I would imagine it’s dangerous and scary to lower yourself into the sewer. I certainly know I wouldn’t want to go down there.

When it comes to investing in low priced and low market capitalization stocks, you are essentially lowering yourself into the sewer.

It is worth it to find “hidden gems”, but you have to be extra careful…it can be nasty down there!

I’ve done exactly that!

My investment strategy to grow my taxable (non-retirement) investments has been entirely with lower-priced (under $5) and lower market-cap (under $500 million) stocks. I decided to only search for investments in this nasty world because my goal was to grow my investments as quickly as I could, while taking minimal risks (to me anyway), because the company I select has to be financially stable, with hardly any debt, growing sales and a solid business plan.

If you find a company that is lower-priced, lower-market cap AND also profitable, financially stable, with a solid growth path in front of it…you will likely be rewarded over the longer term.

However, it is difficult to find companies in this low-price, low-cap world that fit that bill. Many investors and traders get sucked into this “penny stock”, low capitalization world because there is the chance for higher returns.

Since so many of these low price, low cap stocks sh*ty, horrible companies, barely clinging to life, you have to watch your back.

Just for some cold, hard proof, I actually ran the numbers

I did some stock screens, showing the differences between low-price and low market-cap stocks using some basic measures like profitability, return on equity and operating margins, against higher-priced, higher market capitalization stocks.

The results are eye opening.

Here is a table highlighting stocks Under $5 a share

A common definition for a Penny Stock is a share price that is under five dollars ($5). I’m being conservative with this table though…some consider a penny stock to be when prices are $1 or less.

In any case, I ran my screen using 3 very basic fundamental ratios:

• Positive P/E ratio – This ratio is simply price per share divided by earnings per share. If a company made money…actually had earnings, the ratio would be positive – or zero and above. If a company has no earnings and didn’t make a profit, it can’t have a positive ratio (ie: had a loss).
• Positive Return on Equity (ROE) – Return on Equity is taking all assets and subtracting all liabilities, ROE can also be thought of as a return on assets minus liabilities. This measures many dollars of profit are generated for each dollar of shareholder’s equity.
• Positive Operating margin – This is calculated by dividing a company’s operating income by its net sales. Higher ratios are typically better, which shows the company is efficient in its operations and is good at turning sales into profits. 

You can see in the table above, the percentage differences across the ratios between each of the 3 fundamental measures, sorted between stocks above $5 and stocks below $5.

Clearly, you can see that that stocks above $5/share are about twice as “good” when compared to those under $5/share.

Let’s take a look at low market-cap stocks…under $2 billion in total capitalization

Market capitalization is simply taking the number of shares outstanding and multiplying it by the price. This is a simple way to determine the “size” of a company. Companies are typically considered small when they are under $2 billion in market cap.

Again, the numbers are clear…the smaller the company, the worse the ratio!

Now – take a look at when I filtered stocks that were both under $5/share AND had a total market cap of $2 billion or less.

Ughh, right?

Look at the P/E ratio…only 16.25% of the stocks actually had earnings!

Stocks over $2 billion and over $5/share were 4 times more likely to have a positive P/E ratio (65.58% divided by 16.25%) compared to the bottom-dwellers.

Look at the Operating Margin…only 15% of the stocks actually had positive operating margins!

The lower you go in price and market-capitalization, the lower the “quality” of the company.

Common risks when searching for investments down in the sewer

I want to highlight some major areas to be aware of when searching for investments down here in the sewer.

Pump & Dump Scams

When you are buying a low-priced stock, there is a risk that it could be susceptible to a pump and dump. This is when “the bad guys” buy shares of a sleepy and typically horrible business quietly, without moving the price. Then they go all out and promote the stock, spreading false hope. The price moves sharply higher, bringing in suckers and then the cheap shares they purchased (or were given to promote the stock) gets unloaded on the poor suckers. Invariably the share price collapses, typically back to where it started.

Low priced and low market cap stocks are much easier to manipulate like this. You can’t do this type of thing with larger companies.

Promotion masquerading as research

Often, you will see research reports and news articles that are glowing with positivity. Sometimes they can appear more measured and balanced, but still quite positive. Look carefully at the bottom of the “article” or “research piece” though, because the fine print can typically say something about receiving cash or shares in the company they are promoting…typically by the very same company they write so glowingly about.

You might not even see a disclosure statement…there might be no clear connection tying the two companies together, but that doesn’t mean it isn’t there.

You have to dig.

Poor management

Often the people running these lower-tier companies are horrible managers. It could have been the founder, who created a brilliant product or technology…but is horrible at running an actual company.

Contrast that to the typical CEO of a large, Fortune 500 company. No doubt the credentials of the leader of a small company can’t hold a candle to the leader of a huge company. Compare Steve Jobs, Jamie Dimon of JPMorgan Chase, Satya Nadella of Microsoft or Elon Musk, to a bumbling CEO of a small company who thinks they are a pro…in their own mind.

Sometimes, management within these small companies often push the limits of what is acceptable business practices and still worse… some are outright criminals, lying about their business.

An outrageous and famous example of this was a gold mining company called Bre-X. They claimed to have discovered over 70 million ounces of gold at a site they owned in the jungles of Indonesia. The share price went from $1 Canadian Dollar to $290 and the company was briefly valued at over $6 Billion!

It turned out to be completely false…fabricated. The gold drilling samples had been “salted” with gold shaved from jewelry.

Horrible financials

You saw from my tables above how ugly the numbers of smaller-sized companies are when compared to their larger brethren. It is very rare to find a well-managed, high growth smaller company that has solid financials.

Often, I look at a balance sheet, income or cash flow statement of one of these train-wrecks and wonder why they just aren’t put out of their own misery. It is typical to see a loss, year after year after year. You see debt or equity raises (stock share printing), piling up higher, year after year!

That brings up a good point…how do some of these bottom-dwellers survive?

Printing shares

Yep, management just uses the poor shareholders as their own piggy bank, going back to the stock market again and again, selling new shares to fund their operations. Here is where it pays to look at the cash-flow statement, which tells us how a company is funding their operations.

The cash flow statement is divided into three sections: operating, investing, and financing activities.

A company should be primarily funding their operations from operating activities…that is – selling their products and services at a profit, generating cash. The lower you go in price and market cap, searching for a good investment, the more you see hardly any meaningful cash flow from operating activities and much more from financing activities.

These are the types of transactions that belong in the financing section of a cash flow statement.

• Issuance of equity
• Repayment of equity
• Payment of dividends
• Issuance of debt
• Repayment of debt

If you see a huge percentage of the cash flow statement dominated by issuance of equity and debt…run.

Which brings me to another point.

At first glance, a company might have a ton of cash in the bank and hardly any debt. It will show up in the results of a stock screen that is set for great financial stability ratios, like debt/equity, or cash/liability…only to discover that the way they got all of that cash in the bank is by issuing shares.

You will typically see this with biotech companies. That is one of several reasons why I don’t muck around with biotech’s. I have seen year after year of share printing with companies continuing to fund their operations by printing shares.

Also, these types of companies likely will have a “going concern” statement on their financials from their independent financial auditors. This means they don’t have the ability to fund their operations for the next twelve months unless they resort to issuing more debt and equity.

You will also see that they have done reverse splits in the past as well…to reduce the number of outstanding shares and to meet the minimum bid requirements of the stock exchanges they are listed on.

Here in the U.S., the OTC market displays a skull & crossbones symbol next to a stock under it’s “Caveat Emptor” (buyer beware) policy. This is enforced when a stock engages in practices that are warning signs to an investor…like reverse splits and a going concern statement on their financials.

Bottom line…dig deep into the financials when you are down here with me in the sewer. 🙂

The opportunity is there, dig through the muck to find it!

When I run my screens and then dig deep when researching potential low cap or low priced investments, I don’t find that many stocks to invest in…which is good!

I’m only looking for those stocks that meet my criteria.

However, when I find one, I buy with confidence. Sometimes it feels like I see a pile of cash over in the corner (in the future) and to get it, I can just walk over with my wheelbarrow and load it up.

When investing in stocks down there in the sewer, you have to use your head, limit your emotions and most importantly….

Hold your nose!

Glenn