networker ran from
under $2 to $30 – and then back down to zero.

Ampex
(AMPX)
the company that invented the VCR, had a big portfiolio of technology
patents. They proved to a court that the digital cameras essentially used the
same technology that put images on tape. The stock was about $5 when the first
major settlement was announced, and on that news, I was a buyer between $5-
$15. The stock subsequently ran up to ~$55 – before plummeting back to $16.

Burst
(BRST)
Long story short: I looked over
this tech company as a favor to a friend (who owned too much too high) when its
stock was in free fall in 2000. Bottom line: Loved the technology, hated the
management. I told the founder to fire the CEO, get a new business model, and BTW,
everyone is stealing your IP. I joined the Board of Directors when the stock
was 3 cents, and helped to convince the firm to pursue a patent claim against Microsoft. The settlement in 2005 was
for $60 million. The stock ran to over $3. The company issued a one time
special dividend of ninety cents. It’s
about a $1 and change today.

 

Those four were the winners –
and in every instance, the stock eventually came down precipitously. Microcap losers look the same – they go
pretty close to zero – only with out the spectacular run up first.

Final thoughts:

When I do make a micro-cap recommendation, my
disclosures will include the following:

Ownership: If
a special situation comes along, I expect to 1) own it personally; 2) own it in
managed accounts I run; 3) own it in the fund. Yes, we eat our own cooking around here.

Pay for Play: Never. It may be borderline
legal, but its totally unethical in my book. I had a boss some years ago who was dying to
capture $25k plus in fees for each report he wanted me to write (I refused, and then quit a few weeks later). I
thought the guy was a criminal – and from what I hear, he’s under NASD/SEC
investigation. Can’t say I’m surprised.

More next week — including the macro housing piece I promised a week ago . . .

-Barry Ritholtz
September 8, 2006

Category: Investing, Psychology, RR&A, Trading

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

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